Although General Motors Co. and Ford Motor Co. have reduced the risk of their pension plans through offering a lump-sum payment option to some plan participants, not all employers are in the financial position to immediately follow suit. Jason Richards, senior retirement consultant at Towers Watson & Co., gives suggestions on the small steps most employers can take now to prepare their organizations to take advantage of opportunities to minimize their pension plan risks when they are ready.

When General Motors Co. and Ford Motor Co. announced plans to reduce their pension plan risks by settling retiree obligations through lump sums and insurer annuities, you could almost hear wheels turning inside the heads of pension plan sponsors across the United States. The announcements of those unprecedented actions, and the two IRS private letter rulings that followed, focused laser-like attention on the opportunities and challenges of pension plan risk reduction.

For those two large employers with well-funded pension plans—both of whom carefully analyzed options and prepared in advance to take action—the tactics hold significant promise for reducing pension plan risk. But many plan sponsors can't take such dramatic action, at least not today, because of funded status, cash situation or other reasons.

Those who can't take immediate, sizeable steps today can gain traction by putting a risk management plan in place and by taking a series of smaller steps that will lead to reduced pension risk. These steps can gradually fill the funding gap and reduce risk over time as the plan's funding status improves, while preparing the organization to take advantage of opportunities to further reduce risk when they arise.

%%BREAK%%

Risk-growth culprits

The push to reduce risk has had a fairly simple impetus: Pension plan risk has grown to record levels.

On average, pension plans have grown larger, and so are complex and more costly to manage. Markets have become more volatile, and analysts and rating agencies are more sensitive to the financial risks associated with underfunded plans. New U.S. regulations require sponsors to more quickly recognize deficits and make contributions in response. This is exacerbated by the strong correlation between how the pension plan and the business perform.

But the prolonged period of low interest rates might be most culpable. Rates at historic lows have increased pension plans' liabilities and led to funding shortfalls. And there's less optimism that rates will rise in the near future. Hence, many plan sponsors are looking to better understand the options that are available to them in this environment and make decisions on when and how to take action.

Ready and able to minimize risk?

A plan's funded status is an important benchmark in any risk-management plan and largely determines whether the time is right to take action and what types of actions are appropriate. In general, sponsors need a strong funded status before they can effectively cut risk.

To fill a funding gap, a plan sponsor can manipulate three variables: time, cash and risk. In our work with sponsors, we've found that two of those three factors must take top priority and that strategies will differ among organizations. One sponsor's strategy to act quickly to eliminate a sizable amount of risk could threaten the organization's cash situation and operations budget. Another's strategy to reduce risk while conserving cash might mean that the funding gap will fill very slowly.

Options exist to improve this trade-off, such as borrowing to fund. That decision, which is a good one for some organizations, has much to do with timing. With interest rates low now, the borrowing cost is low as well. When interest rates begin to rise, plans' liabilities will drop but borrowing cost will go up. This is why borrowing to fund a pension plan can be somewhat interest-rate neutral.

Regardless of the approach taken, sponsors with underfunded plans must first determine how to fill this gap before they can take significant action to reduce pension risks.

%%BREAK%%

Immunize or settle to stabilize funding status

There are two routes to a more stable funded status: immunize or settle. When you immunize your plan, you adjust your investment strategy so that the plan's liabilities and assets move more in tandem through a liability-driven investment strategy. Then when interest rates move the plan liabilities up or down, asset values move in the right direction, and funded status becomes more stable.

Settlement vehicles (lump sum payments and annuity purchases) have drawn attention in recent months because of the immediate effect they can make. By settling liabilities, you can quickly shrink the size of your plan, and experience less vertigo when liability levels fluctuate.

Lump sum payments

Now that changes made by the Pension Protection Act are fully phased in, plan sponsors can pay out lump sums at high-quality corporate bond rates and get full risk-reduction plus elimination of future operating costs. No other instrument in the marketplace can match that. And there's a big opportunity with lump sums this year because of how the rules work. If you want to pay out lump sums in 2012, you'll calculate the sum using interest rates from 2011. With falling interest rates, this means you can pay out the liability at a rate higher than today's rate.

Lump-sum payments, though an excellent option for some plan sponsors, certainly aren't right for every organization. Some companies have valid reasons to avoid lump sum payments. For example, some employers philosophically prefer retirement annuity streams to a lump-sum payment. This is a reasonable perspective that moves what might be a black-and-white financial matter into shades of gray.

Annuity purchases

Annuity purchases can be a very effective stabilization option and annuities for retirees and can be a good choice today given available pricing in the marketplace. There's low demand along with a good supply—a market situation that could change quickly. I advise clients to be aware of these marketplace opportunities, so they can take advantage of opportunities that may exist.

There are some situations in which the case for annuity purchases isn't as strong. For example, annuities for deferred vested participants—who, in some cases, might reject lump sums—can be very expensive. Plan sponsors trying to stabilize a plan with a healthy funding status might be better off holding onto those liabilities rather than settling them.

Despite the moves by Ford and GM around retiree lump sums, the most popular approaches being considered today are lump sums for deferred vested employees and annuity purchases for retirees. The advantage of the former is cost (settled at or potentially below liability levels). The advantage of the latter is the ability to reduce more of the liability, given the large proportion of retiree liabilities in many plans and the fact that, while lump sums are voluntary and must be elected, annuity purchases require no such affirmative election by plan participants.

%%BREAK%%

The pressure's on

Whether through liability-driven investment strategies or settlement tactics, plan sponsors are feeling the pressure to cut risk, to a great extent because of large deficits. For example, for the 100 publicly traded U.S. plan sponsors that make up the Towers Watson Pension 100, the total pension deficit jumped from $173 billion at year-end 2010 to $260 billion at year-end 2011—a loss of $86 billion. The risks associated with large deficits can't be ignored.

As discussed, plan sponsors can take dramatic action to reduce risk significantly in one fell swoop, which requires a strong funded status or a large amount of cash. Or they can create a plan for filling the funding gap and reducing risk gradually as funding status improves. The strategy will differ among organizations and industries.

For example, health care organizations typically need to keep cash on hand for operations, so many are interested in borrowing to fund their pension plans. Their settlement options are limited because of how settlement affects financial ratios. Regulated utilities are very focused on cost predictability, so liability-driven investment strategies tend to be more appealing to utilities. Banks, too, might shy away from settlement, as they can be sensitive to one-time charges because of the effect it may have on capital ratios.

Prepare your plan now

Even with variances among industries, and factoring in the philosophical aspects of settlement decisions, preparation is key. Preparation permits sponsors to take action when opportunities arise and the price of execution is a cost that makes sense for their plan. We advise plan sponsors to make such preparation a fundamental part of their well-reasoned, risk-management plan. This leaves their business in a better position to meet organizational goals, whether those goals include continuing a defined benefit plan, focusing more on core operations or strengthening the bottom line.

Jason Richards is a senior consultant in the St. Louis office of Towers Watson & Co. He can be reached at 314-719-5848 or at jason.richards@towerswatson.com.