Employers sponsoring defined benefit (DB) plans have a lot to consider this year. While many things remain unknown, like market volatility and interest rate uncertainty, there are several strategies that can help them manage costs and maintain the plan’s funded status.
Asking three important questions can help plan sponsors assess the current state of the plan and better prepare for the future.
1. Should we offer a lump sum window in our pension plan?
The increase in bond rates during 2022 means lump sum conversions of traditional pension benefits were significantly lower—25-50% lower compared to recent years. This presents an opportunity for plan sponsors to move more participants out at more favorable prices to help shrink their balance sheet liability and reduce Pension Benefit Guaranty Corporation (PBGC) premiums. Since rates have fallen from their peak in October 2022, many retirement plans can experience financial gains as lump sums are paid out.
While this may be an opportunity for plan sponsors to offload risk and cost at a reasonable price, it’s likely that fewer participants may choose to accept the smaller benefit payments. Plan sponsors will want to consider the potential for lower take up rates as they design their programs.
Offering a lump sum window may provide an opportunity for plan sponsors to reduce risk and cost at a reasonable price in 2023.
2. Is it time to consider a change in investment strategy?
Financial markets are in unfamiliar and unsure territory in 2023: Equity forecasts are pessimistic, inflation is high, and interest rates are uncertain. Last year was marked by historic losses in many asset classes, which were matched by equally large reductions in plan liabilities that resulted in little net change in many plans’ balance sheet positions.
While it may be tempting to wait for assets to recover before reducing risk, a net return perspective suggests this may be the year to reduce risk though a liability-driven investment (LDI) strategy, even if it means selling assets at relatively low prices.
Today’s new challenging investment risk environment appears to call for a review of investment strategy.
3. When is the right time to move towards a liability-driven investment strategy to improve funding?
Equity and bond rate volatility may make it difficult for plan sponsors to determine when to move away from a successful return-seeking strategy to a more conservative allocation to help reduce risk. A poorly timed shift in strategy could mean missing out on a stock market rally or suffering gross losses on long bonds, should rates continue to rise.
Interest rates and equity returns play critical roles in the market value funding position of pension plans. Understanding the four phases of defined benefit economics can help plan sponsors make informed decisions on their way to LDI.
| Four phases of defined benefit economics | Expected impact on market value funding position | Why |
|---|---|---|
| Accommodation | Neutral | Access to government money drives stocks up and rates down |
| Flight to quality | Negative | Fear drives both stocks and bond rates down |
| Inflation and tightening | Neutral | Rising rates lead to dropping stock prices |
| Economic confidence | Positive | Growth causes both stocks and rates to rise |
Volatility makes it difficult to determine when to move away from a successful return-seeking strategy to a more conservative allocation. Understanding the four phases of defined benefit economics can help plan sponsors time the jump.
What's next?
By asking these three questions, plan sponsors can start to navigate some of the challenges ahead for defined benefit plans. Explore Principal® Complete Pension Solution to learn more about how we can provide customizable solutions to help plan sponsors address their biggest challenges.
