Defined-benefit (DB) pension de-risking: Balancing funding, costs and risk 

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February 1, 2023

Reducing defined benefit pension plan risk is a key challenge for all trustees and plan sponsors

Assessing and managing risk has always been a challenge for providers of defined benefit (DB) pension plans, whether it relates to investment returns, member longevity or the strength of the employer covenant. While securing the benefits of all plan members is the ultimate end-game for DB pensions, a range of factors, including volatility in global investment markets, growing life expectancy among scheme members and cyclical changes in employers’ funding positions, can have a profound impact on the scale of risk facing DB plan trustees.

Recent years have seen a significant growth in the number of innovative solutions enabling DB pensions not only to identify and assess the scale of such risks, but also to implement measures to manage and eliminate them – thereby strengthening the long term security of their members’ benefits.  

Industry innovation has been complemented by increasingly risk-orientated regulatory developments, where under the IORP Directive for example, European pension plans are now required to have a dedicated risk management function acting as a ‘second line of defense’ to complement the activities of the plan’s day-to-day management and governance. 

Identifying defined benefit pension plan risks

The core objective of any DB pension plan is to secure the payment of all members’ benefits in full and on time. As a DB pension provider, the key risk is therefore that of failing to achieve this objective, and the nature of plan risk management has been to balance the risk of failure against affordability constraints and broader financial management.

Historically, failure risk was not seen as a significant issue for most DB plans. Funding levels were generally healthy, employer covenants were strong, accounting and funding standards provided flexibility, and liabilities based on actuarial assumptions were relatively “affordable”.

Since the 1990s, several factors have ensured a higher profile for pension-related risk. Increases in life expectancy significantly extended the length of pension liabilities, while funding volatility, evolving accounting standards, employer insolvencies and regulatory developments all combined to bring de-risking options into sharper focus. 

The replacement of DB plans with defined contribution alternatives helped reduce short term costs for many employers, but did little to address the long term liability risk for DB plans as they matured, with fewer contributing members and growing proportions of their membership in retirement. Persistently low interest rates inflated liability valuations, prolonging the time period over which deficit contribution requirements and funding volatility have challenged plan stakeholders.  

Increasingly, the combined risks facing DB pension plans are being assessed more holistically, taking account of risks related to funding, investment and sponsor covenant. Given the unpredictable political and economic climate in which today’s DB plans operate, holistic risk management is more important than ever in enabling plans to act promptly to identify, manage and eliminate risk, and to secure members’ benefits.

Strategies to minimize defined benefit pension risks 

In view of the multiple risks facing them, the aim for DB pension plan providers has increasingly become to identify, and work towards, a clear outcome or endgame, to narrow the range of potential outcomes around progress towards that endgame, drawing on the range of available de-risking options. The extent to which this range can be narrowed can sometimes be limited however, whether through practicalities, affordability or member expectations, and achieving balance is key. 

In seeking to reduce funding volatility, for example, growing numbers of DB plans employ Liability Driven Investment (LDI) strategies, whereby assets are allocated to bonds or other liability hedging investments that address inflation or interest rate risks, rather than investing purely for growth. In some cases, plans have adopted cash flow matching strategies which enable them to match benefit payments to high-quality and sometimes less-liquid investments that distribute predictable income, thus avoiding forced selling of assets at times of market volatility.

Arguably the most significant risk facing DB plans in recent years has been longevity risk - with pension benefits in payment for longer periods than anticipated. A relatively recent innovation in this area is longevity hedging – an option that mitigates longevity risk whilst allowing the DB plan to retain the investment flexibility needed to continue closing any funding gap.

A longer-established option is a bulk annuity, also known as a buy-in or buy-out. This is a transaction between the trustee and an insurer through which, in return for a single premium payment, the insurer undertakes to meet the liabilities of an agreed proportion of the plan’s membership, ensuring that those members’ benefits continue to be paid on time and in full. This approach has seen a huge growth in activity over the past decade, often enabled by supporting short-term funding from sponsors who benefit from lower balance sheet risk. Increasingly, more affordable alternatives to buy-out have become available, but without the underpinning of insurance regulation, require particular care in assessing suitability to purpose.

De-risking can also involve the sharing of risk with individual DB plan members, particularly those at or approaching retirement and in return for an incentive. These can include:

  1. Enabling members to transfer cash sums out of their DB plan, for example to a personal retirement savings vehicle or DC plan;
  2. A pension increase exchange, under which a member receives a higher initial pension in return for foregoing subsequent pension increases.

Defining your de-risking approach 

Every DB plan is different and there is no single solution that fits all. Variations in funding position, covenant strength, size and member demographics can all influence a plan’s approach to eliminating unrewarded risk. But each plan should take into account a handful of core considerations in deciding its approach to de-risking:

Questions to ask yourself 

  • What is your endgame?
  • What is the timeframe for your long-term goal, and your appetite for risk over this timeframe?
  • Within what regulatory and accounting constraints are you operating?
  • How strong is your sponsor covenant and what levels of contribution can you expect for each year?
  • What is the required return on your investments if you are to meet your liabilities?
  • Which de-risking solution - or combination of solutions, will best help you to reach your endgame?

Whichever de-risking approach a DB plan takes, the first important step is to understand its risks in a holistic way. With a clear idea of the nature and scale of the risks faced, backed by an agreed endgame or objective, DB plans can choose from a wide and constantly evolving range of de-risking solutions to ensure the effective management of risk and ultimately, to ensure members’ benefits are paid in full and on time. For most, implementing an effective de-risking strategy is not a matter of if, but when.

Our pension risk consultants can help you identify your risks and put a strategy in place. This could include endgame planning, integrating risk management with funding improvement such that affordable de-risking glide paths are implemented, LDI, portfolio construction, risk transfer and strategies for stakeholder engagement. 

Andrew Ward
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