In our latest episode, Elliot Dinkin, president and CEO of Cowden Associates in Pittsburgh, joins us to discuss the current state of defined benefit plans, where they stand in the short and long term, and employee benefit plan derisking strategies.

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By: Jim DeLuccia, Manager, Learning Content

Podcast Transcript

Elliot Dinkin, president and CEO of Cowden Associates in Pittsburgh, joins us on the phone today to discuss the state and future of defined benefit plans, strategies companies can implement to “de-risk” these plans, and much more.

What is the state of defined benefit plans today?

[Dinkin] Nobody's starting new defined benefit pension plans any longer and they've kind of fallen out of favor. However, what I do is we kind of look at it as three different types of categories of pension plans. There are employers who still very much believe in defined benefit pension plans and are continuing to maintain them either because they want to or they may have collective bargaining negotiations. They still believe that's a good thing.

There are others who have frozen their pension plans, meaning that either no new entrants are coming in, but others are still accruing service, or they've frozen it altogether and aren't sure what to do with those plans.

The third category is really those who have said, "Look, we're out of the pension business and we want to exit it as soon as possible. We just are sort of waiting for the right time to do that."

So I classify them in those three buckets.

In your opinion, what does the future look like for defined benefit plans? I'm talking short-term and long-term.

[Dinkin] I think in the short term, we'll still see a lot of this. In between long-term, I would imagine that this trend will continue and I'll certainly ... if and when rates ever returned to a different level, meaning that as the rates go up and the liabilities go down, you might see even a bigger push to get rid of these frozen defined benefit plans. So, in the short term, maybe a little bit more status quo. Longer-term, meaning maybe over the next five to 10 plus years, dependent on interest rates and market and other priorities of businesses, a simple termination of those plans would likely occur.

What does it mean to de-risk a plan?

[Dinkin] On a de-risking concept, what you're doing here is basically saying, "What I want to do is try to take away or try to take out of the equation the volatility that's occurring in my pension plan today because of changes in discount rates, market performance, surprises on my balance sheet. I get surprises on my P&L and I get surprises on my cashflow."

So, what I want to do is put a strategy in to take as much of that risk out as I can. Because what I'm trying to do here is eliminate what I call retiree debt. By doing de-risking, what I'm doing is trying to take off the table some components of risks that are inherent my plans today without having to terminate the entire plan. Because a lot of plan sponsors look at this and go, "Well, we can't do anything about it because it's such a big nut to crack. I'd have to put in too much cash. It's a big P&L charge, it affects my balance sheet, I don't want to do it."

But the de-risking really says you need to look at this in a series of tranches, and we could talk about what that means, but the idea here is to take the risk away as much as you can.

What are a few de-risking strategies you would recommend?

[Dinkin] Let me talk about managing a pension plan like a separate line of business. If you think of a pension plan today, there's a lot of people who touch it. You have treasury folks who are handling it maybe from an investment perspective. You have accounting, you have HR, you have legal counsel, you have external actuaries. You've got a whole bunch of people managing it, and if I don't think of it like a separate line of business, like I would manage any other business with budgets and forecasts and assign responsibilities, it just kind of sits out there and surprises me at the wrong time.

I think of a frozen pension plan like a discontinued operation. It's sitting out there in my backyard, it might be like a wasting/EPA site, if you will. If I don't manage that properly, it seeps into my operations and causes me problems. So I really want to be proactive in managing it that way. And by the way, the accounting rules kind of look at that as well. They say, from now I record above the line as part of my regular operations, my normal service costs associated with the pension plan. If my plan is frozen, I don't really have an ongoing service cost. Everything else is below the line. This is all these unamortized gains and losses, prior service costs, whatever, all that sort of shifted below and I'm capturing it that way anyway from an accounting perspective.

I'm setting that up as a plan. Once I have an understanding of that separate line of business. What I mean by that is I look at my pension plan in three categories of people: current retirees, these are people who had retired or collecting a pension; deferred vested retirement, these are people who have left the company and are just waiting until they reach a magic age to get their benefit; and then I have current actives, whether they're earning service or not. I can't do anything with current actives really until either I delay leave or I terminate the plan. If I look at my risks in those components, I can take into certain strategies whether the plan is frozen or not.

One of the de-risking strategies that makes a lot of sense is offering voluntary lump-sum windows. What I would do there is say to both current retirees, which now I'm allowed to offer them as well, as well as deferred vesteds, I write them a letter and I say, "You have a choice today if you want. Again it's completely voluntary, to take an immediate lump sum. And if you don't, you don't, we will pay you the regular elected amount or the normal form of benefits."

The reason why I would do that is historically the rates that are used on lump sums have been more favorable than my ongoing value evaluation rate for either funding and or financial statements. From that perspective, that's why I would want to do it. Again, the idea here is saying I have this retiree debt and that might be a good way to do that. As for that option, however, they have to then factor in a couple things that are worth considering.

One is the impact from an accounting perspective, the so-called settlement charges. Basically if the lump sums hit a certain level, which is in fact tied service cost and interest cost, that triggers a settlement charge. Basically what the settlement charge looks at is the percentage reduction in my liability and I take that percentage and I multiply that by any unrecognized losses. That gets recognized immediately for P&L purposes, and some companies who are looking at earnings per share or whatever don't like those. Again, even though it's below the line and non-cash, they don't like them, so they manage toward that.

But the concept here really is to figure out these buckets of risk and these buckets of liability and how to better manage them. Keeping in mind here from a strategy is I can never invest my way out of this problem. I'll never earn enough to eclipse the growth of my liabilities. It's just not going to happen. The days of earning 20% or 30% or whatever per year aren't going to happen. If you think of it also, if you take too risky of an approach and you lose, those losses get baked into my expense and my liability as well. I have to manage that accordingly.

The other de-risking, as I mentioned briefly before, was looking at purchasing non-participating annuity contracts with a qualified insurance company. This is an undertaking that's been going on for some time, mainly with current retirees. You’re paying an insurance company, a qualified insurance company, to assume that risk and you're saying it's going to cost me X. Why would I do that again? Because I'm eliminating retiree debt and, like any debt, I manage it accordingly, and certain debts have a premium associated with it. Those are the two most prominent de-risking strategies that work and have worked and are used quite a bit.

How do annuity purchases factor into DB plans?

[Dinkin] If you think of it today, I have a group of retirees and let's say I'm entitled to a monthly pension benefit of $1,000 a month. As a pension plan today, that person is 68 years old, I continue to make that payment and the liability can go up and down on that amount based on interest rate changes. And don't forget I have mortality risk and everything else. What I'm doing is I figure out the present value of that amount using both the required assumptions for funding as well as my P&L and balance sheet, and I compare that to the purchase price of an annuity. The purchase price of annuity in an insurance company basically says they look at the risk of that population, that individual, they use certain interest rate assumptions, certain dual mortality, and they say, "Well, for that person that's going to cost you X, you need to cut me a check for X." What I'm thinking of there is I compare that amount to both the funding liability and the accounting liability and I may have a gain or I may have a loss.

From a funding perspective that loss then gets amortized over the future. So let's say it's going to get amortized over the next seven years, give or take, and I may decide that that's a reasonable trade-off for me to undertake if I have a loss or I have a gain. For accounting purposes, what happens is forget the settlement charge item. Over and above that, those accounting losses, the difference between, or accounting gains if you will, they get put into an accounting bucket under the gain/loss amortization. Depending on where that is from a quarter roll will determine whether or not that gets recognized into expense today, sometime in the future, or never, depending on the corridor rules under the accounting standards. That's all part of this analysis that you would say pros and cons of each action. What's the consequences of this? What else happens? That is part of the whole decision.

The other item on the de-risking, on the annuity purchases, is there a fiduciary obligation on the trustees of the plan. There's a rule that basically says that you have to choose the highest qualified provider of annuities at the optimal price, and they really have to be in this line of business. So you have to go through a search, and the idea is it's a process of a bidding. They have to be qualified in this business. They have to have the right manpower to handle this administration. They have to be highly rated and actually have to be at the lowest price or the best price given that combination. That's all part of this de-risking strategy that you would go through.

What would annuity purchases mean for employers and employees?

[Dinkin] Well, from an employer perspective, that I no longer have a risk at all for those individuals. They're off the plan’s records. I have no trailing obligation. I'm done at that point. I've cut a check and the insurance company steps in my shoes. That's really why I would do it is because I'm, extinguishing, for lack of a better word, that retiree debt.

From a retiree's perspective, what do I have today and my pension plan? I have the plan sponsor’s guarantee and under the rules I have what's called the pension benefit guarantee, a guarantee up to a certain limit. In other words, once you, if you're under that limit, then you get the guaranteed benefit. If I transfer that risk to an insurance company, I don't have that kind of pension benefit guarantee corporation risk any longer. You're now really on the ability of that insurance company to stay in business. That's why it has to be highly rated because you want to make sure that you're making a good decision. But from an employee, a retiree perspective, that is the only other trade-off that you're giving up, if you will, that you don't have that pension benefit guarantee sort of oversight or protection there for you.

There hasn't really been an insurance company that's failed in a very, very long time. Even when it did back in the early 1980s, the other insurance company stepped in. So, I'm not saying that could never happen, but the likelihood of an insurance company really failing is fairly remote. But that is part of my fiduciary duty, to shop that around so I don't have that risk coming back into my lap down the road, or at least I could demonstrate that I did it properly from a search perspective.

Where can one get more information on running defined benefit plans like a separate line of business?

[Dinkin] We have quite a bit on our website at www.cowdenassociates.com. Basically what we have is an analysis, and I’d be happy to share it with individuals who contact me about sample presentation, and really what this means and how to manage it, how to be proactive, how to do budgets and forecasting. What you're trying to do is to be in a position when things change to take advantage of a situation. Because if you wait until that happens and say, "Gee, we need to start thinking about this now because ABC happened," until you get all the data organized and all the information and all the analysis completed, that window may have been ... that opportunity may close pretty quickly. The idea of doing these forecasts and this analysis on a rolling basis is to say, "Hey, this happened. We could take this strategy now and let's move accordingly."

That's why, just like you would in any other line of business, if you approach this large liability that's on your financial statements in that manner, that would give you the best chance of succeeding. Our website has a fair amount of information on it, articles, and my contact information is there as well.