Redefining defined benefit plans to meet challenges, improve exits

Like their for-profit counterparts, higher education institutions are doing away with overly generous defined benefit plans to make them more affordable and less risky. They are seeking the best approaches to do so, mainly freezing their pension plans with the ultimate goal of terminating them. 

Higher ed defined benefit plansAfter a lofty start, plans are being reeled in Changing plans is possibly more difficult in the higher education community than in other industries, since the cultural norm has been a standard of great retirement benefits focusing on active income replacement payouts. It is still generally believed a viable leveling of the playing field with corporate America, a way to be competitive with for-profit organizations on a total compensation basis. Defined benefit plans have offered institutions an opportunity to recruit, retain and reward top talent. They gained momentum in the 1980s and continued to be a wise strategy during the 1990s, when the stock market yielded favorable results and provided growth to plan assets, helping to drive up plans’ funded statuses. This minimized the need for significant contributions from plan sponsors and created a sense of security for participants and plan sponsors alike. With limited cash outflow for institutions, it was a bit of a back-burner topic for many boards and executive teams.

Moving through the 2000s, a series of events unfolded as a perfect storm. The bubble burst, stock market performance precipitously declined and interest rates were extremely low, resulting in the decline of plan financial results, thus forcing a significant increase in plan funding obligations due to regulatory requirements and basic long-term funding expectations. This was compounded by the federal government revising pension plan funding requirements, as well as the FASB issuing revised standards that updated the method for plan sponsors to calculate and report plan assets and corresponding liabilities. In the years since, many plans have experienced volatile results due to fluctuating short-term interest rates and large swings in the investment returns of the plan assets. The fiduciary and fiscal responsibilities for plan sponsors administering defined benefit plans were decidedly affected and significantly heightened through the years.

For-profit organizations and higher education institutions alike are carefully re-examining retirement options afforded their employees. With fiscal stewardship at the forefront, more institutions are deciding to close their defined benefit plans to new entrants or freeze the plan’s accrued benefits. They often couple such a change with the introduction of defined contribution plans as an alternative or replacement vehicle. Defined benefit pension plans continue to evolve and shut down as a sole choice for pension funding.

Changes must balance talent attraction, fiscal reality It is clear that with the combination of adverse and ever-changing markets and continued low interest rates, many plans are extremely underfunded. For-profit organizations have acted quickly to manage the risk of sponsorship by either transitioning plan designs to a defined contribution approach or implementing comprehensive governance structures to manage risks and keep the plan compliant. Higher education institutions have had no choice but to follow suit, with each institution making choices about financially responsible changes that will yet maintain an advantage in the competition for talent.

The varied approaches all coalesce around consistent themes ― managing risk, improving funded status and reducing volatility. The IRS- and FASB-prescribed methods for determining discount rates focus on fairly short-term rates, which recently have been at historic lows and resulted in much higher plan liabilities. Observed and projected increases in life expectancies are additional factors for heightened liabilities, with pensions paid for a longer period of time than originally anticipated. In defined benefit plans, these significant risks are borne solely by the plan sponsors. Even with closing or freezing plans and employing new strategies to mitigate investment risk, plan sponsors must consider interest (discount) rate risk and mortality (longevity) risk, which are essentially outside of their control. As a result, there has been an across-the-board rise in obligation-focused investing strategies, tying the asset mix to obligation maturity. Lump sum distributions and annuity buyouts are also appearing more frequently.

As your institution contemplates termination strategies, keep in mind these key points:

  • Cost of the termination ― Typically, interest rates used to determine termination liability are lower than those used for funding and accounting requirements, which can result in a liability higher than expected. Plan sponsors should not be caught off guard if the assessment of different scenarios includes significant required cash flow expectations, which can be heavily influenced by this approach. Understanding these scenarios can help to drive budgeting discussions and board member education around the potential impact.
  • Time horizon to termination ― Full funding on a termination basis is heavily dependent on the difference between the plan assets and potential termination liability. Depending on the plan sponsor’s cash requirements, the magnitude of this difference will likely influence how long it will take to attain a fully funded status. Therefore, in addition to the assessment of the plan liabilities and funding scenarios, a carefully prepared company/organization cash flow, performance analysis and reserve review should accompany this decision-making process.
  • Funding strategies ― The choice is to fund the minimum under the Pension Protection Act rules or contribute at a higher level to attain full funding sooner. While the opportunity to meet the minimum funding standards is available, it is important to have a reasoned discussion relative to the long-term implications for this approach, even when the plan is well-funded or at least reporting to be “well-funded” under reduced standards.
  • Asset allocation ― Investment strategies for assets in a plan can be aggressive in hopes that earnings will help close the funding gap, or conservative to avoid possible losses that will widen the gap. Therefore, the asset allocation determination process when the objective is to sustain the plan indefinitely may be vastly different than a plan that is considering one of the termination or freezing scenarios. It is critical to adjust your investment allocations and strategies to align with the overall plan objective.
  • Risk management during termination ― Particular attention should be paid to potential accounting implications, strict PBGC filing requirements and time frames. The decision-making process benefits from the inclusion of a larger cohort of colleagues and subject matter experts with specialized knowledge of not just benefit plans, but also potential regulatory, legal and financial reporting issues, as well as ongoing administration concerns.
  • Communication with plan participants ― Communication must be transparent and constant throughout the process. In addition, the approach and language should be crafted carefully to mitigate HR issues. A best practice is including a marketing or communication expert on the team.

  • The reality is that the majority of frozen defined benefit plans will ultimately terminate. A carefully planned and coordinated effort will provide your institution with the greatest success and ideally, the lowest cost.

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