Mercer: Pension Plans Reach a Tipping Point

As the $3 trillion defined benefit pension fund market faces a stubborn deficit situation that is not being alleviated by stronger cash flows and a bull market, more funds are opting for participant annuities, giving participants defined benefits plan benefits as a cash-out option, or outright plan terminations, according to a new report by Mercer.

The report, “DB Pensions and the Emergence of the Big Bang Theory,” written by Mercer partner Richard McEvoy, found that this trend will become more apparent in the next decade or so.

Initially, McEvoy said more plans thought their deficit situations would be helped by stronger cash flows and rising markets, but persistent low interest rates have  not resulted in decreased pension underfunding. Instead, corporations have used the stronger cash flows to engage in stock buybacks and distribute larger dividends, as pension plans faced ever-increasing funding shortfalls that were “range-bound” despite gains in the bull market, McEvoy said.

As a result, pension funds have made minimal contributions as mandated by the Pension Benefit Guarantee Corporation (PBGC) and essentially have followed a plan of “can-kicking of minimum funding requirements,” he said.

But McEvoy identified a growing trend for plans to engage in “de-risking” (adopting less risky investment strategies or offloading an entire pension plan to an insurance company) and bulk annuity buy-outs that he says is now in its infancy. “Over the next five  to 10 years, we expect to see a shakeout in the corporate pension market, with substantial outflows to insurance and household balance sheets in the forms of annuities written by insurers and participants taking their DB benefit as a cash option,” McEvoy wrote. An estimated 30% to 40% of all pension plans now are frozen, and that number is increasing, he said.

In an interview, McEvoy said a number of global events will accelerate these changes as plans have already gone through a de-risking trend comprised of risk transfers. But these efforts have fallen short of meeting pension prefunding levels, so plans are opting to shift that risk to participants.

“Against this backdrop, we see a tipping point on pension pre-funding that will , in turn, drive (or be driven by) pension risk transfer opportunities,” he wrote.  But many plans will continue to do nothing and hope for a bull market to boost corporate funding levels. And for frozen pension plans, he recommended that this may be a “very smart” time now to voluntary terminate these plans. 

What’s Driving this Trend

McEvoy identified six factors as driving this trend:

• A four-fold increase in the pre-participant and variable-rate (“deficit tax”) participant PBGC premiums
• The attraction of getting a corporate tax deduction due to pre-funding
• If a proposed tax is approved to repatriate cash from overseas, plans could use that inflow to fund frozen plans, so they can be terminated
• Plans sponsors are suffering from “volatility fatigue” as they have waited for rising rates to solve their underfunding problems. This has led more plans to seek a different strategy than one dependent on rising rates
• A more selective insurance market that is carefully considering the packaging of benefits offered to vested and terminated plan participants. This gives corporations that want to end their pensions a “first-mover advantage” in terms of pricing with insurance companies as more corporations eventually use insurance companies to provide deferred benefits to a larger market
• Dealing with a more complex market that includes everything from longer life expectancy assumptions to ever-changing regulatory oversight

On a brighter note, McEvoy said that while the shift from defined benefit to defined contribution plans is part of a sea change affecting employer-employee relationships, some corporations are attempting to improve plan transparency and reduce fees in their DC plans. This is being done by improving the financial education of employees, accompanied by teaching employees that they will have to become more responsible for their long-term financial futures.