Practice Management
Should you de-risk your pension plan? A recent analysis takes on the matter in light of plan finances and factors present this year. 
In “Management of DB Finance 2023—a Framework,” October Three looks at de-risking in the context of defined benefit plan finance, as well as factors relevant in 2023, such as choosing between (1) a settlement or an ongoing liability driven investment (LDI) strategy, and (2) a lump-sum window or annuitization/risk transfer.
Correlating Risks
Plan sponsors that seek to pursue an LDI strategy need to correlate two risks, argues October Three: asset performance and liability performance. And 2023 is no different than any other year, they say, in that one will encounter and must consider fluctuations in asset performance, interest rates, and liability performance.
Stable years. In years in which interest rates change but other factors are largely static, they say, return seeking and LDI asset/liability portfolios generally should perform in a roughly similar manner.
“Interesting” years. Interest rates and the performance of assets not correlating result in years they call “interesting” years in which one of two situations may be the case:
Situation 1. Interest rates go down and asset values go down (or at least don’t go up “as much”). When interest rates go down, and liabilities therefore grow and are not offset by asset performance, October Three says, plan sponsors that follow a return-seeking DB plan finance strategy will have a difficult time.
Situation 2. Interest rates go up and asset values don’t go down (or don’t go down “as much”). When interest rates go up, and liabilities drop and that is not offset by asset performance, that would be a good year for plan sponsors to encounter a more positive environment for a return seeking DB plan finance strategy.
“Sweet spot” years. Sometimes, says the analysis, interest rates increase and the stock market does as well—and the most recent such year was 2021.
Good News
October Three says that the gains that resulted from 2021 being in a “sweet spot” have not disappeared. Instead, they report, the net funding gains consolidated in 2022; further, through spring of 2023 at least, those gains continued to hold.
In such a situation, says October Three, “many sponsors will at least want to consider “moving DB plan liabilities off the books.”
LDI or Settlement
Since inflation (1) appears to have hit a plateau and (2) some anticipate a long-run trend of falling interest rates, October Three says that many plan sponsors anticipate a greater risk of lower interest on the horizon.
Plan sponsors that are interested in hedging against such a circumstance likely would follow one of two basic types of DB finance interest rate hedging strategies:
1. LDI (in which plan assets are invested in duration-matched fixed income securities); and
2. Settlement either through payment of a lump sum or distribution of an annuity (also known as a pension risk transfer).
October Three outlines considerations regarding both strategies.
LDI. There is one principal advantage in pursuing an LDI strategy rather than a settlement, says October Three: LDI is not permanent. Through it, they observe, a plan sponsor can stabilize balance sheet volatility and still have the opportunity to change its mind about strategy.
Settlement. There are two advantages to pursuing the option of pursuing settlement:
1. Precision. Settlement is more precise than an LDI strategy, says October Three, since LDI will never perfectly match plan liabilities. To the extent the match is imperfect, they further say, some volatility will remain on the books. Settlement will remove the settled liabilities forever, at the specific cost of settlement (the cost of the annuity/lump sum).
2. Reduced overhead. DB liabilities that remain on the books will result in the sponsor having to continue paying annual Pension Benefit Guaranty Corporation premiums and administrative expenses. These per capita costs result in plan sponsors realizing the greatest return for settling the smallest benefits.
Lump Sum or Annuity
October Three outlines considerations regarding both strategies.
Lump sums. Lump sum windows are more labor intensive than annuity purchases, says October Three, and require a plan amendment and the preparation and processing of participant election forms. Benefit liabilities for plan participants are often much lower than retirees’ liabilities. Lump sum settlements, they note, track employer balance sheet liabilities closely.
Annuities. Settling for retired lives through a group annuity purchase from an insurer is the simplest settlement strategy plan sponsors can pursue, says October Three. For non-retired lives, insurer group annuity pricing is typically 125% of the balance sheet liability or higher.
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