Economic turbulence, demands for increased financial disclosure, changes in financial reporting and increased pension funding requirements are combining to make defined benefit pension plan risks more obvious, and requiring more proactive management by plan sponsors. Yet, an analysis of the funding policies of more than 250 defined benefit plans conducted by Mercer reveals that 27 percent fail to develop and then adhere to a formal, well-documented funding policy. Altogether, 51 percent of sponsors surveyed fund only the minimum amount required by law, either by default or intentionally.
“An effective pension funding policy helps an employer better manage the defined benefit pension plan’s financial risks, costs and returns, balancing a long-term view of funding and risk management with a blueprint for determining each year’s contribution,” said Bob Moreen, Mercer worldwide partner and global leader of Mercer's Financial Strategy Group. “The funding policy provides a context for the tactical decisions that plan sponsors make and establishes certain objectives – for example, whether to reduce year-to-year contribution volatility, minimize unwanted outcomes on the balance sheet or target a formal pension plan termination. Plan sponsors that have effective funding policies have put their risks in context and understand the potential consequences of all financial markets.”
By raising the minimum funding level to 100 percent of a pension plan’s target liability (up from 90 percent under prior law), the Pension Protection Act of 2006 (PPA) highlighted the need for plans to have an articulated funding policy. ERISA, the 1974 law governing pensions, has always required a written funding policy, which could be as simple as a statement of intent to fund the minimum required amount. The PPA now requires that each plan sponsor must provide participants with a written “annual funding notice” that includes a description of the plan’s funding policy along with the funded ratio.
Nearly one fourth (23 percent) of the plans surveyed by Mercer have implemented an explicit funding policy. Another 49 percent have an implicit funding policy; 24 percent fund the minimum, while 25 percent fund some other amount (such as the fiscal year pension cost, an amount to cover accrued accounting liabilities (ABO) or an amount to cover the projected accounting liabilities (PBO) to extinguish any balance sheet unfunded obligation). The remaining 27 percent are contributing the minimum as required by law but without benefit of an articulated policy.
“Plan sponsors should take a more strategic and proactive approach to pension funding,” said Mr. Moreen. “Contributing the minimum amount to a plan may well result in more volatile year-to-year contributions, particularly if sponsors want to avoid the funding levels that trigger various adverse consequences under the new law. The current financial environment is providing plan sponsors with their first ‘real time’ test of the consequences of adverse markets for minimum or trigger-avoiding contribution strategies. These turbulent economic conditions will underscore the need for stronger risk management, stress-testing of outcomes under a range of scenarios and adopting more proactive contribution and funding strategies.”
"We expect to see more formalized pension funding policies as employers see how volatile the minimum contribution is under the new funding rules,” said Mercer actuary and worldwide partner Elizabeth Dill. “Another influence could be passage of the stalled technical corrections bill for the PPA, sitting with Congress, which would permit plan sponsors to use a modest smoothing technique to value the assets in the pension trust. Unfortunately, it appears that this bill will not be considered until some time in 2009."
The survey also found:
*82 percent of plan sponsors value liabilities using the PPA “segmented” yield curve as the interest rate, as opposed to a full yield curve. The segmented yield curve results in expected lower year-over-year volatility in required contributions and greater predictability of discount rates, which facilitates more accurate budgeting. Mercer expects plans that strategically invest their assets to closely resemble their plan liabilities (e.g., liability driven investing) will want to use the full yield curve, and that more plan sponsors will use the full yield curve in the future.
*21 percent of plan sponsors surveyed said they intend to terminate the defined benefit plan if economic conditions are right. Among these, just one third have developed an exit strategy resulting in a formal termination of the plan.