In just a few years, the frozen pension plan sector has moved from being a footnote in the institutional investment story to a central plot point—a billion-dollar segment of the market in which some of the most rapid strategic development is occurring.
Every defined-benefit (DB) pension plan exists in one of three states. If it's an open plan, it continues to enroll new participants and benefits continue to accrue. If it's a closed plan, it is not enrolling new participants, but already-enrolled participants continue to accrue benefits. And if it's a frozen plan, not only does it not accept new participants, but no new benefits accrue. Figure 1, below, shows the proportion of U.S.-based defined-benefit pension plans that fall into each category; it's based on the latest reports available from the Pension Benefit Guaranty Corporation (PBGC), along with our estimate of pension plans' current position.
It's worth noting that there is some minor variation in how the concepts of open, closed, and frozen pension plans are applied in practice. The PBGC data shown in Figure 1, for example, defines a "closed plan" as either a plan that is closed to new entrants but continuing accruals, or else a plan in which benefit accruals are partially frozen.
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As Figure 1 illustrates, the proportion of U.S.-based plans that are frozen has grown dramatically over the past decade, and around 10 percent of all U.S.-based plans have been closed since 2008. This growth in popularity for closing and freezing pension plans has happened because many American corporations have chosen to move away from a defined-benefit plan toward the easier, more predictable defined-contribution model. As they have done so, their DB plans have not gone away—these plans will continue to exist for as long as there are assets to manage and benefits to be paid—but they have changed.
A frozen plan is different from an open plan, and it needs to be managed differently. One key difference is that a frozen plan has a finite life span. Even though that life span may be decades long, once a plan is frozen the plan sponsor should start working almost immediately toward the new end game. Freezing a plan shortens its investment time horizon, and the sponsor of a frozen plan should increase focus on marked-to-market asset and liability values, as well as on risk management. The longer a plan is frozen, the greater the distance between the sponsor's ongoing business operations and decisions around investing plan assets.
This is a rapidly changing sector of the investment world. In 2013 Russell Investments produced a handbook called "The Investment and Management of Frozen Pension Plans." Within 18 months, we already needed to update it to capture some important new developments: the emergence of the concept of hibernation, the growth in popularity of risk transfer, and the growing importance of PBGC premiums in plan decision-making.
Pension Plan Hibernation as a Strategy
Once a pension plan has been closed to new entrants or benefit accruals have been frozen, the plan starts to change. The typical lifecycle of a frozen plan is illustrated in Figure 2, below.
A frozen pension plan will go through a number of stages before it ceases to exist. For this reason, any risk transfer decision—whether to pay lump sums to plan participants, offer an annuity-based buyout, or (ultimately) completely terminate the plan—is in effect a decision about timing. Will the liabilities be met one monthly pension check at a time, or will they be met more quickly via a risk transfer? And if the plan does transfer risk, should it do so now or is it better to wait?
This is the context in which plan sponsors have started to use the word "hibernation" to refer to the decision to delay termination and keep running the plan within the corporate structure. In a loose sense, every frozen plan that has not been terminated is in hibernation. But in practice, hibernation really becomes significant when a plan sponsor makes a conscious decision to delay termination beyond the point at which it first becomes feasible. The plan sponsor weighs the costs and risks of terminating sooner versus those of terminating later and decides whether or not to hibernate, for now. Since termination costs vary over time, one benefit of hibernation is that it gives the plan sponsor control over the timing of the termination decision and the ability to wait for potentially favorable market conditions.
Risk Transfer Has Become Common
Pension plan risk transfer takes two primary forms. The plan may make lump-sum payments either to terminated vested plan participants—i.e., those who have left the company but have not yet started to receive a pension—or, less commonly, to current retirees. Alternatively, the plan may purchase annuity contracts from insurance companies, so that retirees receive their pension benefits in the form of ongoing annuity payments from the insurer.
Pension benefits can be paid as a lump sum only when the plan participant chooses (except in the case of de minimis benefits—if the lump sum benefit is below $1,000, the plan can cash out a participant without his or her consent). Since 2012, hundreds of U.S.-based companies' pension plans have undertaken programs to offer lump-sum cash-outs; typically between 30 percent and 70 percent of participants who are offered a lump sum take the offer. The total amount of money involved runs into the tens of billions of dollars.
Meanwhile, the market for annuity buyouts—which ran at around $1 billion a year from 2009 to 2011—exploded in 2012. First, GM announced a $26 billion deal, then Verizon Communications followed up with a $7.5 billion announcement. According to LIMRA, activity in 2013 totaled $3.8 billion, which would have made it seem a strong year prior to 2012. Then 2014 came in at $8.5 billion.
The incidence of risk transfer activity can be expected to ebb and flow as market conditions shift and change the attractiveness of both lump-sum programs and annuity purchases. Risk transfer compresses the lifecycle of a frozen plan, reducing the size of both assets and liabilities, decreasing the plan's footprint on the corporation, and bringing the plan one step closer to eventual termination.
How PBGC Premiums Affect Funding and Risk Transfer Decisions
Until recently, PBGC premiums were an unwelcome cost, but they were marginal. They were not a significant consideration in funding or risk transfer decisions. But both the Moving Ahead for Progress in the 21st Century Act of 2012 (MAP-21) and the Bipartisan Budget Act of 2013 increased PBGC premiums substantially (see Figure 3). As a result, PBGC premiums are now hard to ignore for plan sponsors making decisions about how much risk to retain.
The increase in variable-rate premiums creates an incentive for plan sponsors to accelerate contributions in order to pay down a shortfall. In effect, for as long as the shortfall exists in the plan, each marginal dollar that is retained in the corporate account suffers a penalty of almost 3 percent a year. Most CFOs like to have dry powder on their balance sheet, but 3 percent a year is a high price to pay for holding cash rather than improving the pension's funded status. In fact, even if a company does not have the requisite cash at hand, it may find that it would be cost-effective to borrow money in the capital markets in order to fund the pension plan.
The increased fixed-rate premium may likewise factor into some plan sponsors' decisions about pension plan management. Specifically, the potential savings of $64 a year per participant adds to the attractiveness of both lump sum payouts to participants and the purchase of annuity contracts.
From 2016 forward, the variable-rate PBGC premium will be capped at $500 per participant. For plans that are affected by this cap, the dynamics of the incentives created by PBGC premiums change significantly. In that case, the savings from reducing headcount within the plan would no longer be $64 a year per participant, but rather $564 a year. That's enough to demand attention from just about any CFO.
The Frozen Plan Segment Continues to Evolve
The number of U.S.-based pension plans that are frozen can be expected to continue growing. At the same time, the age of participants in plans that have been frozen in the past 20 years will also rise, and frozen plans will become ever more separate from the corporations that sponsor them. In light of these trends, we expect to see continued innovation and development in strategy and in best practices for managing frozen pension plans. These developments will be shaped by market conditions, changing attitudes, regulation, and competitive pressure.
The story of frozen pension plans is only just beginning.
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Bob Collie is chief research strategist in Russell Investments' Americas institutional business. Collie is responsible for the strategic advice delivered to the various parts of Russell Investments' institutional client base, as well as for working with the manager research team, product groups, and other research efforts across the company. He is also the lead author of the Fiduciary Matters blog.
James Gannon is managing director, asset allocation and risk management in Russell Investments' Americas institutional business. Gannon oversees the examination of pension plans from an actuarial perspective, and helps advisory and investment outsourcing clients reach an effective asset allocation decision by bringing together actuarial liabilities and available asset classes in a risk-reward framework.
Justin Owens is a senior asset allocation strategist for Russell Investments' Americas institutional business. As a subject matter expert on defined-benefit plans, Owens regularly publishes research covering a variety of topics related to risk management and investment strategy for DB plan sponsors.
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