Case study: Plan testing during a mid-year amendment
How does a complex pension plan not only pass nondiscrimination testing but also pass this testing in the future?
A publically owned client in the finance sector asked Milliman to prepare a strategic and practical strategy to assist their officers with de-risking their defined benefit (DB) pension plan. The client is headquartered outside of the U.S. and reports financial results under IFRS International Accounting Standards (IAS19).
The client’s objective was to reduce their DB plan balance sheet footprint in order to make them more attractive for a potential sale. The DB plan has a legacy/grandfathered pension formula (based on final average pay and service) and a cash balance benefit for participants hired during the last 10 years.
The final average pay accruals were frozen several years ago, and include cost of living increases for certain participants upon retirement. The cash balance benefit includes the option for participants to elect a lump-sum distribution upon retirement. The DB plan assets were about $25 billion at the time the de-risking strategy commenced. Participants who had retired and commenced their annuities represented approximately $20 billion of the plan’s $30 billion total actuarial liabilities, also known as the PBO. The plan was about 83% funded on an accounting basis at the beginning of the fiscal year in which the de-risking took place.
Milliman consultants worked with the client to set achievable goals, understand their risk tolerance, and discuss different de-risking solutions.
Discussions began with Milliman explaining how the path to de-risking included a wide spectrum of options ranging from risk retention via modified plan design to third party risk transfer. Milliman also discussed the advantages and disadvantages including costs associated with several de-risking options. The client’s decision would be dependent on their risk tolerance (which they defined) and willingness to incur additional short-term costs (i.e., increased cash requirements and/or one-time profit and loss charges).
The least costly de-risking solutions generally start with risk retention options where the focus is more on plan design modifications. Costs escalate as one moves along the de-risking spectrum away from risk retention. A lump-sum window would generally be more costly relative to making a one-time plan design change. A third-party risk transfer such as an annuity purchase would generally require the largest cash commitment from a plan sponsor. Milliman reviewed all of these approaches with the client.
De-risking through plan design. Two-thirds of the DB plan’s PBO was attributable to current retired participants. Grandfathered active participants already had their benefits frozen and new entrants had cash balance accruals. Future accruals under the cash balance plan were already accruing at a diminished level (relative to final average pay accruals) and the client did not want to further lower participants’ accruals.
Offering a lump-sum window. The client inquired about a popular de-risking technique in which inactive participants would be offered an option to voluntarily cash out their benefits via a one-time lump-sum distribution (a.k.a. lump-sum window). Those participants with cash balance benefits were already able to commence their benefits via a lump sum and the client wanted to understand if this option could be made available to the legacy/grandfathered group. They mentioned that some of their competitors were considering this approach.
The client was hoping that this would allow for them to significantly reduce their retiree headcount and liability while achieving risk reduction as longevity risk (e.g., risk of participants living longer than expected based on actuarial mortality tables) would be transferred from the plan sponsor directly to the employee who elected a lump-sum benefit. After hearing the client’s thoughts and intentions, Milliman cited IRS guidance explaining that the lump-sum window could only be an option for terminated vested participants and not for retired participants. Under current IRS rules, a plan sponsor is not permitted to offer a lump-sum opportunity to retired participants who already commenced benefits.
Milliman further clarified that while the plan could be amended to offer lump sums to terminated vested participants in the legacy/grandfathered group, this approach may not be optimal given the cost considerations. Milliman examined the terminated vested data and found that a majority of the former employees had a cost of living multiplier associated with their accrued benefits. Milliman performed a numerical costs-benefits analysis for the lump-sum offering. The results of that analysis led the client to dismiss this alternative.
Purchasing annuities. The next option Milliman reviewed with the client involved purchasing annuities from a qualified insurance company for a select group of retirees. We constructed a matrix consisting of different grouping of retirees based on age and service categories alongside whether or not participants’ accrued benefits were cola-bearing. We also estimated annuity purchase costs for each of the cells in the matrix.
In addition, we analyzed the approximate effect on the employer’s financial statements under IAS19 for each annuity purchase scenario. While this option was one of the more costly de-risking options available given that third-party risk transfer was involved, it appeared to be a good fit considering the client’s risk tolerance and objectives.
Having reviewed the various retiree annuity purchase options presented by Milliman, the client settled on the retired block of participants with the smallest aggregate benefits that were not affected by cost of living multipliers. This group also tended to have characteristics of an older population. Having outlined the target retired group, Milliman on behalf of the client conducted a search of various qualified insurers willing to participate in the annuity purchase transaction. We used prudent selection criteria in accordance with Department of Labor guidelines to narrow down the participating insurance companies to one choice.
Milliman prepared settlement accounting estimates under IAS 19 for the employer’s financial statements. Milliman also prepared contribution funding projections for the client to illustrate the short-term volatility in the DB plan’s funded status and the expected rise in IRS minimum required contributions. Milliman made sure to make the client aware of the short-term costs associated with the de-risking transaction from both a cash and financial statement perspective.
The client was satisfied with Milliman’s consultative approach and the eventual outcome of having a smaller sized pension plan with less risk. They were comfortable with the costs based on the retired group selected. In spite of the upfront premium to execute the transaction, the client felt that the balance sheet came out looking better in the end. Having a reduced pension footprint would allow the client to be more favorably viewed by a potential buyer, thus allowing the client to meet their overall objective.