Pension plans experienced an incredible recovery in 2013 making pension risk transfer more feasible and less costly for plan sponsors. In addition, potential future developments could increase the cost to maintain pension plans as well as the cost to transfer pension liability, meaning plan sponsors would do well to make risk transfer moves now.

There are steps plan sponsors can take to better prepare their plans for pension risk transfer, noted by Chip Conradi, treasurer and vice president of tax at Clorox, who spoke about risk management strategies executed by the company during a webcast sponsored by Mercer.

A couple of years ago, the company did a total rewards review, and as part of that analysis, decided its pension plan would be frozen. Clorox wanted to reduce the effect of volatility of pension funding on its financial position, so it worked with Mercer on a liability-driven investing (LDI) strategy.

Conradi said Clorox implemented a glide path strategy guided by certain triggers. For example, at 70% funded, the company changed the plan’s asset allocation to hold 45% bonds, 80% funded triggered a move to 50% bonds, another even triggered a move to 55% bonds, and the next trigger is an 85% funded status.

One problem the company had was educating the pension committee, according to Conradi. He explained many committee members didn’t understand why they would move to more bonds in a high interest rate environment. But, the firm educated the committee to change members’ focus from asset performance to managing the gap between assets and liabilities.

“Committee members are familiar with investment success, but what about risk management success?” Conradi queried. By hedging against interest rate movement and removing some equity risk from the plan, the plan’s funded status volatility was reduced from 11% to 6%.

De-risking did not have a significant effect on plan expense, Conradi said. The company has not made any contributions to the plan since the introduction of the glidepath, yet volatility risk is reduced, and funded status has increased.

Gordon Fletcher and Richard McEvoy, Mercer pension risk experts, explained as plans progress down the risk management path, they change the composition of their plan’s hedge portfolio—portfolio of bonds to match liabilities. The hedge portfolio becomes richer as the plan moves along the glide path; it includes a mix of credit and treasuries, and uses duration-matched bonds.

But, LDI strategies are not set and forget, they warned webcast attendees. During market stress, the hedge starts to unravel, bonds can be downgraded and possibly default. The plan’s liability may be unchanged, but assets are hit and it reduces the plan’s funded status. The key is active management of the credit portfolio and active management of the split between credits and treasuries, they said.

Improved funding as a result of LDI strategies enables defined benefit plan sponsors to take a closer look at pension risk transfer. Fletcher and McEvoy explained that a pension buyout currently has a premium of 8% above the plan’s accounting liability, while offering a lump-sum window to certain participants will only cost employers the plan liability for those participants. A lump-sum window for terminated vested participants offers a financially attractive option. However, the cost of maintaining a plan’s liability on the company’s balance sheet has risen, while the cost of transferring to an annuity has decreased, so plan sponsors should consider what is best for their plans.

Plan sponsors should also consider what may be coming down the regulatory pipeline, Geoff Manville, from Mercer’s Washington Resource Group, told webcast attendees.

He said the issue of derisking has become an active discussion in the policy community in Washington, D.C. The Treasury and PBGC have made it clear they have concerns about offering lump sums to those who have already commenced annuity payments. Although they have not stated a public position yet, Manvilled said there’s a chance they will soon. He notes that it will not affect lump sum offers to terminated vested participants not currently taking an annuity; that law is settled.

In addition, Manville noted the Department of Labor is looking at recommendations from the ERISA Advisory Council made late last year (see “ABC Testifies on Pension De-Risking”). Those recommendations include: clarify the “safest available” annuity rule applies to any purchase by a defined benefit plan; more disclosure and a minimum 90-day decision time frame for lump sum windows; clarify consequences of fiduciary breach in selecting an annuity buy-out carrier; and provide education and outreach to plan sponsors.

Manville said no relevant bills have been introduced in Congress, but a coming Government Accountability Office (GAO) report could prompt a legislative response. Finally, he noted that state lawmakers are looking at model legislation that would place costly new requirements on state-regulated insurers providing annuities to qualified defined benefit plans.