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Frozen Plans on Ice
Session 36

Moderator: Scott A. Hittner, JPMorgan
Presenters: Richard O. Giberson, JPMorgan; James M. Reidy, JPMorgan Asset Management; Jason C. Richards, Towers Perrin
Recorder: Michael J. Petrauskas, JPMorgan

With the increasing number of traditional defined benefit plans being frozen in recent years, an often forgotten issue is the obligations that still face companies sponsoring these frozen plans. There is a tendency for companies to see the freezing of their pension plan as an instant remedy for the burdensome administrative and financial issues surrounding the plan. However, even companies that institute hard freezes on all future benefit accruals still faces obligations that extend far into the future. Upon freezing a plan, a laundry list of items still face the plan sponsor, including drafting employee communications, possible benefit audits, potential data clean-up, continued actuarial and financial reporting, and perhaps most importantly the development of a wind-down investment strategy for the plan.

When a pension plan is frozen, a thorough asset/liability study may be more important that ever before. Five key risks continue to affect the plan, and a well-designed investment strategy is imperative to ensure that benefit payment obligations are met over the somewhat refined horizon that the freeze establishes. These five risks are equity risk, interest rate risk, demographic risk, regulatory risk, and operational risk. Certain aspects of these risks can either be transferred to third parties or eliminated through an annuity purchase or lump sum payouts, but many sponsors of frozen plans maintain some or all of these risks. While regulatory and operational risk are difficult to hedge, equity risk, interest rate risk, and to a lesser extent demographic risk can be handled through a carefully planned investment strategy.

When developing an investment strategy for their pension plans, companies traditionally have thought in terms of asset volatility rather than surplus volatility. This becomes a particularly risky practice for frozen plans as the horizon for solidifying an adequate asset level shortens significantly over time, especially when the benefit payment rate exceeds the discount rate. The key to mitigating surplus volatility is minimizing equity and interest rate risk through a variety of investment techniques. Equity risk can be diminished through diversification and implementing hedging derivatives. Interest rate risk can be reduced through evolving fixed income and derivative investment strategies aimed at minimizing duration mismatches between assets and liabilities.

There are three main duration matching strategies that companies can pursue: generally increase asset duration through the addition of long duration bonds to their portfolio, dollar-duration matching, and immunization. Each offers an increasing amount of risk mitigation, and the decision among the three often is contingent upon the plan sponsor’s level of risk aversion and willingness to cover unexpected shortfalls. Adding long duration bonds to the portfolio can help to align the asset and liability interest rate risk due to the generally long duration of the liabilities. By matching the dollar-duration of assets and liabilities, a plan sponsor essentially establishes a portfolio free of interest rate risk. Immunization takes this a step further by eliminating all investment risk through duration and cash flow matching in a 100% bond portfolio.

For frozen pension plans with a plan document that allows for derivative investments, interest rate futures and swaps can be utilized to further increase asset duration. This strategy often is referred to as an overlay. Both futures and swaps have advantages and disadvantages. Futures tend to have low counterparty risk and typically are offered in relatively small sizes, but they have no spread and have difficulty covering all segments of the yield curve. Swaps, on the other hand, are easily customizable and offer more yield curve coverage, but they tend to have higher levels of counterparty risk and generally are offered only in large denominations. Plan sponsors pursuing an overlay strategy also have to be prepared to cover large marks-to-market following interest rate increases.

If the future is anything like the past few years, defined benefit pension plan freezes will not be unusual. However, it remains to be seen whether the level of emphasis plan sponsors place on mitigating the risks that could impact their frozen plans will increase. The one certainty is that as long as they maintain the obligation of paying benefits out to the horizon of the plan, they are subject to various risks. Fortunately, there are several investment alternatives that can be utilized to help the plans achieve their long term goals, stabilize their surplus, and ensure benefit security.

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