Fidelity Research Launches with Retirement Strategies Perspective

A survey conducted by Towers Perrin immediately following President Bush's signing of the Pension Protection Act (PPA) found more employers are likely to maintain their defined benefit pension plans than freeze them in response to the Act's more stringent funding requirements.

A survey conducted by Towers Perrin immediately following President Bush’s signing of the Pension Protection Act (PPA) found more employers are likely to maintain their defined benefit pension plans than freeze them in response to the Act’s more stringent funding requirements.

Results of the survey show that plan sponsors for the most part anticipate only a modest change in required contributions to fund DB plans, and 63% categorized the financial risk imposed on their companies by their DB plans as still “manageable” after the PPA’s passage. Another 30% of respondents said the risk was “acceptable…and appropriate for the value we see in the program,” according to the survey report – findings that may be of comfort to advisers who currently support these type programs.

When asked about the expected change in required pension plan contributions under the PPA, 44% of the 126 companies responding to the survey reported an expected 0% – 10% increase. Thirteen percent said they expect an 11% – 25% increase in required contributions, while 3% reported an expected increase of 26% – 50% and 7% said they expect an increase of over 50%.

Financial executives that responded to the survey did not seem intimidated by changes required by the PPA, as 39% said their organizations are well prepared to handle the complexity of the new funding rules and 53% said their companies are at least somewhat prepared.

Towers Perrin’s survey did not corroborate the view that the PPA will lead more companies to decide to freeze their DB plans. Almost half (49%) of respondents said they are likely to maintain their plan with the same or similar benefits. Nine percent said they would maintain their plan but reduce future benefit accruals. Of those saying they are likely to freeze their plans, 17% said they are likely to eliminate their plans for new hires and 5% said they are likely to freeze benefits for current participants. Twenty-eight percent said they were undecided.

Investment Strategy Shifts

Concern about contribution requirement volatility in response to changing capital market conditions is prompting pension plan sponsors to reevaluate their financial management strategies, Towers Perrin found.

Almost a third of respondents said they are very or somewhat likely to increase the level of bonds in their asset mix to help more closely match plan assets to liabilities. Only 5% of respondents said annuities were a potentially viable funding approach. However, 16% said they would consider transferring pension financial risks to outside parties at prices more favorable than annuities.

More than half (51%) of the executives surveyed said they need to do more analysis of investment approaches.

Towers Perrin’s analysis suggests that contribution amounts may not be more variable year after year though, since some provisions will help suppress the volatility expected to be increased by other provisions. While provisions of the PPA increase contribution volatility by decreasing the period of years for smoothing assets and liabilities and by restraining the use of credit balances, the new law enables more effective liability/asset matching strategies through the use of market values instead of averaged assumptions and provides more flexibility to advance fund DB plans during favorable economic periods, the report says.

Funding Levels Matter

However, the analysis suggests that DB plans will be affected by the PPA differently depending on current funding levels.

Plans with a current funding level of 100% or more can take advantage of the PPA’s permission to fund up to 150% in order to use surpluses for harder times, but they must be careful of the Act’s limits on what surplus funding can be used for and the fact that there is a restriction on the use of credit balances if the plan ever falls below 80% funded.

Plans currently funded near 90% on a solvency basis will face significantly higher contribution requirements than under existing law, according to the report. After a phase-in period, sponsors of these plans will be required to contribute until they reach the 100% funding target.

Additionally, if capital market conditions deteriorate, sponsors of these plans could face the 80% threshold that triggers limitations on the application of credit balances and an at-risk designation that can significantly ramp up funding requirements and Pension Benefit Guaranty Corporation (PBGC) variable premiums.

For poorly funded plans, the PPA provides a seven-year period to make up their funding deficiency, which may reduce the amortization amounts in the initial years. However, these plans will not be allowed to use credit balances until their funded status reaches 80%, and the “at-risk” designation is likely to be applied to these plans.