Successful retirement plan financial management requires careful coordination on the part of the employer. Without the knowledge to properly manage the plan, plan sponsors could face serious repercussions, says Gary Gausman, a senior consulting actuary at Towers Watson.
“For plan sponsors to manage their programs, there are four main areas to focus on — benefits policy, funding policy, investment policy and accounting policy,” says Gausman. “There are a number of things you can do in each area, and there is a lot of interaction between them that you need to be aware of.”
Smart Business spoke with Gausman about the keys to successful retirement plan financial management.
What do plan sponsors need to know about their benefits policy?
Look at the plan design to determine benefits that are going to be earned in the future and how you are going to deliver those. Also, look at your exit strategy for legacy liability. Employees have already earned benefits for service rendered to date, and there’s liability associated with those that you need to deal with. With legacy liability, there are former employees who are retired and are currently receiving benefits, those who have terminated employment and are not earning additional benefits but are entitled to benefits in the future, and active employees.
Retirees are receiving a monthly benefit and there’s not a lot the employer can do because benefits have already been earned and are being received. But you can mitigate the risks associated with retirees by purchasing an annuity contract from an insurance company to take that liability off your hands.
For those who have terminated employment who have not yet started their benefits but are entitled to future benefits, consider offering them the benefit in one lump sum payment. If someone is 45 and entitled to $1,500 a month starting at age 65, perhaps that person would rather get a lump sum now equal to the value of those payments. That removes some employer risk. Annuity benefits are payable until the person dies, which might not be for decades. But if you pay a lump sum equal to the actuarial value of the payments, you are done.
With active employees, look at plan design. Traditional plans are final average pay plans, where if you work for a company for 30 years, you get, for example, 1.5 percent of your final average pay per year, or 45 percent of your final average pay, starting at age 65. The risk to the employer is that the benefit is indexed to what the employee earned, for example, in the last five years before retirement, which could spike dramatically in an inflationary period. As a result, many employers have shifted to a career average approach, in which benefits are instead based on what the employee earned ratably over his or her career.
How can employers address funding policies?
To maintain the tax-qualified status of plans, employers must satisfy various rules, including putting in a certain amount of money every year. Historically, some have put in the bare minimum, but in 2006, new rules said that, in addition to satisfying minimum funding requirements, you also have to maintain a certain funded ratio, which is the assets of the plan divided by liability, to continue to operate the plan according to all of its intentions and be able to take advantage of funding exemptions. For example, if a plan allows lump sums, it must maintain an 80 percent funded ratio in order to be able to pay out lump sums
If a company is just trying to satisfy the minimum funding rules while maintain that 80 percent ratio, additional volatility in the contribution amount could ensue. Companies could instead consider a more generous funding pattern to develop a cushion so that in lean years, when plan assets may have dropped and business results aren’t up to expectations, you can draw on that excess. This funding policy could involve, for example, contributing a certain percentage of pay each year.
In the 1990s, when things were going well, some companies took their eye off the ball. They didn’t have to make minimum contributions because their assets were doing so well, and in many cases, that has come back to bite them, as they haven’t built up the excess they now would like to have.
How can investment policies impact employers?
For years, employers chased returns and forgot about liabilities in the plan and how those would play out over time. In the last 10 years, that strategy has not worked well, as the stock market has been very erratic. As a result, when liabilities increase, assets may decrease, creating an even wider gap. Employers are taking a more focused look at investments, trying to better match assets and liabilities so that if liabilities increase, assets increase, as well, and the gap will not change as much. With the transition to cash balance type plans that allow employees to take lump sums at termination, you need to make sure you have the liquidity to pay those out. And to do that, employers need to look at investments in a different light and better align them with their liabilities.
How do accounting policies play into the mix?
When implementing pension plans, companies made certain elections, and they are mostly tied to those. If you change your accounting policies or methods, it must be to a ‘preferred’ method. For example, many companies chose smoothing in their accounting policies. Depending on the methods chosen, this could mean that if assets tanked last year, they would not have to recognize the full decrease in one year, but rather could spread it out over up to five years. That’s been fine, but the trend in accounting is toward ‘mark to market’ accounting, which eliminates smoothing. The auditor wants to know exactly what your assets and liabilities are based on current market conditions, i.e., current interest rate market and current asset markets. This can have implications for a company’s investment policy and funding policy, for example. By understanding each of these areas and how they work together, companies can position themselves for successful retirement plan financial management and minimize their risks.
Gary Gausman is a senior consulting actuary at Towers Watson. Reach him at (818) 623-4763 or [email protected].
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