Identifying Retirement Plan Risk
An Important First Step to Managing It
All professionals involved with retirement plans, whether they be defined benefit (DB) or defined contribution (DC), look to measure and, to varying degrees, manage “risk.” Pension actuaries, investment advisors, recordkeepers and auditors understand that no matter how carefully investment and contribution strategies are designed, there is inherent uncertainty associated with every benefit program over time that cannot be avoided. As the leading actuaries and consultants to multiemployer plans, Segal Consulting knows this widespread interest in risk needs to be put in context. One of the primary reasons multiemployer retirement plans were established was to protect workers and employers in an industry and mitigate hazards by pooling large groups of employees from different employers. The collaborative labor-management structure at the heart of multiemployer plans assures that the interests of all stakeholders are taken into account. These unique characteristics of multiemployer plans have contributed to their strength, with nearly two-thirds of multiemployer plans continuing to be well-funded, despite the economic turmoil of the last two decades.
Retirement plan trustees fulfill their fiduciary obligation to participants and to the plan by understanding and exploring the ramifications of various factors that can affect a multiemployer plan. Understanding these factors (or risks) is the first step to being able to appropriately manage retirement plans — both DB plans and DC plans — in order to allow trustees to be best positioned to make decisions to achieve the specific goals of each plan.
Although we commonly perceive risk as something to be avoided, it is worth keeping in mind that there is an upside to risk. Investors who understand that duality refer to risk and reward as two sides of the same coin.
This publication is devoted to identifying risk in retirement plans. It is the first in a series. Subsequent installments will offer tools to help trustees quantify and analyze risk, identify risk-management strategies (including plan design alternatives) and outline the major components of running a well-managed plan. For professional advisors, participants and — most important — plan sponsors, the question is not whether risks exist, but to identify and manage them effectively.
A Range of Risks
There are many economic and non-economic risks inherent in retirement plans. These will be viewed differently depending on whether one sponsors, contributes to or participates in the plan. Most retirement plan decision makers are concerned about what exposes the plan to unexpected negative outcomes. Risk for participants can mean inflation eating away at the purchasing power of their benefit. From a contributing employer’s perspective, it can be an unexpected increase in the cost of the ongoing plan or an increase in withdrawal liability.
The following risks are associated with both DB and DC plans:
- Investment This is the most familiar risk for all retirement plans and is particularly prominent given the volatility in investment markets over the past 15 or so years. It consists of the impact of fluctuating or less-than-expected investment returns. In DB plans, it is borne by employers through the need for higher negotiated contribution rates and participants through the allocation of their wage and benefit package and in the establishment of benefit levels. In DC plans, participants bear 100 percent of investment risk.
- Longevity The possibility that retirees may live longer than projected by the actuary can increase the cost of a DB plan. For participants in DB plans, longevity risk is pooled or shared. That means retirees can count on income in retirement no matter how long they live. In contrast, in a DC plan, longevity risk is not shared. As a result, each individual DC plan participant bears the responsibility for accumulating a sufficient account balance for retirement and for properly managing its drawdown after retirement.
- Inflation Increases in the cost of living prior to and after retirement can erode the purchasing power of a fixed DB benefit. The effect of inflation on a DC account balance means that participants have to withdraw larger amounts to maintain a level standard of living, thus increasing the likelihood they will outlive their account balances.
- Involvement For the plan sponsors, failure to take an active role in monitoring a plan could result in higher costs and/or lower benefits through missed opportunities, such as increasing contribution rates or modifying benefits sooner rather than later. Participants’ involvement consists of reviewing periodic statements of their accrued defined benefit and DC account balances. In participant-directed DC plans, not taking an active role in asset allocation could result in a smaller account balance or in the participant bearing more investment risk than he or she originally intended.
- Laws and Regulations Federal laws, such as the Pension Protection Act of 2006 (PPA’06), the Multiemployer Pension Reform Act of 2014 (MPRA), the Internal Revenue Code and the Employee Retirement Income Security Act, and/or regulations under these laws from the Internal Revenue Service (IRS), the Department of Labor or the Pension Benefit Guaranty Corporation, can have an impact on contributions, administration and benefits for DB plans.IRS regulations also determine the maximum amounts that participants can contribute through deferrals to a 401(k) plan and the additional catch-up contribution that can be made by participants age 50 and older. New laws and regulations can require a reevaluation of plan objectives, opportunities and risks.
- Administrative Whether calculating benefits for DB plans, or maintaining account balances for DC plans, both participants and contributing employers are exposed to this less obvious risk, which is associated with maintaining any pension plan. DB plan participants could have their benefit calculated incorrectly. DC plan participants could have contributions posted either late or improperly or both. Both DB and DC plan administration and compliance is complex and excessive administrative fees can deplete plan assets that could otherwise be used for benefits. Plans or contributing employers could be required to pay any fines or fees associated with mistakes in administration. Even seemingly small problems can turn into large issues that are expensive and can consume considerable resources to correct.
Additional Risks for DB Plans
DB plans face these additional risks:
- Employment If employment in the industry declines, the contribution base needed to support the promised benefits will likely decline. This can have severe implications for the long-term funding of a plan and could be a significant obstacle in achieving and maintaining a well-funded plan.
- Interest Rate A low interest rate environment may dampen the overall investment return on plan assets. Low interest rates can also affect actuarial assumptions, like those often used to determine the actuarial present value of vested benefits for withdrawal liability purposes or those used for the calculation of certain optional forms of benefit payment.
- Benefit Reduction PPA’06 gave trustees of “red-zone” plans the ability to reduce certain benefit features known as “adjustable benefits.” Under MPRA, for critical and declining plans there is now a potential for plan trustees to consider a reduction in plan benefits already earned in addition to benefits to be earned in the future. This applies even to retirees who are already in pay status. DB plan participants, especially those in red-zone plans, need to be aware that benefits could be cut back.
- Contribution Rates Employer contribution rates or allocation of the wage/benefit package to the pension plan can change, which is important for the plan sponsors because contribution levels have the most direct controllable impact on funding. Of course, this is significant to both participants and contributing employers who are responsible for those contributions.
- Withdrawal Liability If a contributing employer that withdraws from a multiemployer DB plan incurs withdrawal liability, it is required to continue making payments to the plan to help continue to fund the plan’s unfunded liability for vested benefits. For the remaining contributors, to the extent payments from withdrawn employers are insufficient to completely pay their allocated unfunded vested benefits, they may have to increase contributions in order to fund any shortfall created by the withdrawing employer.
- Accounting The Financial Accounting Standards Board and/or the American Institute of Certified Public Accountants can change accounting and disclosure requirements for DB plans or the companies sponsoring them. Rating agencies, like Moody’s and Standard & Poor’s, can change their approach to taking into account an employer’s contribution commitments to multiemployer plans in their ratings of the company’s creditworthiness.
Risks Unique to DC Plans
Less familiar risks associated exclusively with DC plans include the following, all of which can increase costs and lead to lower investment returns for the participants:
- Participation In multiemployer DC plans that allow participant contributions, this refers to the extent to which participants actively participate — or do not participate — in their plan. Lack of participation, or participation at too low of a contribution rate, will reduce the amount of income accumulated at retirement for a given individual. Moreover, a plan with fewer active participants has a smaller group over which to allocate administrative expenses.
- Vendor Management and Communications A well-functioning team of vendors, including recordkeepers, investment managers, consultants and legal counsel, will theoretically maximize returns and minimize expenses. Lack of communication can result in participants not fully understanding the value of the plan’s benefits. Additionally, vendors that do not work well together increase the likelihood of administrative errors and duplication of expenses.
- Investment and Administration Fees Plan fees that are too high, are allocated inequitably or are not sufficiently transparent produce an inefficient program and, ultimately, lower net investment returns and the retirement benefit for participants.
Identifying Risks Is the First Step to Managing Them
When reviewing retirement plan risk, it is important not to lose sight of the fact that multiemployer plans continue to be a great way to provide retirement benefits because they share risks among all stakeholders. Risk sharing is one of the main reasons why these plans were established in the first place. Over the years, management of these risks has become more challenging.
Knowing a multiemployer fund’s risk exposure is only the first step in the process of managing risk. Once the risks have been identified and thoroughly explored, the next step is to understand the tools available to help measure and manage them.
The next publication in this series will focus on quantifying retirement plan risk, including tools to help trustees analyze risk. As the publications are released, they will be accessible from the Managing Pension Risk page on Segal’s website.
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To discuss how Segal Consulting can help you identify the risks associated with your fund’s defined benefit and defined contribution retirement plans, contact your Segal benefits consultant, or one of the experts listed below.
Strategic Consulting Services for Multiemployer Retirement Plans
Consultants and actuaries from Segal Consulting, together with investment consultants from Segal Marco Advisors (the SEC-registered investment solutions member of The Segal Group), can be of assistance in developing the appropriate strategies for maintaining and enhancing benefit security. Our strategic consulting services for multiemployer pension plans include the following:
- Performing forward-looking projections of the plan’s funded status,
- Updating current Funding Improvement Plans or Rehabilitation Plans to stay on target,
- Investigating the potential for benefit suspensions and partitions, and
- Assessing risks and evaluating options for reducing or eliminating them.
For information about these strategic consulting services, contact your Segal consultant, the nearest Segal office or one of our experts.
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Segal Multiemployer Retirement Experts