During the plan termination process, one issue often overlooked is the consequences of investment risk prior to paying out benefits. This can lead to disastrous results. Benefits may be fully-funded when the termination decision is made, but significant contributions will be required if assets are not invested conservatively and a market downturn occurs prior to paying benefits.
Here are a few investment issues to consider when working through the plan termination process.
- Plan terminations change the focus of pension plan investments to short-term risks. An investment strategy based on 30-year expectations is not compatible with a one- to two-year plan termination horizon.
- The plan termination process can take a while (over a year) and financial conditions may change dramatically between the termination decision and the date when benefits are actually paid out. Funded status volatility during this waiting period should be minimized.
- A change in investment policy doesn’t have to be abrupt, but it should adjust quickly to minimize investment risk as terminating plans get closer to being fully-funded.
- Minimizing investment risk helps lock-in the funding gains made over the past couple of years. It may also limit the chance of large investment returns, but for many plan sponsors this will be a satisfactory risk/return trade-off.
- A liability-driven investment (LDI) strategy works well for terminating pension plans because it focuses on keeping plan assets aligned with plan liabilities. Keep in mind, though, that the plan termination liability target will be different than the traditional funding or accounting liabilities.
Many sponsors of frozen DB plans are becoming more interested in terminating their plans, especially as their funding level improves. We’ll continue to add posts that address important issues related to plan terminations and how to make them go as smoothly as possible.