According to the Pension Benefit Guaranty Corporation (PBGC), there are more than 25,000 corporate pension plans in the United States.1 For each of these plans, managers in the sponsoring company make decisions on a regular basis about how much and how frequently to contribute to the plan and what investment strategy to pursue with plan assets. Until recently, the most common approach to these decisions taken by plan sponsors could be loosely characterized as: Let’s make contributions at the minimum level permitted by regulation, and let’s use a growth-oriented investment approach, trusting that over time the combination of market returns and legislative smoothing will lead the plan to be fully funded at a reasonable—and reasonably stable—cost.
That approach doesn’t necessarily work anymore. The Pension Protection Act of 2006 (PPA) redefined how contributions are calculated, moving in the direction of marked-to-market valuations and also reducing the time period over which funding shortfalls need to be made good. Statement of Financial Accounting Standards SFAS 158 had a similar impact on how pension plans are captured on corporate balance sheets. These changes increased the complexity of managing pension plans’ impact on the sponsor’s financials.
Another important consideration in contribution decisions is the possibility that capital may become trapped in the plan if market conditions become more favorable and the plan’s funded status improves. This is mainly a concern for frozen plans, which are no longer accruing benefits and so cannot use the surplus to offset the cost of future accruals. Withdrawing money from a pension plan can be difficult and tax-inefficient, so possible upswings in asset values should be a factor in contribution decisions.
Once the funded ratio approaches 100 percent, the possibility of trapped capital starts to loom. To manage this risk, funding policy and investment policy need to work in harmony. This is a major reason why liability-responsive asset allocation (LRAA) is growing in popularity. LRAA ties asset allocation to the plan’s funded status. As the plan’s funded status improves, the plan makes less-risky investments. In other words, the plan takes risks only when they would have a useful payoff. If success would simply lead to trapped capital, then a plan has nothing to gain from a risk-oriented investment policy.
Compared with its effects on the corporate income statement, a pension plan’s implications for the balance sheet are fairly straightforward. The corporate balance sheet must include a net pension asset (or liability) equal to the current surplus (or deficit) of asset value over liability value in the pension plan. In some unusual situations, the balance sheet calculation can be more complicated—for example, if the plan has a surplus that is too large to offset against future contributions.
The PBGC, which protects pension plan participants in the event of a plan sponsor’s failure, is funded by the premiums plan sponsors pay. Unfortunately, the PBGC is currently in a weak financial position: The latest annual report disclosed a shortfall as of September 30, 2012, amounting to $34 billion. (This calculation uses more conservative assumptions than most corporate plans do, and some industry groups have argued that the PBGC overstates its weakness as it seeks better funding and lower liabilities.) Concerns over the strength of the PBGC translate into greater demands on plan sponsors. In addition to the substantial premium increases introduced by MAP-21, there have been proposals to link a plan sponsor’s premium level to its corporate credit rating, which would further increase pension costs for many organizations.