Case study: Long-term funding strategies

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The challenge

A common question from many of our clients with defined benefit plans is, “How much should we contribute in each plan year?” There are many quantifiable ways to set contribution amounts each year; the challenge is choosing the strategy that meets the specific goals for each plan sponsor’s unique set of circumstances.

The solution

Finding a solution should start with defining plan objectives such as the acceptable risk tolerance of the plan, the desired current and future funded levels, and the preferred level and stability of the annual accounting expense and contributions. It is important for a plan sponsor to have a formal written funding policy, which should state the desired funded status, interim goals, and a back-up plan if actual plan experience does not match the stated assumptions, such as inflation and asset return. Guidance on how much to fund between the minimum and maximum ranges provided in the Pension Protection Act of 2006 (PPA) should also be included. The plan objectives should be reflected in the funding policy.

Having a well-funded plan provides additional security to the benefits of the plan participants and avoids a potential transfer of cost between generations of employees, shareholders, taxpayers, and other stakeholders. It also provides the possibility of a contribution holiday if the plan remains well-funded and may provide the options of terminating the plan without requiring excessive contributions or asset-liability matching to reduce risk and volatility. Any surplus can be locked in to preserve the funded status if the right investment strategy is chosen (e.g. Liability Driven Investments (LDI)). This would maintain the fully funded level of the plan.

The plan sponsor can elect to make only the required minimum contributions each year, thereby freeing up cash to be used on the business and for investments. This strategy may lead to larger required contributions in future years. The size of the contributions can play a key role in a company’s credit rating, the cost of raising capital, borrowing costs and broader business plans. A decline in funding status can reduce shareholder equity and increase future accounting expense as losses are amortized.

If the plan does not have minimum required contributions, the amount of the normal cost could be funded each year. An alternative approach is to contribute a level percentage of total compensation to try to minimize contribution volatility. Contributing the plan’s accounting expense amount can simplify accounting and be an effective way to maintain the current funding level.

Many plans would like to reach targeted funded levels within a specified time period. These levels can be based on the market value or smoothed asset value (either with or without plan credit balances) as a percentage of a chosen plan liability measure. The most commonly used liability measures are: the PPA funded target liability, the vested funded target liability for Pension Benefit Guaranty Corporation (PBGC) premiums, the projected benefit obligation or the accumulated benefit obligation. Reaching 80% of funded target liability to avoid benefit restrictions or to avoid reporting under section 4010 of the Employee Retirement Income Security Act (ERISA) are popular goals, as is being 100% funded to avoid having shortfall amortization amounts added to the minimum required contribution or quarterly required contributions, and to avoid PBGC variable rate premiums.

Milliman consultants can discuss funding strategies and provide exhibits showing the contribution amounts needed for each approach. Models to calculate projected annual contribution amounts needed to reach specific funding goals in future years can also be set up if plan sponsors are interested in taking this additional step.

The outcome

Since each plan sponsor has a unique situation, a “one-size-fits-all” strategy is not the right solution. We listen to your objectives and will provide you with the tools and analysis needed to create the right funding strategy for your plans. We also share with you what other plan sponsors are doing and what is trending in the industry. Our ultimate goal is to help you find a successful strategy. Many of our clients choose to fund the minimum required amount. However, we have several clients who choose to contribute the plan’s accounting expense amount each year or the amount needed to avoid a variable rate premium if higher than the accounting expense.