Navigating Defined Benefit Plan Derisking: Strategies and Considerations for Plan Sponsors
Defined benefit (DB) pension plans have long been a valued component of retirement security for some workers, but they also present complex financial challenges for sponsoring organizations. With rising market volatility, interest rate fluctuations, and increasing life expectancy, many DB plan sponsors are turning to derisking strategies to reduce exposure and improve the long-term sustainability of their pension obligations.
Advisors are often called upon to help navigate these considerations with plan sponsors. In this blog, we break down what derisking means, why it’s becoming a strategic priority for some sponsors, and what methods companies are using to effectively reduce risk.
What is Defined Benefit Plan Derisking?
Derisking in the context of DB plans refers to a range of strategies designed to reduce the financial volatility and long-term liabilities associated with maintaining a pension plan. Unlike defined contribution (DC) plans, where investment risk is borne by the employee, DB plans place the investment and longevity risks squarely on the employer. As a result, plan sponsors can face unpredictable funding requirements, particularly during economic downturns or periods of low interest rates.
Derisking aims to limit this unpredictability and shift certain risks off the sponsor’s balance sheet, either by adjusting the investment profile or by reducing the size of the plan’s liabilities directly.
Why is Derisking a Growing Priority?
Several key trends are accelerating the focus on derisking:
- Interest Rate Sensitivity: Low or fluctuating interest rates increase the present value of liabilities, requiring higher funding levels.
- Market Volatility: Equities and other higher-return assets can experience significant swings, creating funding instability.
- Longevity Risk: As people live longer, plans must make payments over extended periods, increasing long-term costs.
- Regulatory Pressure: Funding rules and accounting standards (e.g., ASC 715, IAS 19) demand more transparency and often penalize volatility.
- Corporate Strategy: Some companies are shifting focus away from legacy benefit obligations to invest in core business activities or prepare for mergers and acquisitions.
Common Derisking Strategies
Derisking can be approached in several ways, depending on a sponsor’s financial position, long-term goals, and regulatory environment. The most common strategies include:
- Liability-Driven Investing (LDI)
LDI aligns a plan’s asset portfolio with its liability profile. Instead of chasing higher returns through equities, the plan invests in fixed-income instruments (e.g., long-duration bonds) whose cash flows closely match the timing and size of projected benefit payments. This reduces the mismatch between assets and liabilities, stabilizing funding levels and accounting outcomes.
- Plan Freezing or Termination
Freezing a DB plan stops the accrual of new benefits, either for all participants (a hard freeze) or only for new hires (a soft freeze). This limits the growth of future liabilities. A full plan termination goes a step further—typically involving a final contribution, full settlement of liabilities, and plan dissolution. While termination offers complete derisking, it requires full funding and can be costly upfront.
- Lump Sum Windows
Plan sponsors may offer eligible participants a one-time opportunity to take their benefit as a lump sum instead of future annuity payments. This can reduce plan size and future payment obligations, especially if taken up by a significant portion of deferred vested participants. It also removes longevity risk associated with those individuals.
- Pension Risk Transfers (Annuity Buyouts or Buy-ins)
Through a pension risk transfer (PRT), the sponsor offloads part (or all) of its pension obligations to an insurance company. In a buyout, the insurer assumes responsibility for paying retirees directly, fully removing those liabilities from the plan. In a buy-in, the insurer holds the assets and liabilities, but the plan retains the obligation—a strategy often used as a step toward a future buyout.
Key Considerations for Plan Sponsors
While derisking can offer long-term financial and operational benefits, it also comes with important considerations:
- Cost Implications: Some strategies, such as annuity buyouts, may require significant upfront funding, especially in underfunded plans. However, the long-term savings from administrative costs, Pension Benefit Guaranty Corporation (PBGC) premiums, and reduced volatility can outweigh the immediate expense.
- Regulatory and Fiduciary Compliance: Plan sponsors must ensure compliance with the Employee Retirement Income Security Act of 1974 (ERISA) and Internal Revenue Service (IRS) rules when implementing lump sum offers or engaging in PRT transactions. Fiduciary responsibilities must be carefully considered, especially in terms of participant fairness and disclosure.
- Employee and Retiree Communication: Transparent, empathetic communication is crucial to help participants understand their options and avoid confusion or concern. Derisking efforts should be positioned within the broader context of retirement plan strategy.
- Accounting and Financial Reporting: Some derisking actions can lead to accounting gains or losses, affecting reported earnings. It’s important to coordinate with finance and investor relations teams.
Conclusion
Defined benefit plan derisking is no longer just a tactic for distressed plans—it’s a proactive, strategic decision that more companies are considering to align pension obligations with their financial goals. Whether through investment changes, participant options, or liability transfers, derisking offers a way to reduce uncertainty and create a more stable financial future for both sponsors and participants.
As the retirement landscape continues to evolve, organizations should regularly assess their DB plans in light of their broader business objectives, market conditions, and workforce demographics. With thoughtful planning and execution, derisking can be a powerful tool in ensuring long-term pension sustainability. Pentegra’s consultants are available to help. For more information on our pension consulting services, contact us at 855-549-6689 or solutions@pentegra.com.
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The information, analyses and opinions set out herein are for general information only and are not intended to provide specific advice or recommendations for any individual or entity. Nothing herein constitutes or should be construed as a legal opinion or advice. You should consult your own attorney, accountant, financial or tax advisor or other planner or consultant with regard to your own situation or that of any entity which you represent or advise.