You've frozen your pension plan: now, the work really begins; Freezing a defined-benefit pension plan is not a 'done deal.' Rather, it requires a prompt and urgent top-to-bottom re-evaluation that includes asset allocation and investment strategy, making active engagement by corporate financial executives critical.

Not a week goes by without an attention-grabbing headline about the poorly funded condition of one or another of a U.S. private pension plan, and the resulting problems inherited by the governmental agency (the Pension Benefit Guaranty Corp., known as PBGC) that insures the benefits under those programs. Indeed, as this article goes to press, Congress was considering how to reform pension-funding rules.

Regardless of what is ultimately proposed by Congress--which may have changed again by the time this is read--it will be the most significant change in pension funding rules since the enactment of the Employee Retirement Income Security Act (ERISA) in 1974. The challenge was to repair certain perceived inequities in the funding rules, and not create a new set of rules that would continue to drive employers away from defined-benefit (DB) plans. But unfortunately, whatever actions Congress may take may already be a case of too little, too late.

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Over the past 20 or so years, a series of legislative actions have over-regulated employer-sponsored pension plans into what looks like a no-return zone. Hundreds of corporations, having already given up, have frozen their defined-benefit pensions, while hundreds more are about to do so. Although the reasons for freezing plans are varied (not just about regulation, but also economics), one especially hazardous financial misconception is that by doing so, the plan sponsor can stop worrying about it; that a frozen pension hangs in suspended animation or simply winds down on a kind of "auto-pilot."

In fact, freezing a pension plan requires a prompt and urgent top-to-bottom re-evaluation on several fronts, including, perhaps most importantly, asset allocation and investment strategy. Indeed, investment strategy and performance may hold even greater significance for the sponsor of a frozen DB than for the sponsor of an ongoing plan. As a result, active engagement by corporate financial executives is critical. This begins with understanding the implications of freezing plans and the investment approaches when evaluating the requirements of a frozen plan.

"Frozen" Defined

Frozen pensions come in two varieties: "hard" and "soft." When a pension is hard-frozen, nobody accrues any new benefits from the date of the freeze. Benefits accrued to that point by current participants are fixed, and ultimately will be paid out to those employees consistent with the provisions of the plan.

By contrast, in a soft freeze, employees already covered by the plan at the time of the freeze will continue to accrue benefits under the original terms of the plan and may ultimately retire with a full pension. Future employees, or existing employees not yet eligible to participate in the plan, however, will not accrue benefits under the frozen plan. This is also sometimes referred to as the "generational" approach to freezing a DB plan.

The most common approach to freezing a DB plan is the soft freeze, for several reasons: a soft freeze does not impair the "promise" or "deal" that the employer has with existing employees; and a soft freeze is equal to a hard freeze when it comes to addressing, at least in the short term, what is often the plan sponsor's current financial pain point--the underfunding of benefits that have already been accrued.

In theory, the natural life of both soft- and hard-frozen DB plans can be equally long; both plans would continue to exist until the accrued benefits of the youngest employee at the time of the freeze are distributed. (Practically speaking, most plans will eventually purchase annuities when only retirees remain and the annuity market is favorable.)

Typically, in both scenarios, the employer will either enhance or create a new defined contribution plan, such as a 401(k), to offset the impact of putting the old pension on ice. From a regulatory perspective, little changes when a pension is frozen: All frozen pensions remain subject to all the original Internal Revenue Service (IRS) and Labor Department funding and disclosure standards--not to mention a few new ones that arise in the course of freezing the plan.

A New Ballgame

Under both hard and soft freeze scenarios, from virtually every other perspective, almost everything changes. Most basic--and typically the principal motivation behind the freeze--is that from a funding perspective, the certainty now exists that at some point in the future, no more corporate cash will need to be contributed to the plan. That date, however, cannot be predicted with certainty, but can be modeled, by regularly analyzing all the variables inherent in pension finance, including pension fund investment performance, employment duration, longevity and wage escalation.

From the perspective of the fund itself, freezing a pension means that ultimately, the fund will be fully depleted. Instead of essentially acting as a long-term capital financing device, the fund becomes a sinking fund--a doomed piggy bank--with critical implications for investment policy.

Looked at another way, freezing a pension means cutting off the stream of future, younger beneficiaries with far-off retirements (less imminent plan liabilities). From a funding perspective, the effect of choking off the supply of future beneficiaries is to lose the ability to smooth out good and bad investment or demographic experience between successive generations of workers.

Further, and perhaps most importantly, is the fact that unlike an ongoing plan in which the duration of the liabilities remain fairly constant over time (fostering a fairly steady investment allocation strategy), the duration of liabilities under a frozen plan will surely change over time, and this change requires a dynamic investment allocation strategy.

Cashflow-based Investing

The investment strategy implications of freezing a pension plan demand careful review and policy decisions by financial executives. In short, what's required is a new cashflow-based investment strategy, focusing on: liquidity requirements of the fund; volatility tolerance; and an orderly process for transitioning from an equity-fixed income mixed asset allocation to a bond and cash-only portfolio.

Two approaches to cashflow-based pension investing are worthy of careful consideration. The first, a basic "dynamic asset allocation strategy," involves building a tailored asset allocation for each class of pension beneficiary, based on their proximity to retirement. For example, liabilities attributable to beneficiaries eligible for retirement in 25 years might be assigned a 60/40 equity/bond asset allocation, whereas liabilities attributable to beneficiaries 10 years out might be need a 20/80 mix.

Using this asset-class approach, based on the liabilities in each class, an overall asset allocation scheme can be derived for the pension fund. The strategy is dynamic because it evolves continuously as participants grow older and draw closer to retirement eligibility. Thus, over time, the equity/bond allocation would steadily move toward an all-bond portfolio.

A second dynamic cashflow-based pension investment strategy is known as "horizon matching." Under this approach, the plan sponsor picks a relatively long period of time sufficient to cover a couple of typical investment cycles--say, 10 years--and determines the number of payments that will need to be made to pension beneficiaries until the "horizon" (in this example, 10 years out) is reached. Pension assets needed to pay for benefits over that period are invested very conservatively, perhaps exclusively in bonds and cash. Funds required to cover benefit payouts beyond that horizon are invested more aggressively.

Although, ideally, the horizon is always kept the same distance away in time, the proportion of total fund assets of a frozen fund within the near side of that horizon will steadily grow as more and more covered employees draw closer to retirement. As that occurs, the overall asset allocation of the pension will become more and more conservatively deployed, ultimately becoming all bonds and cash.

Strict discipline must govern these cashflow-based investment strategies to assure their steady and consistent implementation, thereby minimizing the risk of a large forced sale of equities during a down-market cycle to pay benefit cashflows.

These are just a few investment approaches that sponsors of frozen (or soon-to-be frozen) pensions should consider. What works best will depend upon the sponsor's financial philosophy, financial strength and plan demographics.

In fact, in the United Kingdom, the trend of freezing DB plans is a few years ahead of the U.S., with approximately 75 percent of plans already frozen. David Jones, partner in the leading U.K. actuarial firm, Lane Clark & Peacock, comments, "Our closed pension plan clients say they have a much better understanding of the reasons behind these dynamic investment strategies compared to more 'traditional' approaches. A majority of them have now adopted these investment techniques and there are signs that many other U.K. plans are following suit."

U.S. pension plan sponsors are advised to take heed: this may forecast your future.

Stewart D. Lawrence, FSA, is a Senior Vice President in The Segal Cos. National Corporate Benefits and HR consulting practice and a member of Financial Executive's Editorial Advisory Board. He can be reached at 212.251.5315 or [e-mail]. John De Mairo is Senior Vice President and Chief Operating officer for Segal Advisors Inc. an SEC-registered investment consulting affiliate. He can be reached at 212.251.5262 or [e-mail].

RELATED ARTICLE: Should the Pension Portfolio Be Invested 100% in Fixed Income?

One emerging school of thought in the investment community holds that frozen pensions (or, for that matter, even ongoing ones) should invest exclusively in bonds. Advocates of this approach--also referred to as "financial economics"--reason that since pension fund liabilities are bond-like in nature, the only way to fund them without needlessly increasing financial risk to the sponsor is a bond-based funding policy. And, organizations that have a tolerance or appetite for the investment volatility inherent in equities should assume that risk outside of the pension plan, argue the financial economists. According to this view, doing so not only drastically reduces pension funding risk, but leverages tax benefits associated with equity-based investing (including low long-term capital gains tax rates) where they can actually be used--outside the pension trust.

An analysis of the historical risk-reward trade-off patterns among different investment asset classes, and the potentially higher funding requirements based on a bond-only portfolio, may prevent many sponsors of frozen defined-benefit (DB) plans from going that route. But, the bond-only advocates do call attention to the critical importance of reducing exposure to asset volatility and aligning investments with the cash flow requirements of a DB plan--especially one that's frozen stiff.

See accompanying graphics for illustrations of the approaches to asset allocation for frozen pension plans.

Asset Allocation Over Time -- Current View

                    Dynamic Components
          Combined  Pensioners  Non-Pensioners
          $300 MM   $100 MM     $200 MM

Equities  67%       20%         90%
Bonds     33%       80%         10%

Asset Allocation Over Time -- In Ten Years

                      Dynamic Components
          Combined  Pensioners  Non-Pensioners
          $300 MM   $200 MM     $100 MM

Equities  43%       20%         90%
Bonds     57%       80%         10%

Source: The Segal Company and Lane Clark & Peacock, LLP

Note: Table made from pie chart.

RELATED ARTICLE: takeaways

* A misconception about freezing pension plans is that the plan sponsor can stop worrying about it. Actually, freezing a plan requires a prompt and urgent top-to-bottom re-evaluation on several fronts.

* Frozen pensions come in two varieties: "hard" and "soft," with soft being the most common approach.

* In either the hard or soft freeze, employers will either enhance or create a new plan to offset the impact.

* A new cashflow-based investment strategy is required, one that focuses on liquidity requirements, volatility tolerance and a process for transitioning to a bond and cash-only portfolio.