This is the first in a four-part series analyzing news and trends in the defined benefit retirerment industry.

Most analysts agree DB plans ended 2007 in surprisingly good shape, as year-end data presents a healthy picture including a slowdown in freezes and robust funding levels.

"There is an opinion that [defined benefit] plans are somehow an albatross around the neck of corporate America. But when you look closely, you get a very different picture," says Michael Hall, a consultant at Russell Associates, and he is not alone in his assessment. This is in contrast to the doom and gloom scenario forecast about the impact of new regulations on DB plans. The Pension Protection Act and phase one of changes from the Financial Accounting Standards Board have fundamentally altered the regulatory framework for defined benefit pension plans, marking the biggest change since ERISA some 30 years ago.

Although plan sponsors are still scrambling to absorb and implement new requirements, the more immediate threat to the status quo is the recent plunge in stock markets and availability of credit. This volatility could severely disrupt what would otherwise be a relatively pretty pension picture.

"It's getting pretty bouncy," admits Alan Glickstein, a senior consultant at Watson Wyatt. But most plans are ready to handle the turbulence. One key trend, he notes, is "a serious and thoughtful review of pension plan financing and design at every major organization I've worked with."

Freeze frame

Plan freezes are a crude but honest measure of the state of the DB industry, and by this metric the industry has reason to cheer. "While there has been much talk in the market of the freezing of pension plans, in fact we have seen a slowdown in the number of plan freezes," says Joe McDonald, North American lead for global risk services at Hewitt Associates. Moreover, most plans that were considering freezing or closing, at least in the near future, have already done so. According to McDonald, "most organizations have looked in depth at this issue and have come to a conclusion, one way or another and have already implemented it."

Pat Kendall, vice president of Diversified Investment Advisors in Purchase, N.Y., also has found DB freezes among his company's clients have slowed. About a third of clients already have frozen, a third still are assessing the issue, and a third have rejected the idea. "Once they get through all the analysis and consider the issues from all angles, a certain portion of plan sponsors will choose to do nothing," Kendall says.

Ironically, though many in the industry worried the stiffer funding requirements from the PPA and FASB changes would lead to more closures and freezes, they may have had the opposite effect. The Pension Benefit Guaranty Corporation's insurance program, as well as plans themselves, are now on sounder financial footing. Many plans that would have otherwise terminated will now only freeze.

Says Dallas Salisbury, CEO of the Employee Benefit Research Institute, "The ability to say a benefit is insured' by the government is one that employees like and thus sponsors like," reducing freezes.

But freezes might someday return. Sponsors continually revisit this issue and could change their strategy. Most importantly, FASB's phase two accounting changes are expected in 2012, and experts anticipate they will have a significant impact. Under phase two, funded status will flow through income statements, unlike phase one, where funded status has made its way onto balance sheets but no farther. With funded status part of corporate earnings, as is likely under phase two, the DB system will face new stresses.

"Accounting standard changes ... will prove to be more important for the future of the DB system than the funding changes of PPA," Salisbury predicts. Combined with market volatility and low interest rates, this could create another tipping point leading to greater freezes.

Assessing funded status

The funded status for Fortune 500 plans went largely unchanged in 2007, hovering around the mid 90s, according to statistics from most pension consultants. But what "unchanged" doesn't indicate is that 2007 was a wild year in terms of volatility. Though plans roughly started and ended the year in the same place, they were dramatically overfunded in the middle of the year. So far in 2008, estimated funding levels have declined, also dramatically, perhaps by as much as 10% in January alone.

"Until the end of the year, everybody had lots of cash, and funding wasn't a problem," says Hall. Market conditions accounted for this. So did accounting changes, and PPA's funding targets, to be phased-in during 2008.

Under PPA, plans generally will have to reach 100% funded levels. Underfunded plans will face greater reporting and disclosure burdens, and in extreme cases may be required to close. Plans may have been "front running" or anticipating PPA and therefore improving their funded levels.

But what happened in the first month of 2008? "There is still a lot of volatility in the pension system, regardless of the intentions of the PPA," says Hall of how plans handled the market dowturn. But not everyone is at risk for facing crippling funding deficits. Overall, according to Russell findings from fiscal 2006 disclosures, there is a "skewed distribution" regarding funded status. Some plans are overfunded, the median is 90% funded, but a small number of plans, 5%, are severely underfunded at only 60% of their target level.

The health of the sponsoring organization is important to this issue as well. If a pension plan is huge relative to the company, it will have trouble making up any deficits through contributions. Despite worries in the press, most pension plans are small compared to the market value of the corporation. Unfunded liabilities, in terms of the overall size of the company, are smaller still. For plans in the Russell 1000, at the median, unfunded liabilities represented less than 1% of market value - little more than rounding error. There are, of course, some exceptions - airlines come to mind.

The bottom line, according to Hall: "Most plans are well-funded. And most shortfalls are only a small part of their sponsoring organization," resulting in a healthy funding environment, despite current market challenges.

"Whether ongoing or completely frozen, our forecasts show almost everyone will reach 100% funded status over the next seven years," he says, if not through favorable market conditions, then through contributions making up the difference.

In the long run, the new stringent standards for funding and solvency could mean overfunding becomes the real problem for plan sponsors. DB plans that still exist are highly unlikely to be underfunded. "The issue of the future may be overfunding with no way out for the assets," Salisbury says. "It will lead to future debate over whether or not sponsors should have access to funds in a plan, or be allowed to use them more easily for other post-employment benefits."

Investment solutions

The immediate challenge facing plans is market volatility as well as declines in both equity markets and interest rates. Recent accounting changes and PPA mean this volatility is more transparent and hitting plan financials. This has led plan sponsors to consider investment approaches that address these challenges head-on, such as liability-driven investing (LDI) as well as absolute return and portable alpha strategies to enhance returns. "They are all efforts to deal with the new dynamics of DB plans, and we are seeing activity in that regard," says Andrew Klebanow, a consultant at Greenwich Associates.

LDI is the strategy with the most buzz. In essence, LDI is a portfolio-wide strategy, or even mindset, where assets are benchmarked against liabilities rather than an index. Investments are managed in a liability-sensitive manner. LDI investment solutions can involve a change in asset mix to better match liabilities, such as the use of long duration bonds. Or in complex form, it can entail the use of an overlay strategy of swaps to hedge out interest-rate risk.

"Every plan sponsor we meet with is interested in considering the concept of LDI. There is considerable movement out there," says Scott Jarboe, a principal and senior retirement consultant at Mercer. Jarboe has found sponsors are beginning to think more about their liabilities in setting strategies, even if they haven't formally changed their benchmarks or their policies.

But if they are looking at LDI and thinking about LDI, this doesn't mean they are implementing LDI. As Jarboe admits, many plans don't have the assets to meet liabilities and must engage in targeted risk-taking by trying to grow assets. In essence, plans are balancing risks versus costs. Says Jarboe, "Some plan sponsors are deciding the trade-off is such they are willing to tolerate risks in order to pursue performance-seeking strategies." Others, however, will determine they cannot tolerate risks and will move to LDI to take asset/liability mismatch off the table.

Along the same lines, Kendall of Diversified says, "LDI is not terribly dissimilar to freezing in one respect. To date, there has been a lot more talk than action." He feels LDI has been implemented by many large plans, but most small and midsize plans have been slower to act.

So if plans are busy discussing but not actually implementing LDI, what are they doing instead? Data from Greenwich Associates show the real action in 2007 was not in LDI but in changes to allocation to traditional asset classes. Equities still dominate, but there has been an increase in global exposure and a decrease in domestic exposure. Allocations to alternatives, such as hedge funds or private equity, remain low but are rising. In terms of fixed income, plans explicitly embracing an LDI strategy may be using overlay strategies as well as increasing their bond durations, but overall, says Klebanow, "We are not seeing a universe-wide shift from equities to fixed income." (Watch for the June 1 Investment Insider for more detailed coverage of LDI.)

Operational solutions

Outsourcing - of administration or even investing - is another way for plans to add efficiencies. Freezing can control liabilities, and investments can improve funding levels, but reducing administrative expense can create savings, too. Bundling services together using fewer vendors, or perhaps only one, can reduce administrative and financial burdens. This trend is most pronounced among smaller plans and frozen plans, but experts expect it to grow. A single firm can do online calculations, trust and custody, benefits statements and recordkeeping.

Fiduciary concerns may prevent large-scale outsourcing of the investment program, but this not always the case. "For sponsors of frozen plans in particular, the plan is no longer a critical piece of a benefit program, so plan sponsors are looking for different delivery models," says McDonald of Hewitt.

Frozen plans, though they still need to satisfy their fiduciary requirements, could delegate or transfer assets to someone else. One common solution is to transfer assets and liabilities to an insurance company via an annuity purchase. Going forward, McDonald envisions alternative risk-transfer vehicles for frozen plans, such as selling liabilities to a financial services firm.

Liability-driven investing creates a particular need for outsourcing because traditional managers may not have the skill sets to execute the complicated swaps involved. Says Scott Jarboe of Mercer, "We think there will be a trend for more outsourcing of unique risk management solutions." Smaller plans may be willing to consider actually outsourcing assets, whereas larger plans may outsource more of the advice but still control LDI execution.

Sponsors' perspectives

"Clearly, the regulatory environment with PPA and FASB has made plan sponsors more sensitive to the volatility of pension expenses and funding, and so a lot more are doing LDI in one form or another," says William F. Quinn, chairman of American Beacon Advisors, a wholly owned subsidiary of AMR Corporation, the parent of American Airlines. It manages the DB plans of American's unionized workers but also has mutual funds open to retail clients. The funded status of the DB plans is close to 90%.

American Beacon has been using a form of LDI since 1982, says Quinn, proving a liability-sensitive investing strategy is nothing new, even if the acronym LDI is. In American Beacon's case, it consists of a heavy allocation to long-duration bonds, which make up close to 40% of the portfolio. The big change recently has been the addition of an interest rate swap overlay of 10%. The resulting portfolio is 50% hedged against any interest rate shifts.

"The reason we added the overlay strategy was partially the new regulations and partially because our funded status got better," says Quinn. Even so, he is continually looking for better returns in a low return environment. Hence, he has allocations to alternatives like private equity, as well as oil and gas. Twenty-five percent of the portfolio remains in U.S. value stocks.

The Boeing Company is another major plan sponsor pursuing an LDI strategy, partly in response to changing regulations. Unlike American Beacon, they made the shift recently.

"Last year, we transitioned to a liability-driven investment/ alternatives approach. When we developed that approach, we considered PPA, [FASB] phase one and Boeing's business model, among other things," says Mark Schmid, Boeing's chief investment officer.

In Boeing's case, the strategy consists of a substantial allocation to long-duration bonds, which now make up 45% of the portfolio and closely match the duration of pension liabilities. Alternatives like hedge funds, private equity and real estate account for a full third of the portfolio. U.S. equities have been substantially reduced. Together, the new allocations have added returns and diversification, while reducing volatility by 300 basis points.

The DB plan, at year end 2007, was 110% funded, up from 80% five years ago. An internal team of 20 makes investment and strategy decisions. Schmid says having a long-term perspective when making investment selections is key. LDI has been useful, too.

In what is certainly an understatement, Schmid says, "The strategy we implemented during 2007 has been timely, given the higher volatility of recent months."

A central lesson from American Beacon's and Boeing's experiences is that plan sponsors are finding new ways to manage risks without freezing the plan. Most sponsors have looked at the design of their plan and reached a decision about whether or not to freeze it. The next challenge facing most sponsors, therefore, is how to better tackle financial governance and volatility. Looking back at the promise and peril of recent regulatory reforms, Glickstein of Watson Wyatt says, "We thought we were at a tipping point in terms of accelerating the end of DB plans. What each plan sponsor does next is situation-specific. But we now feel the system is in a very healthy place."

David Adler is a New York City-based freelance writer specializing in retirement benefit issues. He will write three additional issue of Investment Insider this year for EBN.

Where the retirement savings are (listed in billions of dollars)

Source: Employee Benefits Research Institute, 2007

Retirement income disparities between men and women

Source: Employee Benefit Research Institute, 2007

Expectations that a defined benefit pension plan or Social Security will provide a major source of retirement income, by race/ethnicity and household income.

Defined Benefit Pension Plan