Two notable, if not surprising points can be gleaned from Exhibit II. First, the median contribution amount of $273 million seems only marginally higher than the $237 million cost for the traditional plan – an additional cost of only $36 million on a billion dollar plan. How can this be? Where is the supposed benefit to the traditional plan from holding equities and other assets that promise a risk premium?
In large part this missing payoff can be explained by the asymmetrical impact, from a sponsor contribution perspective, of holding return-seeking assets like equities. In bad market scenarios, contribution requirements increase as funded status deteriorates. But in good scenarios, higher funded status has a limited impact on the sponsor, since plan surpluses can only reduce contributions to zero.5
Said differently, once a plan is fully funded from a regulatory perspective (which PPA requires over a 7-year timeframe), leaving the assets invested in equities means they can only do harm by requiring more contributions if markets decline, but can’t reduce contributions if markets rise.
In that sense, it is perhaps less surprising that the hibernation strategy does not require much more cash than the traditional strategy, in which the long-term impact of equity allocations is effectively capped from the sponsor’s perspective.
Second, we note the dramatic reduction in contribution volatility in hibernation. The 5th
range of simulation outcomes is much tighter, with roughly $60-70 million of uncertainty in either direction from the median contribution total. While the majority of the market risk has been removed by matching assets to the liability, some residual volatility remains due to remaining risk factors like longevity risk and variation in corporate bond defaults and downgrades. Nonetheless, the risk-return tradeoff of a hibernation strategy seems quite compelling. By comparison, the traditional strategy appears to be risking a lot to gain a little.6
Having seen one de-risking strategy, the question quickly turns to how various strategies stack up against each other. We expect sponsors are most eager to compare hibernation to annuity buyouts. However before doing so, we should acknowledge that any real world decision is likely to consider broader factors beyond the contribution analysis we present here. Decision-makers are likely to include a variety of quantitative and qualitative factors when weighing the pros and cons of hibernation and annuity buyouts, such as the value of a buyout’s longevity hedge, the risks associated with litigation, and so on.