Pension plan derisking enters its dynamic era

Faced with the volatility of equity markets, declining interest rates and rising pension deficits, U.S. corporations are exiting the business of providing and investing defined benefit pension plans. By now, fully one-third of S&P 500 companies have no defined benefit plan liabilities at all.

Of the plan sponsors that still do, our research shows that 60% have either closed or frozen their plans. Meanwhile, the recent high-profile decisions of Ford Motor Co. and General Motors Co. — to transfer pension volatility for thousands of salaried retirees and former employees through lump-sum payout offers and, in the case of GM, through an annuity purchase — only affirm that we've entered a new era of pension plan derisking.

Consider some of the latest numbers. According to figures from Mercer, the aggregate deficit in pension plans sponsored by S&P 1500 companies grew $80 billion in May to $488 billion. This deficit corresponds to an aggregate funded ratio of 76% as of May 31, 2012, compared with a funded ratio of 79% as of April 30, 2012, and just barely above the funded ratio of 75% at Dec. 31, 2011.

Thus, the funding gains achieved in the first three months of 2012 were effectively wiped out by the market trends of the second quarter. Much of this is due to a continued decline in interest rates on high-quality corporate bonds, which are used to measure pension liability. The discount rate for a typical U.S. pension plan, as calculated by the Mercer Pension Discount Yield Curve, dropped to a record low of 4.15%, driving aggregate S&P 1500 liability in excess of $2 trillion for the first time.

Indeed, the growing incentive for DB plan sponsors to address such risks was underscored by GM's June 1 announcement that it would transfer the pension risk for most of the company's salaried retirees — by far, the largest pension buy-out in U.S. history — through a combination of voluntary lump-sum offers and an annuity purchase by Prudential (Oliver Wyman and Mercer, affiliated firms of Marsh & McLennan Cos., were appointed by State Street, the independent fiduciary for the GM plan, to act as its insurance adviser on the transaction). A month earlier, Ford announced it would offer lump-sum pension payout offers to 98,000 white-collar retirees and former employees this summer.

Obviously, sponsors are thinking carefully about what the endgame will look like for their plans. Some are considering strategies where they retain pension liabilities (and associated risk) by aiming for a fully funded plan runoff over the long-term using a low volatility investment approach. Many, like Detroit's manufacturing giants, are expressing interest in risk transfer strategies to shrink liabilities, through a combination of voluntary lump-sum payments to plan participants and full or partial termination by purchasing annuities.

The potential flows involved are very large and are receiving a lot of attention from banks, insurers and asset managers. Let's consider the strategic landscape. For starters, defined liability pension plans can be segmented into three classes:

1. Open plans, where sponsors are providing defined benefit pensions to all active employees;


2. Closed plans, where future accrual to new employees was stopped at a point in time; and


3. Frozen plans, where no future pension benefits are accruing.

It's not always obvious into which category a particular company falls — indeed, it's possible to have multiple plans across the different categories. Most sponsors of closed or frozen plans are considering how to navigate the road to derisking them; it's mainly a question of “when” and “how” rather than “if. Given penal excise tax rules on pension funding surpluses, we see sponsors of frozen plans leading the derisking and pension risk transfer trend, because they will be pushed to full funding by Pension Protection Act rules and will have the least use for surplus given their lack of ongoing accrual of liabilities.

Many CFOs find such risk transfer approaches attractive in concept. A fundamental question, though, is whether the economics are beneficial for shareholders and what the accounting and cash consequences of any potential actions might be.

When considering pension funding and derisking actions, therefore, it makes sense for firms to adopt a holistic balance sheet view in order to capture the underlying economics in a far more rigorous and powerful way than traditional accounting or actuarial approaches. In this approach, pension deficits should be viewed as corporate debt whereby firms have borrowed from the pension plan. Firms might choose to replace this pension debt with direct borrowing from financial markets when the after-tax cost of this borrowing is less than the prevailing pre-tax risk-free rate.

Even at the very low risk-free rates prevailing at this time, about one-third of large plan sponsors can access capital market borrowing at spreads that make fund deficits inefficient from a tax standpoint. These are the organizations that are most likely to pursue pension risk transfer in order to maximize shareholder values. And in the U.S., pension risk transfer primarily involves two components:

1. Offering optional lump sums to plan participants, whereby they can elect to take the value of their benefits either as a rollover payment to an alternative pension arrangement (for example, an IRA) or as a cash lump sum; and


2. Annuitizing residual liabilities after any lump-sum offering with an insurer. In its simplest form, the plan pays a premium to an insurer which then assumes full responsibility for payment of benefits from that point forward.

By our estimates, combining lump sums and annuitization would save each of the 20 most affected S&P 500 companies between $1 billion and $6 billion in economic cost, according to Oliver Wyman research. However, the U.S. GAAP treatment of these strategies suggests they are costly when, in fact, the accounting treatment of liabilities does not reflect true economic cost, which differs from accounting cost because it capitalizes future plan expenses, such as PBGC premiums and administrative expenses, and includes opportunity cost. But market participants are becoming more sophisticated in their understanding of the risks involved in pension provision and are open to taking material, value-adding derisking actions even where accounting treatment is negative.

Given the attractiveness of annuitizing liabilities as described above, particularly those of retiree populations in corporate plans, is there capacity in the U.S. insurance market to absorb a material level of risk transfer flow? Flow in the U.S. has been very modest for the last two decades, with no year exceeding $5 billion in total amount annuitized. In our view, there is no real capacity barrier in the immediate term. However, for jumbo deals, the insurer engagement and negotiation process needs to be carefully handled to ensure that adequate price competition is preserved and potential sources of capacity are appropriately engaged.

In the light of Ford and GM's landmark decisions, the defined benefit world has embarked on its most dynamic journey, as plans seek lower and lower risk, strategies for doing so continue to evolve, and plan funding and accounting frameworks converge on the underlying economics. For those with an interest in ultimately reducing or eliminating their defined benefit exposure, it's time to evaluate the options using a rigorous, holistic framework grounded in financial economics as opposed to the conventional wisdoms of accounting. As some of America's greatest companies lead the way, others are bound to follow.

Note: The information contained herein does not constitute investment advice. Mercer and Oliver Wyman are affiliated companies of Marsh & McLennan Cos.

Sean Brennan is a principal in Mercer's New York office and is a member of Mercer's financial strategy group. Tom Murphy is a senior partner at Mercer and U.S. head of fiduciary management.