General Motors Co.'s announcement that it will pay lump sums or annuities to more than 100,000 pension recipients is a game-changer. For years, corporations have been looking for ways to derisk their pension plans, to limit their liabilities and to avoid the volatility that comes with an underfunded plan. There have been many ideas circulating, but for real and substantial derisking, nobody wanted to “go first.”
Federal pension legislation passed in 2006 has put tremendous pressure on corporate defined benefit pension plans. For a law carrying the name The Pension Protection Act, it has imposed some onerous obligations on corporations that want to keep their pension plans intact. It requires corporations use AA corporate bond rates to value their liabilities. So in today's interest rate environment, the stated value of pension liabilities is at historic highs. As a result, the average funded ratio in the S&P 1500 is around 75%, and overall unfunded pension obligations are nearly $500 billion. At the same time, the law requires more aggressive actions by most plan sponsors to amortize their underfunding over seven years toward a target of full funding.
These factors will cause required pension contributions to double over the next 10 years. So it is no surprise that corporations have looked for solutions. GM is known to be a sophisticated manager of its pension liabilities and is a thought leader in this industry, so in coming weeks corporate boards will be occupied with the question “What are we doing?” And numerous other corporate sponsors will soon follow suit in considering all their derisking options.
One solution is liability-driven investing, which tries to use asset allocation or derivative overlay strategies to make the performance of a plan's assets rise and fall in parallel with the plan's liabilities. If you could invest 100% in AA corporate bonds with same duration as your liabilities, your assets and liabilities would rise and fall together as interest rates changed. However, many plan sponsors believe that if they adopt LDI, they are either locking in their deficit or throwing in the towel with rates so low.
Some corporations have considered a “buy-in,” in which they purchase an annuity from an insurance company as an asset of the plan, and that annuity is designed to meet specific liability-related cash flows in the future. This can also be done more flexibly and more cheaply without the insurance company in certain situations. This allows the company to avoid the settlement accounting charges that can accompany a complete defeasance in the purchase of annuity buy-outs.
Another option is issuing debt to fund the plan. This can make a lot of sense, because pension underfunding is a form of leverage and rating agencies increasingly are looking upon pension underfunding as debt. Moreover, because rates are so very low, it can be a good time to take this action. It is not suitable for all sponsors, but can make sense for many. However, many CFOs resist the idea of “crystallizing” this debt.
Each of these tools is designed to provide some relief from the crushing obligations of the PPA. However, while the PPA increased pressures, it also offered one particular form of relief — lump sums.
Before 2006, the discount rate for calculating liabilities paid in a lump sum was 30-year Treasuries. The PPA changed that rate to a corporate bond rate that was phased in over five years. That phase-in period concluded on Jan. 1. So now, a corporation that is considering paying lump sums can use a rate similar to AA corporates to calculate the value of the liabilities it extinguishes in a lump-sum payment. This essentially fully extinguishes the GAAP liability, and it provides the retiree with full value.
Lump sums are not for everyone, or for every liability. If they are paid directly out of plan assets with no additional contribution to the plan from the sponsor, the plan's funded ratio will fall. Some CFOs will not want the plan to become smaller, because they will lose potential earnings that can be attributed to the pension. If the corporation considers funding lump sums with cash, finance officers will have to consider whether that is the best use for that cash — or perhaps whether to issue debt to fund the lump-sum payments.
The most likely solutions will be combinations of these tools, and they will vary for every company. But whatever approach sponsors take, expect to see a flurry of derisking of pension plans in coming months. It has often been said that what is good for General Motors is good for the country. That may or may not be true, but what's good for the General Motors pension plan is certainly worth thinking about for others.
Charles E.F. Millard is managing director for pension relations at Citigroup Inc. He was director of the Pension Benefit Guaranty Corp. from 2007 to 2009. The views expressed are his own.
