The ultimate form of derisking a DB plan portfolio is risk transfer (e.g. purchasing an annuity or offering lump-sum distributions). With a risk transfer, a third party assumes responsibility for the pension liabilities. After the transfer, the plan sponsor is no longer required to report the liabilities on its balance sheet and incur administrative costs and expenses, such as Pension Benefit Guaranty Corp. premiums.
While prospects of jettisoning pension liabilities may appear appealing for many plan sponsors, the conditions that must be satisfied to implement this derisking strategy are likely to give most plan sponsors second thoughts. For example, paying lump sums will require that the transferred assets (i.e., payments to retirees or separated employees in lieu of future benefit payments) be equivalent to the present value of the liabilities. In the alternative case of annuities, insurance companies will require a premium to assume the annuitized pension liabilities. Thus, risk transfers through lump sums or annuities will require contributions for underfunded plans. Otherwise, any residual liabilities (those not included in the transaction) will be less funded than prior to the transaction.
For DB plans that are not fully funded, the question remains whether it is an optimal use of corporate cash or borrowing capacity to fully fund these pension liabilities. In addition, there are questions relating to current discount rates, accounting issues, and risk tolerance.
Providing lump-sum distributions or purchasing an annuity serves to settle liabilities at current discount rates and forgoes the possibility of reaping the potential windfall of an improvement in funded status from rising interest rates. Settling liabilities also may require special charges to a plan sponsor's reported earnings.
Risk tolerance is, of course, difficult to quantify. The recent announcements by both Ford Motor Co. and General Motors Co. to offer lump-sum distributions to certain salaried retirees and GM's plans to purchase an annuity covering virtually all salaried retirees are examples of how companies address extreme “balance-sheet” risks, in which market capitalizations are significantly less than the present value of the company's pension liabilities.
Although most plan sponsors are not likely to find it advantageous to transfer a significant portion of their DB liabilities to a third party in the near future, they can mitigate risk without materially compromising return objectives.