Concerns over pension de-risking
This summer the ERISA Advisory Council (EAC) held hearings on “Private Sector Pension De-Risking and Participant Protections,” and on November 5, 2013 the EAC issued summary findings and recommendations. At the hearings a number of participant advocacy groups raised issues with aspects of current defined benefit plan de-risking practice.
In this article, we begin with a brief review of de-risking strategies, then describe the issues being raised by participant advocacy groups and conclude with a review of the EAC’s recommendations.
De-risking strategies generally
While de-risking can be understood to include an array of pension plan finance strategies – e.g., liability driven investments – the focus of the EAC and participant advocates is on strategies that involve the transfer of benefits (and their associated assets and liabilities) from a DB plan and its sponsor to participants and, in some cases, insurance companies. When we refer to de-risking in this article we are limiting it to the latter sorts of strategies. These transfers have taken several different forms:
Paying lump sums to terminated vested participants. This has been one of the most common de-risking strategies. For benefits below a certain level (generally, $5,000 or less) this generally can be done on an involuntary basis; above that level it generally requires participant consent (and, if the participant is married, spousal consent).
Offering participants a choice between lump sums and annuities. This strategy can, of course, be used for terminated vested participants, but it has more commonly been used to ‘de-risk’ retirees (that is, retired participants currently receiving benefits). Thus, under this strategy, retirees are offered a lump sum, and for anyone who declines the lump sum option, the plan buys an annuity from an insurance company. This strategy may involve a formal termination of that portion of the plan that is being de-risked.
Distributing annuities. The participant’s benefit is distributed to her without her consent. This strategy may involve identifying specific participants/retirees and distributing annuities to them, without any formal termination procedure.
Lump sums vs. annuities
One way to analyze de-risking strategies is to break them down between those that only involve lump sums and those that include (or are limited to) annuities.
With respect to lump sum strategies, part of what has driven recent de-risking transactions is a change in the rules for lump sum payments in a DB plan made by the Pension Protection Act of 2006 (PPA). Prior to the PPA, lump sums were valued using the 30-year Treasury rate; that rate was (and is) generally lower than the rate used to value liabilities under a corporate DB plan for both funding and accounting purposes. Thus, pre-PPA, it ‘cost money’ to pay a lump sum – the lump sum that was paid out generally was greater than the value of the benefit (liability) being carried on the sponsor’s books.
PPA provided (subject to a phase-in) that lump sum payments would be valued based on the same corporate bond yield curve used for funding. Thus, when the new PPA rule was fully phased in, in 2012, the amount paid as a lump sum was (more or less) equal to the value of the benefit carried on the sponsor’s books and could be paid out without sustaining a loss.
(Note that under MAP-21, which ties funding liabilities to 25-year average interest rates, lump sum benefits will be greater than the funding liability for the next few years, but lump sum payments remain similar to companies’ GAAP liabilities.)
Unlike (post-PPA) lump sums, it still ‘costs money’ to pay an annuity. It has been estimated that paying out an annuity costs 105% – 110% of the ‘book value’ of a retiree’s benefit (even higher for active and deferred vested participants). This additional cost reflects the annuity provider’s regulatory and administrative costs, any difference in underwriting criteria, and profit margin.
Thus, from a strictly financial point of view, under current rules paying out a lump sum is generally more cost effective than paying out an annuity. As we noted, however, there are legal restrictions on paying lump sums – generally, for amounts above $5,000 the participant (and his spouse if any) must consent.
Issues raised by participant advocates with respect to de-risking
Participant advocates (including, e.g., the American Association of Retired Persons (AARP), the National Retiree Legislative Network and the Pension Rights Center) have raised a number of issues with respect to both lump sum and annuity based de-risking strategies.
With respect to lump sum strategies the issues raised by participant advocates include:
In retirement, annuities are better than lump sums. According to the Pension Rights Center, “offering lump sums to retirees in pay status is bad policy.” Quoting AARP testimony at the EAC hearings: “The fact is, most retirees are typically better off in retirement with a defined benefit pension annuity than they are with a lump sum. Study after study demonstrates that retirees who have defined benefit pensions are far less likely to outlive their assets or fall into poverty.” Because of annuity provider fees, regulatory costs, etc., the lump sum recipient is unlikely to be able to reproduce her DB annuity by using the lump sum to buy, e.g., a retail annuity. However compelling this argument may (or may not) be with respect to retirees, it is less clearly an issue for terminated vested participants and de-risking strategies that focus solely on them.
Lump sums may not include, e.g., early retirement subsidies. This has, of course, always been the case and an issue for participant advocates. With respect to de-risking, advocates are particularly concerned about whether the participant understands that this is the case.
The offer of a lump sum can raise a number of personal issues. A number of witnesses at the EAC hearings observed that the recipient of a lump sum offer may come under pressure from family members or be the victim of scam artists. This issue may be more acute for older retirees who may suffer from diminished capacity and are a target for fraudulent financial schemes.
With respect to annuity strategies issues raised by participant advocates include:
PBGC guarantees. After distribution to the participant, the insurance company’s annuity is not protected by PBGC guarantees. If the company becomes insolvent, the participant may not get his full benefit. This was generally identified as the most significant issue with respect to annuity buyouts. Witnesses repeatedly noted that state insurance guaranty funds only cover from $100,000 to $500,000 in losses. Quoting the National Retiree Legislative Network white paper on this issue: “[T]he PBGC’s maximum guarantee in 2013 for a life annuity with no survivor benefits of $57,477 yearly at age 65 equates to $763,672 on a present value basis.”
ERISA fiduciary and other protections are lost. While the initial annuitization transaction will generally be subject to ERISA fiduciary rules (e.g., the ‘safest available annuity’ requirement under Interpretive Bulletin 95-1), subsequent transactions by the annuity carrier (e.g., transferring the annuity to another ‘less safe’ carrier) are not. And, in some states the annuity, unlike a participant’s DB plan benefit, may be subject to claims of creditors.
Where annuities are distributed without a formal termination procedure, plan funding may be reduced. As noted, paying out annuities ‘costs money’ – the cost of the annuity is more than the book value of the participant’s benefit. Generally, if the sponsor does not contribute additional money to the plan to cover this cost, then, post-de-risking, the plan will be less well funded than it was prior to de-risking.
Recommendations of participant advocates
We review the recommendations of the participant advocacy groups because they will give sponsors an idea of the sorts of initiatives policymakers may consider – not just at the Department of Labor but also in Congress. These recommendations include:
Requiring plans to provide enhanced disclosure, including: information evaluating the pros and cons of, and extended time to consider, any election; information about the tax consequences of any election; whether a lump sum does not include an early retirement subsidy; provision of (and perhaps paying for) independent advice; protections to mitigate and prevent undue pressure; information on the effect of the transaction on retiree health benefits rights.
DOL issuing guidance that makes it clear that a de-risking transaction that reduces the funding of the ongoing plan is a violation of ERISA fiduciary rules.
Updating Interpretive Bulletin 95-1 to ‘strengthen’ the fiduciary rules with respect to annuity purchases in a de-risking transaction. Several participant advocates have proposed requiring that the sponsor be required to buy ‘reinsurance’ or a backup guarantee to cover the portion of the participant’s benefit that was covered by PBGC but may not be covered by the relevant state guaranty fund. This guidance could also include ‘minimum standards’ for a de-risking annuity, including, e.g.: protection against creditors; protection against subsequent ‘de-risking’ by the annuity carrier (e.g., conversion of the annuity to a lump sum); and inclusion of a procedure for dispute resolution.
Some advocates would go so far as to ban lump sum distributions to retirees in pay status and to ban annuity distributions without a formal PBGC termination procedure.
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It was in the context of these participant advocate criticisms of current de-risking practice that DOL’s ERISA Advisory Council held hearings on these issues.
The ERISA Advisory Council
It may be helpful to begin with a brief description of what the EAC is. The ERISA Advisory Council was established by ERISA as a group of 15 individuals appointed by the Secretary of Labor. The EAC’s job is to “advise the Secretary with respect to the carrying out of his functions under [Title I of ERISA] and to submit to the Secretary recommendations with respect thereto.” The Council includes three labor representatives, three employer representatives, three representatives of the general public and one representative each from insurance, corporate trust, actuarial counseling, investment counseling, investment management, and accounting.
Each year the EAC undertakes review of certain current ERISA topics. This year, among other issues, the council took up the issue of “Private Sector Pension De-Risking and Participant Protections.” At hearings this summer the EAC heard from participant advocates (whose views are summarized above), plan sponsor representatives and others. On November 5 it released preliminary findings and recommendations; a full report on this issue is expected next year.
The following are the EAC’s recommendations to DOL on de-risking:
1. Confirm that Interpretive Bulletin 95-1 applies to any purchase of an annuity from an insurer as a distribution of benefits under a defined benefit plan, not just purchases coincident with a plan termination, and consider the development of safe harbors within the scope of the Interpretive Bulletin for such purchases.
2. A defined benefit pension plan providing participants with an option of a lump sum distribution within a specified window, with or without a separate option of the distribution of an annuity described in IB 95-1, should provide disclosures similar to required plan termination disclosures, with not less than 90 days’ notice, and include such factors as:
Whether early retirement or other subsidies are included,
Comparison of lump sum to promised benefits under the plan, and
Potential impact of tax penalties, if any.
3. Consider providing guidance under ERISA section 502(a)(9) [the provision of ERISA dealing with causes of action for fiduciary violations with respect to annuity distributions] clarifying:
The consequences of a breach of fiduciary duty in the selection of an annuity contract for distribution out of the plan,
The term ‘appropriate relief,’ and
Under what types of circumstances generally ‘posting of security’ may be necessary.
4. Provide education and outreach concerning de-risking to plan sponsors on:
The range of options available
The distinction between settlor and fiduciary functions
The distinctions among disclosure, education, and advice to participants in connection with distributions, options, and elections.
5. Consider collecting relevant information regarding plan de-risking transactions.
Significance for plan sponsors
Clearly the participant advocate community has some significant problems with current de-risking practice. DOL’s position is, at this point, unclear, but the EAC at least believes that something should be done. Enhanced disclosure seems to be an obvious place to start. Whether there will be enough support for, e.g., a ban on lump sums for retirees or strict limits on the ability of sponsors to distribute annuities remains an open question.
In our next article we will consider the current state of ‘de-risking finance’ – how changing interest rates and accounting and funding rules are affecting the de-risking calculus.