Derivatives, De-Risking and Disclosures

According to survey results provided in "Pension Plan De-Risking, North America 2015" (published by Clear Path Analysis and sponsored by Prudential Retirement), "pension risk management remains a principal concern for many plan sponsors." This should come as no surprise. Low interest rates, longer lifespans and anemic funding levels are a few of the concerns cited by the fifty-one senior professionals who answered questions. Half of the respondents agree that implementing a risk management strategy sooner than later makes sense, with one out of four individuals indicating an intent to transfer risk to an outside insurance company in 2015. Three out of four survey-takers "believe that movement in interest rates will impact their decisions to implement a liability driven investment strategy, or to execute a bulk annuity transaction." When asked about the use of alternatives such as hedge funds, fourteen percent replied that they currently use and seek to increase. One third currently allocates to alternatives and two percent look to introduce. Assuming that a respondent can only answer this question once and that there is one survey-taker per pension fund, this means that there is roughly a fifty-fifty split when it comes to including alternatives as part of a defined benefit plan investment portfolio.

If true that lower interest rates may discourage some plan sponsors from fully transferring risk to a third party insurer via a buy-out but they nevertheless seek to more actively manage pension risks, one could logically expect a greater use of a strategy such as Liability-Driven Investing ("LDI"). To the extent that LDI frequently entails the use of derivatives, those plan sponsors in favor of LDI may want to take note of a recent move by the U.S. Securities and Exchange Commission ("SEC"). As I just posted to my investment risk governance blog, certain registered funds could soon be asked to publish a considerable bounty of data about how they price securities, characteristics of trading counterparties and the specific use of derivative instruments. See "SEC and Asset Manager Disclosures About Use of Derivatives" (May 21, 2015). Sometimes an LDI strategy can include an allocation to alternatives. Post Dodd-Frank, lots of alternative fund managers are registering with the SEC. Connecting the dots, plan sponsors that use LDI and/or invest in alternatives are likely to benefit from enhanced disclosures made by asset managers.

Even those sponsors that decide on a risk transfer of some type other than LDI will soon be impacted by reporting mandates. In "Employers must disclose pension de-risking efforts to PBGC," Business Insurance contributor Jerry Geisel explains that data regarding lump sump arrangements will have to include answers to questions such as those listed below:

  • How many plan participants "not in pay status" were offered a chance to switch from a monthly annuity to the lump sum payout?
  • How many plan participants "in pay status" were given a choice?
  • What was the number of participants who made the choice to take a lump sum?

In its filing with the Office of Management and Budget ("OMB"), the Pension Benefit Guaranty Corporation ("PBGC") writes that "de-risking" or "risk transfer" events "deserve PBGC's attention because (among other things) they lower the participant count and thus reduce the flat-rate premium and potentially the variable rate premium." Fewer dollars being paid for this last-resort insurance "have the potential to degrade PBGC's ability to carry out its mandate..."

Given the complexities of managing pension risks and the regulatory changes underway, you may want to attend the May 27, 2015 educational webinar entitled "Pension De-Risking for Employee Benefit Sponsors: Avoiding Litigation and Enforcement Action." I hope you can join us for a lively and topical event.

De-Risking For Shareholders or Participants?

According to "De-Risking Focuses on Business Issues; Retirement Security a Concern, Critics Say" by BNA reporter Florence Olsen (Pension and Benefits Blog, November 2, 2012), the Pension Rights Center in Washington would like plan sponsors to catch their breath before partially or fully transferring its pension liabilities to third parties like insurance companies. Business Insurance editor-at-large Jerry Geisel writes that the Pension Rights Center wants the U.S. Congress to prohibit further pension de-risking transactions until legislators can assess the ramifications of giving some or all plan participants a choice to convert their future expected pension cash flows into a lump sum or having the employer contract with a group annuity provider to write checks instead of the original corporate sponsor. See "Pension Rights Center wants Congress to put moratorium on pension plan de-risking" (October 19, 2012).

In a forthcoming article for CFO Magazine, ERISA attorney Nancy Ross (with McDermott Will & Emery) and Dr. Susan Mangiero (with FTI Consulting) consider pension de-risking within the context of governance and the duty of loyalty to plan participants. They conclude that while there could be distinct advantages that accrue to retirees and workers when a sponsor enters into a pension de-risking transaction, ERISA fiduciary decision-makers may face personal and professional liability in the event that the economics of a deal mostly benefit shareholders.

In a recent announcement, one company that entered into a pension de-risking transaction cited the upside to include the following:

  • Enhancing the sponsor's long-term financial position;
  • Removing a "volatile" pension liability from the balance sheet;
  • Reducing cash flow and income statement volatility; and
  • Improving financial flexibility.

It is not known yet whether someone will challenge this kind of rationale as being too shareholder heavy or instead primarily in the best interest of plan participants who are impacted by a particular transaction. One might logically assert that a financially stronger plan sponsor means less risk for those participants who remain exposed to its credit risk and "ability to pay."

The use of an independent fiduciary could help to allay any concerns about issues such as deal terms, fees paid, the selection of the "safest available" annuity provider and the fair market valuation of contributed assets that are deemed "hard to value." Outsourcing or delegating the investment management function to a financial institution - in lieu of a pension transfer - may be another approach to consider.

Only time will tell whether the plaintiff's bar sees a possible "two hat" fiduciary conflict as a reason to file an ERISA lawsuit against corporate officers and/or directors.