J.P. Morgan Predicts Gloomy Year Ahead For Pension Plans

According to its Fall 2012 issue of Pension Pulse, published by the J.P. Morgan Asset Management Strategy Group, 2013 is going to be "grim" for pension funds after a less than jovial 2012. Citing a drop in funded status for many U.S. plans this year, "despite a 14% stock market rally," trouble spots are unlikely to disappear any time soon, putting continued pressure on the size of liabilities.

To tame the beasts in the form of "funded status volatility, unfavorable changes in the index used to value pension liabilities and longevity assumptions that increase liability values," employers continue to explore de-risking transactions such as offering lump sums and buyouts. Contrary to popular belief, the authors point out that even companies with underfunded plans like lump sum arrangements. The appeal is in part motivated by tax rules that allow "certain plans to use backdated discount rates to value lump sum payouts" that are higher than current discount rates.

Although the evidence suggests an increased demand on the part of plan sponsors to de-risk, J.P. Morgan professionals reference a ceiling of about $70 billion more over the next four or five years before industry capacity is reached for pension risk transfers. Of course, any time that demand increases and supply remains static, prices will rise as a result. At the margin, that could encourage some organizations from de-risking.

The report goes on to describe a "surreal discount rate" situation as the result of some bank securities being downgraded below AA in June of 2012. The net effect - a change in the discount rate curve that "reduced the weight of financials" - left only ten issuers to make up 75% of the market value of the index. Arguably, this increases the "inherent concentration risk" which in turn could increase the volatility of the index, thereby sending employers off on a measurement roller coaster ride. Shareholders could then feel the pinch if companies have to add cash to a plan as funding levels sink.

Adding insult to injury, the authors describe a change in actuarial assumptions that could significantly push the costs upward for companies that sponsor pension and Other Post Employment Benefits ("OPEB") programs. Their assertions are that (1) "changing actuarial assumptions are likely to increase pension liabilities by 2% to 5%" and (2) uncapped post-retirement health care benefits could go up by 6% to 9%.

Taken individually or together, the various pressures on retirement plan liabilities suggest a busy year ahead for ERISA fiduciaries and their support staff.

CFO Magazine Article About Pension De-Risking

In case you missed the launch of "Applied to Pensions, Risk is a Four-Letter Word" by Dr. Susan Mangiero and ERISA attorney Nancy Ross (CFO Magazine, November 8, 2012), experts conclude that Chief Financial Officers need to do their homework before entering into a particular deal. "Beyond the obvious number-crunching needed to vet what's often a large dollar transaction, the decision to de-risk should minimally include:

  • A thorough evaluation of the financial, operational, and legal strength of the annuity provider as required by the U.S. Department of Labor Interpretative Bulletin 95-1.
  • Independent pricing of any hard-to-value assets that will be contributed as part of a de-risking deal.
  • Economic assessment of opportunity costs in a low interest rate environment and whether it is better to delay a transaction or close immediately.
  • Review of vendor and counterparty contracts that may need to be unwound in the event of a full transfer of pension assets and liabilities to a third party.
  • Review of direct and indirect fee amounts to be paid by a plan sponsor as the result of a de-risking transaction.
  • Assessment of litigation risk associated with plan participants asserting that they've been unfairly treated as the result of a pension de-risking arrangement.
  • Creation of a strategic communications action plan to ensure that plan participants, shareholders, and other relevant constituencies are provided with adequate information."

In a related commentary, ERISA Stephen Rosenberg describes the chaos in the defined benefit plan market that continues to give plan sponsors pause about staying with the status quo. Click to read "On Getting Out of the Pension Business."

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.