Is there a better example of how the financial world is changing than the dramatic shift from defined benefit pension plans to defined contribution plans?
This change represents a significant shift in the responsibility from company to individual for providing financial security during retirement. However, before that shift is totally complete, companies with current DB plans have plenty of financial liability and responsibility left to tackle.
Given the extent of their pension liability, companies are seeking ways to mitigate the existing liability, shift risk and clean up their balance sheets - whether they are terminating their DB plan, freezing it or leaving it be. This focus, in large part, is to prepare for the 2012 deadline enacted by the 2006 Pension Protection Act, requiring DB plans to be fully funded.
This focus has intensified in the last 12 months as pension assets dropped due to market losses and will continue as short-term government funding relief measures end. This article focuses on one solution that transfers a portion of the DB plan liability and the associated risk off the company's balance sheet.
Ideal timing
This is an ideal time for DB plan sponsors to consider the benefits of transferring some or all of their plan liability and future risk to an insurance company. This transfer involves the purchase of commercial annuities and shifts the burden of future risks and liabilities, and the costs associated with benefit payments, to the insurer.
This is a way to not only mitigate the liability, reduce costs and clean up the balance sheet, but it also creates a level of certainty a CFO wants.
This strategy, sometimes referred to as a "carve out" or "buy out," enables the plan sponsor to eliminate the liability and costs associated with a certain subset of plan participants and transferring this cost and liability to a company whose core business is managing risk and benefit administration.
Groups of pension participants to consider in utilizing this strategy are retirees, terminated vested participants in the plan or plans inherited from acquired companies.
Plan sponsors should seek the advice of a qualified independent expert who can evaluate the potential benefits of this type of transaction to satisfy the Department of Labor's "safest available provider" rule for insurance company selection. Independence from the current plan and experience are crucial factors when choosing a provider.
The process begins with the preparation of participant data (census) along with benefit data and plan documents. This typically requires very little time on the part of the plan sponsor, as most of the information is readily available from their current pension actuaries.
As a first step, the independent firm's actuaries will analyze the data and both determine and demonstrate the most advantageous group(s), or subset of participants in the plan, for shifting to an insurance company. Once the populations and associated liabilities have been understood and segmented, a request for proposal is created for multiple life insurance carriers.
The firm earns its keep by working with multiple carriers and understanding how to derive the best offers and pricing by creating bidding wars. The objective is to compare the cost of transferring the liability to the insurance company to the plan's current liability for the particular subset of participants.
For example, on a $100 million plan liability, the goal is getting insurers to compete for the "low bid" of $98 million or $97.5 million. Once the insurers have been vetted and prices assessed and negotiated, the pricing required to purchase a single-premium group annuity contract - one actual annuity per participant - is presented, and the numbers are then compared to other future funding strategies and thought through with the plan sponsor.
Either current plan assets or current/future plan contributions can be used to purchase the annuity. Often, a company will employ a multiyear funding strategy, sometimes referred to as "remove as you go."
This strategy helps plan sponsors:
* Remove unwanted pension liabilities from the balance sheet.
* Reduce volatility of plan earnings and funding levels.
* Reduce the impact of future regulatory changes.
* Minimize the impact of adverse benefit option selection by participants such as subsidized early retirement or lump-sum options.
* Custom-design a risk transfer schedule.
Once liability is transferred to the insurer, the independent firm assisting the plan sponsor will provide participant communication and host group meetings to ensure the integrity of the transition.
One of the key selling points of this idea is that participants are better protected under the insurance company than the plan sponsor company because state guarantee associations, the entities that back up failed life insurers, offer greater protection than the PBGC.
An alternative to the "buy out" plan is to keep the annuity purchase inside the plan, a so-called "buy in." This strategy allows the plan to hold the annuities as an asset of the plan, while eliminating certain risks and effectively covering benefits for a selection of pensioners like an insurance policy.
Unlike many other pension assets, the annuities provide for a perfect "asset-to-liability match" and thus a viable de-risking strategy that should be considered by most plan sponsors.
Implementation of the buy-in method allows for a smooth transition to the buy-out method in the future if, and when, it makes sense to best address the needs and objectives of the plan.
Vernon W. Holleman, III is president of The Holleman Companies, an insurance advisory firm with pension experience, based in Chevy Chase, Md. Jeff W. Webb is the firm's director of advanced planning. They can be reached at Vernon@hollemanco.com and Jeff@hollemanco.com.
