Defined benefit (DB) pension plans are subject to unexpected changes in plan financing as a result of three primary factors: investment performance, interest-rate movements and increases in participant longevity. Lately, sponsors of DB plans have been exploring options for mitigating those risks. One such “de-risking” strategy consists of transferring risk from the plan to current terminated vested participants by offering a lump-sum window.
By law, a plan cannot require a terminated participant to take a distribution as a lump sum if the amount of the lump sum exceeds a certain threshold. Rather, lump sums can be provided only as an optional form of payment that is offered with an alternative annuity payable at the same time, and that can be elected only with spousal consent if the participant is married. A participant who elects a lump sum receives a single payment instead of monthly pension checks.
While DB plan sponsors can offer lump sums as a standard option, offering lump sums only as a one-time window benefit avoids creating a protected right to the lump-sum option in the future and might produce a higher acceptance rate than an option that is a permanent plan feature. Moreover, an employer can choose to limit the size of the group to which it offers a lump-sum window, subject to applicable nondiscrimination rules.
For example, in April 2012 Ford Motor Co. announced it will offer a lump-sum window to about 90,000 U.S. salaried retirees and former employees as part of its efforts to de-risk its U.S. pension plans. Shortly afterward, General Motors said it plans to offer 42,000 salaried retirees and beneficiaries the choice of taking one lump sum in lieu of monthly pension checks.
Before 2012, a lump-sum window generally would have carried with it considerable incremental cost because of the legally required basis for calculating lump-sum payments, which included Treasury bond rates as well as corporate bond rates. Beginning with the 2012 plan year, however, the amount of a lump-sum payment is based solely on corporate bond rates. These rates are similar to the rates used by employers for plan funding and expense calculations, which means that the value of a lump-sum distribution will be aligned better with its corresponding liability on a funding basis and an accounting basis. This alignment should reduce the incremental cost of a lump-sum window and temper the overall impact on a plan’s contribution requirements and balance sheet.
Lowering Financial Liabilities
A lump-sum window can help to de-risk a pension plan in two ways:
• Because liabilities will be transferred through the lump sums to participants who accept the offer, the plan will bear no future investment risk, interest-rate risk or longevity risk for those transferred liabilities.
• Because the size of the DB plan will shrink in terms of assets and liabilities, the dollar impact of any future negative events, such as severe investment losses, will be reduced.
Simply put, volatility surrounding a smaller financial obligation is better than volatility surrounding a larger financial obligation.
One type of plan sponsor that might benefit from this particular de-risking strategy is a company with a pension plan obligation that represents a significant percentage of the company’s net worth or market capitalization. The level of investment sophistication of the plan’s terminated vested participants might be another factor in the decision to open a lump-sum window, given that individuals who are confident in their ability to invest are most likely to welcome a lump-sum window.
Improving Plan Economics
In deciding whether to offer a lump-sum window, a plan sponsor might wish to consider how it would affect its own and plan economics, including the impact on the following:
• Opportunity cost. If the rate of return in the future on the assets disbursed in a lump-sum window would have exceeded the interest rate used to determine the lump sums, the plan will have lost an opportunity to benefit fully from those returns (“opportunity cost”). For example, if an employer assumes that its DB plan assets will return 7.5 percent in future years, the current lump-sum interest rate of approximately 5.0 to 5.5 percent represents an annual opportunity cost of 200 to 250 basis points. The assessment of the importance of this opportunity cost should be weighed against what could be gained by keeping control of investment decisions.
Sponsors of underfunded plans might place greater value on potential additional investment gains than would those of overfunded plans, which have less need for more surplus, such as well-funded frozen plans. However, sponsors of well-funded plans that are not frozen and have continuing accruals also might place a high value on the opportunity to benefit from higher investment returns, which could be used to help finance those future accruals.
• Funding requirements. The impact of a lump-sum window on a plan’s funding will depend on whether the plan is near one of the key funding thresholds, such as 60 percent or 80 percent at the time of the window. If a plan is within 10 percent of these thresholds, a lump-sum window could have a materially negative impact by moving the plan into a lower funded status, which could trigger the need for additional cash contributions or benefit restrictions.
Plans that are not near a funding threshold are unlikely to see a change in their minimum required contributions in the wake of a lump-sum window. This is because assets and liabilities are removed from the plan on a near-equal basis, resulting in an unfunded liability that is substantially equal to the unfunded liability before the window and with little or no change to the funding schedule.
• Accounting consequences. An important issue to consider is whether a lump-sum window will trigger “settlement accounting.” Generally, settlement accounting is required when a significant portion of the plan’s liabilities are discharged, as could happen with a lump-sum window, and it includes financial statement reporting. Plan sponsors that wish to avoid settlement accounting (for example, because of other plan losses that would result in a settlement charge, such as actuarial losses attributable to previous investment losses or interest rate declines) might nonetheless be able to offer lump-sum windows by limiting the size of the group to which a window is offered, to the extent permitted by the nondiscrimination rules.
• Duration of liabilities. A lump-sum window likely will decrease the duration of a plan’s liabilities, because the duration of the group being cashed out (terminated employees not yet eligible to retire) generally is greater than the average duration of the entire plan. With some of the longer duration liabilities cashed out, the average duration of the remaining liability decreases. Therefore, the remaining liabilities are likely to be slightly less sensitive to changes in interest rates. In most cases, where the duration of the plan’s assets is currently less than the duration of the liabilities, this drop in the duration of the liability would serve to decrease that mismatch, further reducing interest rate risk.
• Asset allocation. If a lump-sum window results in a significant reduction in assets and liabilities, the asset/liability profile of the remaining plan should be examined. It might be advisable to change the asset allocation of the remaining plan based on the plan’s new risk profile.
• Plan expenses. A lump-sum window could result in certain expense savings associated with a smaller number of participants. These could include Pension Benefit Guaranty Corp. (PBGC) premium payment savings and a savings in costs associated with the future monthly payment of the benefits paid out as lump sums. On the other hand, there could be current expenses associated with administering the window, including calculating the lump-sum distributions, particularly if the plan has not previously offered lump sums.
Administrative and Operational Issues
Once the economic viability of a window has been determined, plan sponsors should consider the following issues:
• Window design. Determine the final design of the window including the terms of the lump sum (for example, whether it includes any early retirement subsidies and the details of the interest rate assumption), the terms of the immediate annuity that must be offered, the eligible group of terminated vested participants and the applicable nondiscrimination rules.
• Plan amendment. Consider amending the plan to reflect the terms of the lump-sum window, including the method for calculating the lump sums.
• Participant data. Evaluate the accuracy and completeness of the records that will be needed to locate eligible participants, some of whom might have terminated many years ago, and to calculate the window benefits.
• Forms and communications. Consider what special forms and communications will be needed for the window. These might include election and spousal consent forms, relative-value disclosures and summaries of material modification (SMMs).
This article was originally published in the May 2012 issue of Spotlight: Strategic HR Consulting, a publication of Sibson Consulting, a division of Segal, and is republished with permission. © 2012 by The Segal Group, Inc., parent of The Segal Company and its Sibson Consulting Division. All rights reserved.
CFO Survey: Continued Volatility Will Alter Pension Risk Management, SHRM Online Benefits Discipline, December 2011
Risk-Management Q&As for HR Professionals Who Oversee Pension Plans, SHRM Online Benefits Discipline, November 2011
Underfunding of Liabilities Seen as Top Pension Risk, SHRM Online Benefits Discipline, November 2011
Should You Accept a Pension Buyout Offer?, AOL Dialy FInancie, May 2012
SHRM Online Benefits DisciplineSHRM Online Retirement Plans Resource Page