As evidenced by recent pension de-risking transactions involving GM ($26 billion), Verizon ($7.5 billion) and Ford (potentially $18 billion), pension de-risking by extinguishing plan liabilities is emerging as a critical theme among defined benefit (pension) plan sponsor companies of all sizes. 

Over the last several years, plan sponsor concerns regarding volatility in pension obligations have been heightened by changes in accounting and funding rules, as well as by volatile capital markets, a low interest rate environment and longevity risk issues. Many defined benefit plan sponsors have frozen defined benefit plans to new hires, or frozen benefit accruals completely. Some sponsors of both frozen and ongoing plans have sought to reduce the volatility of their pension obligations by pursuing in-plan investment strategies, which include the use of swaps and derivatives, as well as strategies such as “immunization” or “liability driven” investing—or the purchase of annuity contracts held by the plan as an investment. None of these approaches settles or extinguishes the plan’s liabilities and the sponsor remains liable for Pension Benefit Guaranty Corporation (PBGC) premiums with respect to those benefits.

Sponsors may extinguish plan liabilities through a complete plan termination, but this is often not feasible or desirable due either to employee relations issues or the requirement that the sponsor fully fund the plan as a condition of a standard termination. 

More recently there appears to be increasing plan sponsor interest in the selective settlement of plan obligations through the use of “buy-out” annuities for, or offering lump sums to, certain segments of the plan population (both in the context of an ongoing plan or frozen plan, or a spin-off/termination). This increase may be as a result of (i) concerns regarding the relative success/expense of de-risking by plan investment strategies, (ii) recent private letter rulings by the IRS that provide helpful guidance on the use of lump sums and annuities to settle pension obligations, (iii) certain changes in the funding rules made by 2012 legislation known as “MAP-21”1 that make it less expensive for plan sponsors to maintain target funding ratios even after settling a segment of pension liabilities, (iv) increases in PBGC premiums enacted by MAP-21, (v) the possible revision of mortality tables used by pension actuaries to reflect longer life expectancies and (vi) the examples of GM, Verizon and Ford transactions. 

  • Verizon recently announced that it has entered into an agreement to transfer $7.5 billion in pension liabilities to Prudential. The transfer will be achieved through the purchase of a group annuity contract under which Prudential will assume the obligation to make annuity payments to 41,000 management retirees who retired prior to January 2010; the transaction is expected to close in December 2012, subject to final review and approval by an independent fiduciary for the plan.
  • Earlier this year, GM announced that it would spin-off the portion of its plan covering active and some former employees. Most retirees would remain in the existing plan, which will then be terminated. In the course of the plan termination certain retirees will be offered the choice of a lump sum distribution of the value of their remaining benefits. The benefits of those who do not elect a lump sum (and the benefits of certain retirees who will not be offered a lump sum) will be transferred to Prudential. GM estimates that its actions will reduce its pension liabilities by $26 billion. 
  • Under the de-risking program announced by Ford, 90,000 retired and terminated vested participants may elect to have their benefits distributed to them in the form of a lump sum distribution. For those who do not elect a lump sum, no annuities are being purchased from an insurer at this time. It has been reported that the lump sum offering could reduce Ford's pension obligations by up to $18 billion.

For many years, the buy-out annuity market has been valued at approximately $2 billion per year. That changed with the announcements by GM and Verizon, and a number of consultants are predicting that the pace of buy-out annuity purchases will accelerate in the United States (as we have already seen happen in the United Kingdom), particularly if interest rates go up even slightly.

The implementation of de-risking strategies, including the structuring and negotiation of insurance contracts with respect to ongoing, frozen or terminating plans, offering lump sum distributions to individuals in pay status, and the use of novel investments can be incredibly complex and, in addition to the difficult financial calculus, may involve insurance law, tax, qualified plan, accounting, and ERISA fiduciary issues. Companies interested in implementing such strategies are advised to seek experienced counsel.

For more information about the topics addressed in this Legal Update, please contact Maureen J. Gorman at +1 212 506 2679, Stephen G. Rooney at +1 212 506 2567, or Lawrence R. Hamilton at +1 312 701 7055.

1 Moving Ahead for Progress in the 21st Century Act.