17 Feb 2014  Research & Ideas

Companies Detangle from Legacy Pensions

Although new defined benefit plans are rare, many firms must still fund commitments to retirees. Luis M. Viceira looks at the pension landscape and the recent emergence of insurance companies as potential saviors.

 

"Goodbye tension, hello pension!"

That used to be the triumphant cry of millions of new retirees. For decades, Americans assumed a good job came with a good pension, guaranteeing them regular monthly payments from their parent company until the day they died. The plans were also known as "defined benefit" plans because they assured recipients of a set monthly amount they could always rely on.

Then, starting in the 1980s, the nest egg started to crack. As firms began competing globally, pension perks began to be seen as very expensive liabilities. Within a few decades, nearly all corporations ceased offering defined benefit plans in favor of "defined contribution" packages such as 401(k) plans—in which employees contribute a set amount from their paychecks that would be individually invested for their retirement.

"More and more, companies are looking for a way out of pension plans, while still making good on their obligations."

Although companies often match those contributions, they are under no obligation to continue to do so after retirement, and employees can't rely on a predetermined monthly amount the way they could with earlier benefit plans.

"That world has been disappearing," says Luis M. Viceira, the George E. Bates Professor at Harvard Business School. "In the past few years, there have been zero defined benefit plans created in the United States. The trend, at least in the corporate world, has moved very quickly. "

Companies that traditionally offered defined benefit plans have closed them to new hires, and even frozen them for existing employees. Just look to Seattle, where Boeing workers on January 3 narrowly ratified a contract that will convert their traditional pension plans for newly hired machinists to a 401(k) program. Boeing threatened to move construction of the 777X jetliner to another state without the concession.

FUNDING THE FUTURE

Even so, companies are still on the hook for paying benefits to those employees who have already been promised them. As their workers age, employers face the difficult question, How are we going to make good on those promises?

Pensions are a costly legacy for many companies.
Photo: iStockPhoto

The question is particularly urgent now, says Viceira, who teaches in the area of investment management and capital markets. For starters, the financial crisis depleted many pension plans by dramatically reducing the value of investments, even while companies were still responsible for paying predetermined benefits.

Increasing the pressure are two other factors. Life expectancy has increased, adding to the length of time corporations are required to pay. And interest rates have fallen to historic lows, increasing the funding that companies must set apart to make up for the lower yield on the assets already in place.

"Companies have had to increase their contributions exponentially as interest rates declined," says Viceira. That strain was a major factor in bankruptcies in the steel, airline, and car industries. More and more, companies are looking for a way out of pension plans, while still making good on their obligations.

They have three choices, says Viceira. The first is to do nothing and continue to invest in equities, hoping the numbers will work out. The second is to work a deal with employees for a lump-sum payment covering the value of their pension, walking away without further obligations. That number can be large, however, and few companies can afford to pay out all that money at once.

REDUCING PENSION PLAN RISK

The final option is for companies to "de-risk" their pension plan by putting assets into more predictable investments that generate enough income while still reducing the risk due to market or interest rate volatility. To do that, some companies are turning to the experts in evaluating risk: insurance companies.

In the HBS case study Prudential Financial-General Motors Pension Risk Transfer: Back to the Future?, Viceira, with Emily A. Chien, wrote about the historic de-risking of GM's pension plan for salaried employees, a $25 billion deal negotiated last year. GM transferred its assets to Prudential, which then promised to make good on the benefit payouts in the form of guaranteed annuities.

The deal made sense—after all, who better than insurance companies to estimate life expectancy and long-term risk. And by pooling the GM annuities along with its wider population of beneficiaries, Prudential could manage risk better than the automaker could on its own.

That doesn't mean the deal was without its challenges. The two companies had to decide who was going to assume the assets and the liabilities—was GM going to "buy-in" annuities from Prudential while still maintaining full responsibility for paying out the pensions; or was it going to "buy-out" the annuities, transferring both the assets and the liabilities of the plan to Prudential's own balance sheet? The decision would determine who was ultimately on the hook if either company went under.

Eventually, the companies agreed that GM would buy-out the plan by transferring the assets and liabilities to Prudential. But even that had to be done carefully, since selling the assets in the pension plan all at once to buy annuities could potentially affect the value of what they were worth. Finally, there was the overall price of the deal—requiring months of complex number-crunching to determine the value of the investments and cost of the pay-outs over time.

But both companies had incentive to come to an agreement—which they eventually did for an undisclosed sum. GM removed an uncertain liability from its balance sheet, and Prudential got to take a piece of the pension business away from the asset management companies that have traditionally handled those investments.

"Even though [defined benefit plans] are dying elephants, it's going to take a long time for those elephants to die," says Viceira. "Insurance companies are now back in the game of managing these assets, some of which we might see moving from the BlackRocks of the world to the Prudentials of the world."

Another potentially lucrative target being considered by insurance companies are public pensions, "the huge elephants that are very much alive and kicking," says Viceira.

MORE BUSINESS AHEAD

Time will tell if insurance companies are able to stay in the game long term, but so far other pension-pressed firms have shown interest and followed GM's lead; Verizon, for example, also completed a deal with Prudential. Other companies have been stopped in similar migrations only because their plans are not fully funded—but that could change with a moderate rise in interest rates, sending more elephants stampeding into the waiting arms of insurance companies.

"If interest rates go up and [companies] find themselves fully funded or over funded, they will start going for these deals," says Viceira.

While corporate pensions may ultimately go extinct, these kinds of deals may ensure that currently existing pension liabilities will continue to be paid well into the future.

About the author

Michael Blanding is a senior writer for Harvard Business School Working Knowledge.

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Comments

    • Richard Fusinski
    • Retired GM Salary, GM Retiree

    If GM would have managed the pension fund the way they should have instead of borrowing and stealing from the fund it would, be an issue. It's just like the government stealing from the Social Security. The amount of money that we paid into that plan is worth a lot more then the average person will even draw from it. The interest since I was a kid would make me quite wealthy right now. Just big ponzi schemes......... But they are not in jail for it! Now they want to call our contributions "Entitlements" :) Just a bunch of legal crooks.

     
     
     
    • Anonymous

    Once GM decided to freeze the plan, it makes perfect sense to get rid of the liability. DB plans were designed to attract and retain workers and, although they still may have that allure, employers think otherwise and do not need the financial aggravation of maintaining a plan that no longer meets its objective. Insurers, by contrast, are experts at managing annuities and are, as a whole, much more financially secure than most corporations, owing to the strict regulation on assets and capital and duration matching. The real "crime" is that pension actuaries routinely underestimate the true mortality profile of the workers (that is they don't reflect the reality that people live longer now) and overestimate the true interest discount rate. Insurers cannot afford to be wrong about these inputs -- there is no one to go back to if the assumptions are wrong. When rates rise, let's hope the CFOs remember and dispose of their frozen plans before the cycle turns again (e.g., lower stock prices and/or lower rates) and get out while its cheap enough and not a huge cash drain to their business of making cars, steel, or widgets.

     
     
     
    • Kapil Kumar Sopory
    • Company Secretary, SMEC(India) Private Limited

    More and more organisations, even in the Government sector, are feeling the burden of spending on post-retirement pensions and hence planning to devise rules which could replace pension by one time payment (gratuity) at the time of retirement. Some organisations are deducting a pension contribution from salaries which would form a corpus to meet pension payments. A few have developed such and similar schemes involving insurance companies. Although no employer is compulsorily bound to pay pension, on human consideration it is desirable that some respite be made available to employees who have devoted the best part of their life to serve the employer. In old age, some regular income is needed to live till death and the basic needs have to be met. Very few save for such days and even if they do inflationary and other factors reduce the savings quickly. Pension is therefore a recipe for some help on a regular basis.

     
     
     
    • SUMAN
    • Manager, WBSEDCL

    The present mass of employees doesn't seek for the benefit whatever they get after retirement and most of the people doesn't stick to one organization throughout the lifetime,people mostly look for their annual package during employment,that's attracts the mass the most,so at the present situation keeping a pension fund and increase the long term liability has no meaning to attract talent.So its a good move throughout the globe to shift to a fixed saving based onetime payment rather then the conventional pension.