Companies Detangle from Legacy Pensions

"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.