On Nov. 5, 2013, the ERISA Advisory Council submitted findings and recommendations on pension de-risking to the Secretary of Labor. Pension de-risking transactions have received a lot of attention lately, both in the media and among sponsors of defined benefit pension plans. Therefore, this communication from the Advisory Council is an important summary of the current state of the market for de-risking transactions from a business and legal point of view, as well as a possible sneak preview of potential new government regulations in this area.
As readers are probably aware, defined benefit pension plans present risk to sponsors since they are fully responsible to fund benefits for participants up to the level provided in the plan. As a very general matter, “de-risking” refers to one of two ways that a pension plan sponsor can try to reduce its exposure to the volatility it faces, whether it be funding volatility or balance sheet volatility. Funding volatility refers to the fact that, due to a number of reasons (primarily interest rate and asset value fluctuations), it is very difficult for a plan sponsor to project a required contribution level that it is able to rely on for purposes of fully funding the plan. Similarly, balance sheet volatility refers to the fact that, for financial accounting reporting purposes (and for much the same reasons that there is funding volatility) plan sponsors are unable to predict whether they will be forced to recognize a large loss (or gain) due to their sponsorship of a pension plan. Capital markets don’t like surprises, and CFOs find it particularly frustrating when they need to report surprises that are triggered by factors outside of their control; hence, the efforts to de-risk this liability.
The first way that plan sponsors can de-risk pension liability is to attempt to “match” assets and liabilities in such a way as to minimize the volatility of the funding and balance sheet exposures. This is basically achieved through an investment strategy (referred to as Liability Driven Investing or “LDI”) that focuses on the investment of plan assets in fixed-income securities that will correlate returns to increases or decreases in plan liabilities. So, to over simplify, since pension plan liabilities are closely linked to interest rates, the strategy is to invest in assets that will increase (and decrease) in value when liabilities increase (or decrease) in value due to interest rate fluctuations. Since pension plan liabilities are not tied to equity returns, an LDI strategy avoids or minimizes equity exposure.
The second way for a plan sponsor to de-risk liability is to transfer it to someone else. One way to transfer a benefit liability is to transfer the benefit to the participant by paying out the benefit in a lump sum. The other way is to purchase an annuity from an insurance company. When a plan is terminated (the ultimate form of de-risking) all liabilities are transferred to an insurance company or paid as lump sums. Some plans have chosen a partial de-risking strategy, where only the liabilities of a certain segment of the population, typically retirees and/or terminated vested participants are transferred.
So, to summarize, at a very high level, the first approach (LDI Investing) merely involves a change in how plan assets are invested. The second approach has a much greater impact on plan participants, as it may change who will pay their benefit and requires them to decide whether or not they want to receive a lump sum distribution. It is this second approach which raises the most issues under ERISA.
Goals of the Advisory Council
The Advisory Council identified the following four goals:
1. Identify significant factors contributing to the increase in de-risking activity.
2. Distinguish between the two different roles of settlor and fiduciary in de-risking transactions.
3. Explore alternatives to de-risking transactions.
4. Analyze the need for participant protections in de-risking transactions.
The Advisory Council received testimony from more than a dozen sources, ranging from the American Benefits Council to insurers such as Prudential Retirement and MetLife, as well as on behalf of groups such as the Pension Rights Center and the AARP. In its executive summary, the Advisory Council stated its findings as follows:
– Plan sponsors are de-risking their defined pension plans: For a variety of reasons, including the fact that accounting standards and funding rules have increased volatility. In a variety of ways, including transferring risks to participants and insurers.
– Plan sponsors and participants could benefit from a clarification of and from the addition of safe harbors to, DOL’s Interpretive Bulletin IB 95-1 (“IB 95-1”).
– Plan sponsors generally could benefit from educational outreach on the topic of de-risking.
– Participants, especially those in pay status, face challenges in understanding the nature and impact of these transactions on their retirement security.
– Participants could benefit from: Disclosures focused on these specific transactions, and; Sufficient time to review and consider those disclosures.
– Plan sponsors, participants, and the pension system generally could benefit from: The collection of information to track de-risking trends; Coordination of de-risking issues with other agencies.
The Advisory Council concluded with five areas of recommendations to the Department of Labor. These recommendations are summarized below, along with some background and reaction.
First, the Advisory Council suggested confirmation that IB 95-1 applies to any purchase of an annuity from an insurer as a distribution of benefits under a defined benefit plan, and not just purchases coincident with a plan terminated. By way of background, the IB relates to “the fiduciary standard under ERISA when selecting an annuity provider for a defined benefit pension plan.” The IB established what is known as the “safest annuity provider” rule. Although it was clearly issued in response to plan termination related annuity purchases, there is nothing in its text of the IB which would suggest that it only applies in the termination context. Therefore, it appears that plan sponsors should take into account the position of the Advisory Council and of the Interpretive Bulletin prior to purchasing annuities in a de-risking transaction. The Advisory Council further recommends the development of safe harbors within the scope of the Interpretive Bulletin for such purposes.
Second, the Advisory Council recommends that a defined benefit plan providing participants with an option of a lump sum distribution within a specified window, with or without a separate option of the distribution of an annuity in Interpretive Bulletin 95-1, should provide disclosures similar to required plan termination disclosures, with not less than 90 days’ notice, and include such factors as:
– Whether early retirement or other subsidies are included.
– Comparison of lump sum to promised benefits under the plan.
– Potential impact of tax penalties, if any.
While this generally appears to be a suggestion for a requirement that goes above and beyond the rules under current law, plan sponsors offering a lump sum should be aware of the current law fiduciary duty implications of any communications they provide to plan participants regarding an election to take a lump sum distribution.
Third is a recommendation that the DOL consider providing guidance under ERISA §502(a)(9) clarifying:
– The consequences of a breach of fiduciary duty in the selection of an annuity contract for distribution from the plan;
– The term “appropriate relief,” and
– Under what types of circumstances generally “posting of security” may be necessary.
Section 502(a)(9) is relatively obscure provision of ERISA. It provides that:
In the event that the purchase of an insurance contract or insurance annuity in connection with termination of an individual’s status as a participant covered under a pension plan with respect to all or any portion of the participant’s pension benefit under such plan constitutes a violation of part 4 of this title or the terms of the plan, by the Secretary, by any individual who was a participant or beneficiary at the time of the alleged violation, or by a fiduciary, to obtain appropriate relief, including the posting of security if necessary, to assure receipt by the participant or beneficiary of the amounts provided or to be provided by such insurance contract or annuity, plus reasonable prejudgment interest on such amount.
For an interesting discussion of the numerous issues raised by this provision see Testimony of Brendan S. Maher, ERISA Advisory Council, United States Department of Labor August 29, 2013 Hearing: Pension De-Risking, available at http://www.dol.gov/ebsa/aboutebsa/erisa_advisory_council.html#2 (last viewed December 4, 2013).
Fourth is a recommendation for the DOL to provide education and outreach concerning de-risking to plan sponsors on:
– The range of options available.
– The distinction between settlor and fiduciary functions.
– The distinctions among disclosure, education and advice to participants in connection with distributions, options and elections.
The concern of the plan sponsor community on this recommendation is whether the DOL’s view of the rules, as expressed in their “education and outreach” materials would be different than what plan sponsors believe the rules provide. In other words, the DOL should be careful not to make new law by issuing informal guidance that has not been subjected to the normal agency rulemaking process.
Finally, the Advisory Council recommends that the DOL consider collecting relevant information regarding plan de-risking transactions.
Consideration of pension de-risking transactions is almost a minimum requirement for most mid-size to large defined benefit pension plan sponsors for a variety of reasons. Some of those transactions that have been implemented have been criticized by retirees and even the media. While additional guidance would be welcome, it should not add to the already unfavorable legislative and regulatory environment for pension plan sponsors.
Reprinted with permission from Employee Benefit Review - February 2014