Director | CAPTRUST Consulting Research Group
General Motors has received significant press coverage since early June about their decision to implement a sizeable pension risk transfer strategy. This event occurred as most defined benefit pension Plan Sponsors were seeking to control cash contribution and financial statement volatility amidst a challenging legislative and accounting change backdrop. Plan Sponsors face three primary obstacles in their quest to control this volatility: (1) low interest rates; (2) volatile capital markets; and (3) demographic uncertainties. The GM decision indicates that some Plan Sponsors are now willing to pay a premium to reduce this uncertainty. In short, they are evaluating strategies to address more than just capital market risk and the asset-liability mismatch.
General Motors announced that it planned to reduce its underfunded U.S. salaried pension plan obligation by $26 billion by employing a two-part pension risk transfer strategy. The first component involved offering lump sum payments to one-third of its U.S. retirees. Lump sum windows allow the transfer of assets from the plan to the participant and eliminate mortality risk and premiums associated with annuity purchase. As a result of recent rule changes, a disparity may exist between lump sum rates and current discount rates used to measure pension liabilities. In some cases, this creates an opportunity for Plan Sponsors to pay lump sums out at a lower cost than the current actuarial measure of the liability.
The second component included purchasing a group annuity from Prudential for the remainder of retirees who were not offered or did not elect the lump sum. Buyout strategies—otherwise known as terminal or single-premium group annuities—involve paying an insurance company a premium in order for it to assume the responsibility for paying participants future annuity streams. This strategy eliminates mortality risk but may trigger settlement accounting, and involves paying additional fees to an insurance company beyond the actuarial measure of the liability.
This combined pension risk transfer approach will cost GM close to $3 billion in excess of the current liability and will reduce their total estimated U.S. salaried pension plan obligations from ~$134 billion to ~$108 billion. While we were not privy to discussions involving this transaction specifically, it is reasonable to assume that GM was focused on a number of the challenges that face most pension Plan Sponsors today. Following you will find a primer on several of these issues.
The current low interest rate environment creates a larger pension liability measured in today’s terms.
Interest rates on high-quality corporate bonds used to discount pension liabilities determine pension funding ratios, contributions, and balance sheet entries. Higher interest rates lead to a lower pension liability in today’s dollars and vice versa. The 10-Year U.S. Treasury, which is a building block for corporate bond rates, touched an all-time low yield of 1.44% on June 1, 2012, driving liability present values higher.1
Disappointing asset returns can create lower funding ratios when compared to otherwise-elevated liabilities. A rough approximation for the historical allocation of mostcorporate pension plans is 60% equity and 40% fixed income.A blend of 60% S&P 500 and 40% Barclays Capital AggregateBond indexes averaged 13.9% in the 1980s and 13.3% inthe 1990s. However, in the 2000s the same blended indexaveraged only 3.5%.2
In layman’s terms, actuaries are understating pension liability if people live longer than projected.
In March 2012, the Society of Actuaries published a study on the mortality tables most pension actuaries use. Mortality tables estimate how long pensioners will receive benefit payments based on life expectancy. This study evaluated the use of a new mortality table that would effectively increase pension liabilities by a margin of 1.4% to 3.6%.3
Annuity discount rates are materially lower than the effective discount rates used to calculate current pension liability. Insurance companies who seek to take on pensionliabilities through annuity transactions charge a premium.This premium generally includes mortality expense, assetmanagement, and administration costs, as well as profit.Dietrich & Associates, a terminal funding annuity servicesfirm, estimated rates between 2.8% and 3.5% in their June2012 update, which are materially lower than the rates oncorporate bonds utilized to calculate current liability.4
In summary, there are many tools that Plan Sponsors can utilize beyond asset or asset-liability strategies to address the volatility created in pension funding, contributions, and financial statements. Since this volatility can often create significant stress for organizations, many Plan Sponsors are evaluating the benefits and costs of pension risk transfer solutions. Each of these strategies has unique costs and benefits and involves a complex decision-making framework. We welcome the opportunity to further discuss what is most appropriate for your plan based on your unique objectives.
For additional information on pension risk transfer strategies, please reference “Pension Risk Management: What Are You ‘Buy-in’?” in our second quarter, 2011 Plan Sponsor Strategic Research Report edition.
1 U.S. Department of the Treasury Resource Center Daily Treasury Yield Curve Rates:
2 Zephyr Style ADVISOR
3 Report of the Society of Actuaries, Exposure Draft on Mortality Improvement Scale:
4 Dietrich & Associates, Inc. Interest Rate Update, June 2012: https://www.dietrichassociates.com/Default.aspx