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.
by Michael Blanding
"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.
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.
Source: Harvard
Business School
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