Leon LaBrecque is one busy financial planner these days. Based in suburban Detroit, LaBrecque has been meeting non-stop this summer with retirees from Ford Motor Co. and General Motors to help guide them through one of most important financial decisions of their lives: whether to accept a lump sum buyout of their pensions.
Both auto giants recently announced moves to terminate large portions of their defined benefit pension programs for retirees and other former workers. Both moves are unprecedented in size and scope – and experts think the moves foreshadow further pension “de-risking” moves by large private-sector pension plan sponsors that will affect current and future retirees.
Ford has offered 90,000 retirees the option to continue with their pensions or receive a lump sum buyout. General Motors followed up with a similar plan affecting 118,000 retirees but with a twist: Those who elect to continue their pensions will be paid through a group annuity contract GM has arranged with Prudential.
Private-sector, defined benefit pensions have been declining for years, and experts have been forecasting a further wave of big corporate pension “de-risking” moves. (Union critics call de-risking “pension dumping.” The problem is even more acute in the public sector, as has been making the news recently, especially with the bankruptcy of Stockton, Calif.) If the trend does accelerate, financial advisors will be on the line to help clients participating in these plans to make sound decisions.
For employers, a termination offers a tempting opportunity to remove defined benefit pension liabilities from balance sheets at a time when plans have become more challenging to run.
Under the Pension Protection Act of 2006 (PPA), plan sponsors were given seven years to boost their plans to 100 percent funded status. At the same time, stock market volatility and ultra-low interest rates have made it more difficult to earn adequate returns on pension plan portfolios. That, in turn, has forced plan sponsors to cut the discount rates used to project future returns, reducing funded status levels.
The funded status of the 100 biggest U.S. corporate pension plans dropped by $90 billion during just the month of May this year, as measured by the Milliman 100 Pension Funding Index. The top plans had a combined deficit of $357 billion, and the $90 billion decline was the seventh largest in the 12 years that Milliman, an actuarial consulting firm, has been tracking the top plans. Funded ratio fell to 78 percent, down from 82.9 percent in April.
The PPA makes termination more attractive for plan sponsors by shifting to a more favorable discount rate for lump sum payout calculations. Starting this year, the rate is pegged to yields on corporate bonds, instead of Treasuries. The higher discount rate produces lower lump sum payouts.
A Prudential white paper on the lump sum opportunities created by PPA estimates that the new discount rate rules can “potentially reduce individual lump sums by 5 to 25 percent,” depending on the age of the participant and the spread between Treasury and corporate bond rates at any given time.
But many plan sponsors have been holding off on terminations while they wait for interest rates to rise – which would boost the value of their pension assets and make terminations less expensive. Matt Herrmann, head of the retirement risk-management group at consulting firm Towers Watson, estimates that about 75 percent of U.S. pension plan liabilities are eligible to be settled “one way or the other.” But he says the timing will be difficult to predict.
“I know a significant number of plan sponsors are aggressively looking at opportunities. Whether they act will be a function of the funded status of their plans, the financial position of their business, how they expect the fixed income and equity markets to perform in the future and whether they are operationally ready.”
Here are some key points advisers should keep in mind if clients receive lump sum or pension transfer offers to third parties such as Prudential.
Lump Sum Offers
There is no one-size fits all answer to the choice between a pension annuity stream and a lump sum. Lump sums can make sense for clients with low longevity odds, or for those who have other reliable sources of regular income – for example, a spouse with a defined benefit pension -- and might benefit from the flexibility of access to the lump sum.
But the starting point for a client with a defined benefit should be status quo, because clients with a reasonable expectation of living long generally come out ahead with the pension. “I always ask the client, 'You already have an annuity. Why do we want to change that?'” says LaBrecque.
Another key question to ask: Can I beat the return of a pension by investing the lump sum? In order to do so, you'd need to be able to consistently beat the discount rate used to calculate the lump sum – currently about 4.25 percent – and to do it using risk-free investments, since the pension annuity stream is mostly risk-free.
I recently interviewed pension expert Moshe A. Milevsky of the Schulich School of Business at York University in Toronto on this topic; you can hear what he's got to say on this topic here.
At GM, a group of 42,000 salaried retirees and former workers who retired since 1997 will be offered a lump sum buyout, or the opportunity to continue with their pensions – but the plan obligations will be shifted to a group annuity GM will buy from Prudential, which will take on the obligations going forward. The remaining earlier retirees will continue with their pension payments, which also will be taken over by Prudential.
“When everything is completed, Prudential will have 100 percent of the responsibility for the pension participants who elect the annuity,” says Preston Crabill, director of strategic benefit planning for General Motors. “Each one of them will get their own annuity certificate that explains the contract between Prudential and General Motors. But that doesn't mean we're dropping our relationship with our retirees. These are 118,000 people who have worked for General Motors for most of their careers. Many of them continue to have life insurance and health insurance through us.”
GM workers who have retired since 1997 will have several choices. They can opt for a lump sum, either as a payout or IRA rollover; they can receive an annuity from Prudential with value can pick a combination of a lump sum and annuity. By law, outsourcing deals like this must keep pensioners 100 percent whole on promised benefits.
Pension transfer arrangements like GM's provide a much better deal than an individual would get buying an individual immediate annuity in the retail market. “I can't find any commercial annuities that are equivalent,” LaBrecque says. “This is like a fee-less annuity with no extra costs. It's worth 50 extra basis points or more, depending on the age of the individual.”
The key difference to weigh between the pension and annuity is safety.
Corporate pension assets are insured by the federally-sponsored Pension Benefit Guarantee Corp. (PBGC). If a plan goes belly up, the PGBC steps in to take over and continue paying benefits; most workers are kept whole on promised benefits up to the point of termination, with the exception of very highly-paid workers and some who participate in multi-employer plans.
Pensions transferred to insurance companies lack that protection, although they are backed up by state-level guarantee associations that step in to take payment of a portion of benefits in the event an insurer fails. Benefit guarantees vary from state to state.
But in most cases, it's $200,000 or $300,000 per annuitant,” LaBrecque says. Information on state plans can be accessed through the National Organization of Life & Health Insurance Guarantee Associations.
Pension transfer deals have one additional variable element that can affect risk. In some cases, the transferred assets are co-mingled with other assets of the insurer; in some cases –like the GM deal – they are segregated in a separate account structure. “If there was a significant financial event that caused stress for Prudential, we wouldn't be permitted to use money in a separate account to meet our other liabilities,” explains Phil Waldeck, senior vice president of pension & structured Solutions at Prudential. “So, we couldn't use GM's account to pay life insurance claims.”
Of course, safety is – to some extent – in the eye of the beholder. “I've been telling clients that the risk difference between a pension from GM or Prudential negligible,” LaBrecque says. “Prudential's balance sheet is exceedingly strong, and the GM pensions will be in a separate account. Meanwhile, the PBGC is underfunded by $26 billion, and GM's plan has been underfunded and the company has gone through bankruptcy. So I have the choice of an underfunded pension plan or a fully funded annuity from double-rated insurer. That might be a slightly higher risk, but not much.”
LaBrecque has published a guide to to the GM offer, which can be downloaded free.
Mark Miller is a journalist and author who writes about trends in retirement and aging. Mark edits and publishes RetirementRevised.com, featured as one of the best retirement planning sites on the web in the May 2010 issue of Money Magazine. He is a columnist for Reutersand also contributes to Morningstarand the AARP Magazine. Mark is the author of The Hard Times Guide to Retirement Security: Practical Strategies for Money, Work and Living(John Wiley & Sons, 2010).