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Big companies look to shed pension burdens -- and that's a good thing

Big companies look to shed pension burdens -- and that's a good thing

A growing number companies are looking to get out from under burdensome pension obligations – and this is not such a bad thing, for either retirees or investors.

Pension programs among those American companies that still have traditional defined-benefit plans have consistently been underfunded.

Yet the financial stress on these plans -- which must pay lifelong benefits to retired workers -- has become even more intense, as ultra-low interest rates make it hard to meet ballooning obligations and lifespans continue to increase.

Pension-granting companies in the Standard & Poor’s 1500 index, which includes both large and small public companies, were only 79% funded, in aggregate, as of Dec. 31, and their collective deficit more than doubled to $504 billion from a year earlier, according to consulting giant Mercer.

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At the end of 2007, the aggregate corporate pension system was fully funded, which means these retirement plans have made up only about one-third of the ground lost in the Great Recession and bear market in stocks.

The main drag on pension finances right now is historically miniscule interest rates around the world. Short-term rates in the developed world anchored near zero and long-term government bonds yielding not much more. Skimpy rates penalize the present value of pension funds by lowering the “discount rate” on future obligations, which inflates liabilities. And the scarcity of safe income squeezes current and expected fund investment returns. In addition, premiums charged by the federal Pension Benefit Guarantee Corp., which backs private pension plans, have been increasing.

Passing off pension obligations

In recent years, big companies have looked to offload their pension commitments by paying an insurance company to assume the obligations for a fee. General Motors Corp. (GM) and Verizon Communications Inc. (VZ) entered such agreements in 2012, with GM shifting $25 billion in retiree pension obligations and Verizon more than $4 billion. NCR Corp. (NCR) and SPX Corp. (SPW) followed with similar deals.

Often, but not always, these so-called “risk transfer” transactions involve lump-sum payments to retirees, and/or an annuity delivering regular income.

Mercer, a division of Marsh & McClennan Cos. (MMC), maintains a U.S. Pension Buyout Index to estimate the cost to companies of transferring pension obligations, which took a dive in the past month, suggesting such a move is becoming more enticing to pension-plan sponsors.

Low rates and increased longevity assumptions for retirees increased the cost to companies of maintaining pensions relative to handing them off to an insurer. Much of the carrying cost to companies comes in the form of complex accounting for long-term liabilities that can depress reported earnings and apply a discount to the company’s valuation in the stock market.

Mercer
Mercer

A MetLife Inc. (MET) survey in late 2014 found that 29% of companies with defined-benefit plans were considering a risk-transfer within the next two years.

At a quick glance, this trend might seem yet another instance of companies withdrawing support for secure employee retirements. Most big companies, of course, spent the past couple of decades imposing defined-contribution plans, such as 401(k)s, placing more of a burden on individual workers to save for old age.

And, not surprisingly, some retirees are made uneasy by the handing off of their crucial benefits to a financial firm eager to make a good return on the business.

A group of Verizon retirees is suing to block the company's pension transfer to a Prudential Financial Inc. (PRU) unit, arguing that the move deprives them of certain protections under ERISA, the main law governing pensions.

For instance, after such a transfer the benefits might not be shielded from creditors in the event of a retiree’s personal bankruptcy. And if an insurance company is handling a plan, the PBGC isn’t a backstop in the event the company fails.

Yet, on the whole, the trend toward shifting pension exposure to the insurance industry is probably a positive for retirees and the system.

Richard McEvoy, head of the financial strategies group at Mercer, points out that this activity represents the movement of long-term liabilities from manufacturing or consumer-service companies to the insurance sector, which is built to price, store and manage such risks.

Another benefit: Usually a pension plan needs to be fully funded before it’s transferred, which often means injecting more capital and setting more realistic investment-return assumptions. This makes the plan more secure before it’s taken over by an insurer subject to strict capital reserve requirements and 50-state regulation.

McEvoy – whose firm, granted, facilitates such transactions – points out that pension transfers move retirement plans from “underfunded, undercapitalized, under-hedged” companies to “overfunded, overcapitalized, hedged” insurers.

The stock market, for what it’s worth, has tended to applaud these moves, lifting share prices of companies that offload their defined-benefit exposure even though it often leads to big upfront expense and accounting charges.

Companies would likely rush in even greater numbers to shed their pension burdens if interest rates finally rise significantly, especially if equity markets hold up well. This would painlessly improve their pension funding status and allow many more boards and chief financial officers to explore this option.

Here’s yet another reason investors and retirees alike might wish for interest rates to “normalize” before too much longer.