Automakers Take Extreme Measures to Reduce Pension Risks

Faced with crushing funding requirements and agonizing volatility, companies sponsoring pension plans are taking drastic measures to cut their risk.

General Motors stunned the pension industry with its recent announcement of a $26 billion plan to offload its pension obligations associated with 42,000 salaried retirees by offering lump-sum payments to those who choose them and annuitizing the rest through an insurer. GM has purchased a group annuity contract through Prudential to settle the retirement obligation for those eligible retirees that prefer to continue receiving monthly benefits. The bold move will reduce its balance sheet obligations by $26 billion, but will cost $3.5 billion to $4.5 billion in fees and pension funding to settle the transaction. And the adverse effects will be immediate: GM expects a hit to earnings of $2.5 billion to $3.5 billion in the second half of 2012 and an ongoing $200 million annual reduction in earnings as a result of the decrease in pension income.

GM announced its plans only a few weeks after Ford Motor Co. rolled out a lump sum offer to certain of its retirees to unload pension risk. Ford did not go as far as GM, however, in annuitizing pension benefits for those who pass up the lump sum offer. In GM's case, “it's about as dramatic a risk reduction approach as you could take,” says Mike Archer, a senior consulting actuary at Towers Watson. “It is taking all the liabilities off the books and passing it on to a third party so it no longer has any responsibility whatsoever.”

GM is not the first company to put a full-court press on pension risk, but it's easily the largest, says Sean Brennan, principal in the financial strategy group at human resource consulting firm Mercer. He said he's seen deals over the past several years that would be measured in the hundreds of millions of dollars, but never anything approaching the size of GM's plan. “It's a landmark decision,” says Brennan. "Many large companies have considered annuitization but have been reluctant to actually implement that strategy.”

Defined benefit pension plans have been dying out over the past several years as liabilities have outpaced funding, compelling companies to freeze plans or close them to new entrants, says Olivia Mitchell, a professor at the University of Pennsylvania and executive director of the Pension Research Council. Volatility and poor returns exacerbated by the financial crisis, along with the increased funding requirements brought on by the Pension Protection Act, have pushed up liabilities and forced companies to consider alternatives.

“What companies want most of all is predictability,” says James Klein, president of the American Benefits Council. “Companies that sponsor pension plans know it can be an expensive proposition, and they usually accept that as long as they can know with some degree of certainty looking out into the future what their pension obligation might be.” The uncertainty created by the current environment makes it difficult for pension plan sponsors to project that liability, which makes it hard to allocate capital to the operating business, he says.

“A sponsor has to be fully committed to believing that it cannot, in effect, outearn what the insurer can earn. There are a lot of companies that have not ascribed to that yet.”

—Mike Archer

Senior Consulting Actuary,

Towers Watson

Essentially, the move is all about risk management. A company would only go as far as GM has gone if it had determined the uncertainty or funding is too great to tolerate, says Archer. “A sponsor has to be fully committed to believing that it cannot, in effect, out-earn what the insurer can earn,” he says. “There are a lot of companies that have not ascribed to that yet.”

The Decision

There are numerous and complex considerations that lead up to a decision to pay out lump sums or annuitize a plan, pension experts say. Plan sponsors must consider the demographics of their plan participants, the funded status of the plan, asset performance, and actuarial estimates about life expectancy, not to mention the costs and consequences of offloading the plan. “It's a real potpourri of issues,” says Klein.

Under current market conditions, with interest rates at record low levels, annuitizing is expensive, says Stephen Herbes, an independent employee benefits attorney and a professor at Rutgers School of Law. “If interest rates were higher, it would be a cheaper proposition to annuitize,” he says. On the other hand, annuitizing enables a plan sponsor to terminate its premium payments to the Pension Benefit Guaranty Corporation, which backs all corporate pension plans in the event of corporate failure.

GM ANNOUNCEMENT

Below is an excerpt from General Motors' announcement regarding the change to pension plans:

General Motors Co. today announced that it will provide select U.S. salaried retirees a lump-sum payment offer and other retirees with a continued monthly pension payment securely administered and paid by The Prudential Insurance Company of America, a Prudential Financial, Inc. company.

The retirement plan actions will result in an expected $26 billion reduction of GM's U.S. salaried pension obligation.

Approximately 42,000 salaried retirees and surviving beneficiaries will be eligible to receive a voluntary single lump-sum payment option. GM plans to purchase a group annuity contract from Prudential under which Prudential will pay and administer future benefit payments to most of the remaining U.S. salaried retirees. The transactions are expected to be completed by the end of 2012, following completion of regulatory review. Prudential would then assume responsibility for the benefits covered by the agreement and begin making the benefit payments in January 2013.

“We appreciate the contributions our retirees have made to the company and we have taken great care in ensuring the security of their retirement benefits,” said Cindy Brinkley, GM vice president of global human resources. “Many of our retirees will now have more flexibility to manage their retirement funds and we are confident that Prudential will provide outstanding service to those receiving a monthly payment.”

Approximately 118,000 U.S. salaried retirees are impacted by these changes in different ways, depending on retirement date and eligibility. Salaried retirees eligible for the lump-sum payment will have until July 20, 2012 to make a decision on their payment options. The eligibility and pension options for the majority of retirees are:

Source: General Motors.

In addition to the upfront cost to settle the obligation with an insurer, companies must consider accounting consequences, says Archer. Currently, companies are allowed to smooth over their pension gains and losses by recognizing them in other comprehensive income rather than directly in earnings. If a company offloads a plan entirely by paying lump sums or annuitizing it, any pent-up losses must be recognized immediately in earnings. “It's a major profit-and-loss effect when this happens,” he says.

Companies also need to consider their fiduciary responsibility to plan participants, Archer says. “The decision as to who to buy the annuity from is still a fiduciary decision. You have to use a solid process to make what is a very, very big decision,” he says.

Brennan expects more companies to consider the course GM has chosen, or at a minimum to re-evaluate their options for managing pension risk. The most common approach he sees is for companies to adopt a liability-driven investment strategy where they focus on asset allocations meant to match the growth in the pension liability rather than match or beat the market. But he also expects annuitizations to grow. “This deal has demonstrated that the insurance market has the capacity to handle these jumbo plans,” he says. Another factor that could pave the way for more companies to annuitize their plans is the reaction GM got from the stock market, says Brennan.  Investors and analysts greeted the news with near indifference, at least in terms of stock price, analyst recommendations, and credit ratings.

David Godofsky, a partner with law firm Alston & Bird and an enrolled actuary, says GM will get other companies thinking. “There are people out there who have never thought about annuitizing,” he says. “They assume they have a plan and they have to live with it.” Companies will have to take careful stock, though, to understand the downside, he said. “In most cases it's going to increase the cost of the plan to de-risk it. So the question of whether you do that depends on how much you worry about the risk and whether you can afford it.”