The Race to De-Risk Pensions?
Business law firms are beefing up their pension departments to advise clients on a range of changes within the industry, including the “de-risking” of defined benefit pension plans.I've already covered why we're in the midst of a golden age for pension lawyers. Osler, which boasts one the country’s largest pension law departments, is on the right track and others will follow their lead.
“The search to find suitable ways to de-risk volatile DB [defined benefit] pension obligations is becoming a more common strategic priority among Canadian employers in the public and private sector,” says Ian McSweeney, a partner in the Toronto office of Osler, Hoskin & Harcourt LLP.
Change is driven by a series of challenges. Stock markets and interest rates have been growing too slowly to meet the financial demands of some plans. Meanwhile, life expectancy is increasing faster than plans originally contemplated, lengthening payout periods.
De-risking involves making changes to a plan in ways that will prevent private and public sector employers from shouldering the entire liability for future pension benefits.
Osler, which boasts one the country’s largest pension law departments, recently recruited pension law and de-risking specialist Jana Steele from Goodmans LLP. Ms. Steele’s expertise lies in addressing what is almost certainly the pension industry’s biggest concern: the financial challenges arising from weak markets that have created huge pension deficits relating to future liabilities.
One way of de-risking involves the conversion of traditional defined benefit (DB) plans into the Dutch model of shared risk plans with target benefits. Ms. Steele advised on the implementation of New Brunswick’s new shared risk plan legislation, which came into effect in July.
In a defined benefit plan, the employer is obligated to guarantee that pensioners receive their benefits, plus cost-of-living increases, regardless of the plan’s market performance. A defined contribution (DC) plan puts the risk on the pensioners, who receive benefits based on the plan’s performance in the market. New Brunswick’s shared-risk model is a hybrid: some benefits are guaranteed and some are conditional.
“The New Brunswick plan addresses the volatility issue by focusing on robust risk management to promote benefit security and pension plan sustainability,” Ms. Steele says.
“Employers’ contributions, which can vary only within a pre-established range, are determined with regard to a prescribed minimum security level of funding that is set when the plan is established or when a benefit is changed.”
Although New Brunswick’s shared-risk model is the first of its kind in Canada, there’s a definite trend toward de-risking in this way. Quebec is finalizing target benefit plan legislation, but only for the pulp and paper sector. British Columbia and Alberta still lack implementing regulations, but have the necessary statutory framework in place. So do Ontario and Nova Scotia, although their legislation only allows target benefit plans in unionized workplaces.
“De-risking is a meaningful, live issue where much should happen in the next few years,” says Mitch Frazer in Tory LLP’s Toronto office.
How much will happen is uncertain, given the polarization between employers’ desire to share risk and employees’ desire for the security of a defined pension after working towards it for a substantial period of time.
“You can’t say that what happened in New Brunswick will happen elsewhere,” says one veteran pension lawyer. “The province was in crisis mode, and the unions had no option but to go along with the legislation.”
Indeed, the spectre of litigation by disgruntled retirees hangs over the New Brunswick legislation.
“The economy ebbs and flows and funding goes up and down,” says Ari Kaplan of Toronto’s Koskie Minsky LLP, who has been consulted on the legality of the conversion issue. “My concern is whether it is just to punish people who worked hard during the good times just because we now happen to be in the down cycle.”
There are other ways to de-risk.
In June, Sun Life Financial Inc. and the Canadian Wheat Board agreed to a $150-million annuity policy that transferred some of the Wheat Board’s pension risk to the insurer. At the time, Brent Simmons of Sun Life told the Financial Post’s Barbara Shecter that de-risking transfers could amount to a $10-billion business in Canada by 2016.
From the legal profession’s perspective, de-risking should help alleviate the reduction in business stemming from a trend away from DB plans to defined contribution plans over at least the last decade.
“If shared risk plans proliferate, the legal work for pension lawyers will increase dramatically,” says James Pierlot of Toronto’s Pierlot Pension Law. “In a DC plan, risk is transferred to the employees, but the plans are simple. A shared risk plan is a complex one that employers and their consultants have to manage.”
As far as the great pension derisking, we are in the early stages of a long secular trend. Facing increasing pressure to curb pension costs, private and public pensions are de-risking their plans through a variety of ways.
But the race to de-risk pensions is fraught with pitfalls and corporations need to carefully evaluate all their options before engaging in risk transfers. J.P. Morgan Asset Management recently put out their Spring/ Summer Pension Pulse Special Edition. The document can be downloaded here.
Apart from noting that rising assets and ebbing liabilities are lifting corporate pension funded status (see my latest on this topic here), the report also looked into transferring pension risk and found that pension buyouts might increase the risk of a plan:
Purchasing a pension buyout for retirees might increase risk for the pension fund and result in greater costs to the company than the premium paid to an insurer, according to a report from J.P. Morgan Asset Management (JPM).The findings of the J.P. Morgan report suggest that corporations need to be careful before opting to transfer pension risk to an insurer. (I am honored that J.P. Morgan decided to use "Pension Pulse" to name their product and would love to see them subscribe to my blog to show their appreciation).
JPMAM's most recent “Pension Pulse” report runs through a case study of a closed pension fund that is 80% funded with about $1.2 billion in assets. Karin Franceries, executive director of JPMAM, said it represented a typical corporate pension fund.
“We (reached) conclusions that were quite different from what we had been hearing from people,” Ms. Franceries said in a telephone interview. “It's just not necessarily the most optimal solution at any state (of the plan).”
Ms. Franceries said the firm decided to study the issue because of the surge in interest from companies since General Motors Co. purchased a pension buyout last June from Prudential Insurance Co. of America. Ms. Franceries said she knew it was an expensive solution to getting pension liabilities off balance sheets, but was surprised by the outcome showing the plan actually became riskier.
The report cites a 2012 study that showed 44% of pension fund executives surveyed said they were likely to engage in risk transfers like buyouts over the next two years. The fiscal environment has improved as well; the aggregate funded status of Russell 3000 companies improved to 86% at the end of May from 77% at the end of 2012.
The report concluded the post-buyout downside risk is larger because the liabilities remaining have a longer duration, the service cost compounds the effect and the funded status is lower because additional assets need to be transferred to an insurer as a premium for taking on the liabilities. While the risk would be greater, including longevity risk, a buyout would also provide more freedom for companies to take on more investment risk for higher returns since the remaining participants would be active employees and not receiving benefits until years down the line.
The two factors that make a buyout attractive are if the plan is frozen and fully funded, Ms. Franceries said. However, the report did not delve into behavioral factors of pursuing a buyout, such as the market reaction, as analysts tend to prefer to see smaller pension liabilities compared to a company's market capitalization.
In the case study, expected pension contributions by a company in the 10 years following a buyout are actually greater than just keeping all the pension assets.
The reduction in administrative costs and Pension Benefit Guaranty Corp. premiums that come with a buyout “honestly doesn't make that much of a difference,” Ms. Franceries said. While there would be fewer members in a plan, premiums would increase because the plan would have a lower funded status.
Finally, Pensions & Investments notes that Moody's proposes more focus on public pension obligations in bond ratings:
Moody's Investors Service is seeking public comment on proposed methodology changes that would increase the weight of debt and pension obligations to 20% from 10% in its ratings of local government general obligation bonds while decreasing other economic factors.How will these proposed changes impact local governments? That remains to be seen but they could raise the cost of borrowing on muni debt. This could place additional pressure on local governments to de-risk their public pensions.
The proposed change “would recognize the potential for large pension liabilities to constrict local governments' financial flexibility. Because pension liabilities and debt each represent enforceable claims … the current methodology should be weighted more heavily to capture the combined effect of both debt and pensions,” Moody's said in a news release Wednesday.
In April, Moody's revised its approach to state and local government pension data to address what officials there considered underreporting of pension liabilities on government balance sheets, and to increase comparability among plans by investors and credit analysts. It also placed the general obligation bond ratings of Chicago, Cincinnati, Minneapolis, Portland and 25 other governmental units on review for possible downgrade because of relatively large net pension liabilities.
Government pension and finance officials worry that further changes by Moody's will create additional confusion. “The data Moody's uses does not align with the financial data that local governments report on their financial statements,” said Elizabeth Kellar, president and CEO of the Center for State and Local Government Excellence. “Giving greater weight to data that may be flawed is a concern.”
If the proposed methodology is adopted, Moody's officials predict some bond ratings would change, but “the vast majority would not,” according to the news release. Comments are due by Oct. 14.
Below, Pittsburgh Mayor Luke Ravenstahl talks about Detroit’s bankruptcy and the Pittsburgh's pension liabilities. He speaks with Sara Eisen and Scarlet Fu on Bloomberg Television’s “Market Makers.”