After a defined benefit (DB) plan sponsor has strategized about how to best manage its program and decided to offload a portion of liabilities through the purchase of annuities to pay benefit obligations, there follow two sets of complex tactical choices. The first addresses high-level, front-office considerations such as the risk profile of the plan and how much of the liability to settle—thus being known as settlor decisions. The second set—fiduciary decisions—is more oriented toward back office details and setting up a mechanism for paying retirees their hard-earned retirement income.
“Settlor decisions are made on behalf of the enterprise and its shareholders: whether to close, freeze or terminate the plan, make lump sum payments to terminated vested employees, or [to make] an annuity purchase,” says Ed Root, senior retirement consultant at Willis Towers Watson in New York City.
“Fiduciary decisions are those made in the interest of plan beneficiaries,” he adds. “How to invest the plan assets and, if the sponsor decides to make an annuity purchase, select the winning insurance company to carry out benefit payments for decades to come.”
Sponsors can draw on many sources to reach the crucial insurer decision. Most hire an “independent expert” to conduct thorough due diligence on the 15 or so companies writing defined benefit pension annuities in the U.S. market and develop a short list of qualified insurer candidates for the sponsor to choose from. In a small minority of cases—e.g., where transactions are very large, or where retirees are especially concerned about how the annuity purchase could affect the security of their benefits—sponsors will turn to an “independent fiduciary”; that professional goes one step further and chooses the insurance company as well, giving the sponsor additional cover.
Central to the choice of an insurer is a 1995 bulletin from the Department of Labor (DOL), interpreting Title I, Section 4 of the Employee Retirement Income Security Act (ERISA). Known as Interpretative Bulletin (IB) 95-1, it was issued after the 1990 watershed failure of Executive Life Insurance Co., which short-changed annuity holders. “Even though it’s just an interpretive bulletin, it’s the most specific guidance we have,” notes Robert Goldbloom, a co-founder and principal at Penbridge Advisors of Stamford, Connecticut, a consulting firm specializing in the many aspects of pension plan risk management.
IB 95-1 sets out six criteria for evaluating the safety of an insurer: its size, financial strength and business lines; the quality of its investments; the structure of its annuity contracts; and protections available from state insurance guaranty funds. The bulletin directs sponsors to choose the safest annuity available, unless the beneficiaries somehow are better served by an alternate choice.
“We see differences in financial strength among the insurers but nothing that is alarming,” observes Jason Flynn, a principal in the Detroit office of Deloitte Consulting LLP. “We look for factors that can add value, such as going to a separate account or reinsuring the annuity liability, both of which provide additional protections.”
Still, IB 95-1 does not fully guide the sponsor to a decision. “It’s not a safe harbor,” says Goldbloom, “and [it] requires that the sponsor also consider the ‘prevailing circumstances.’’’ One factor driving an increasing number of sponsor decisions is an insurer’s capability in administration—setting up the database of retirees at the time of the transaction, tracking people over time and getting the right payments into the right hands.
“Administration is becoming more and more important,” Flynn says. Paying people already retired, who have chosen the form of their benefits, is fairly straightforward, he says. “But where a transaction involves deferred lives—employees retiring 15 years from now—the pensions are not yet calculated.” Cost of living allowances, employee contributions and cash balance plans bring additional complexity, calling for skill and flexibility from the insurer.
Other distinguishing features include the caliber of an insurer’s call center. “Can retirees talk to somebody knowledgeable? That pension is many people’s biggest asset, and you can’t just send people to websites or some automated system,” Goldbloom says, noting that so far there have been no major hacks into insurers’ data systems. “But to be realistic, that’s just a matter of time,” he says, and that cybersecurity is another crucial consideration.
The stakes for choosing an insurer are raised even higher by the permanence of the decision. “These are irrevocable contracts. Once you pay the insurer, that’s it, and you can’t switch because you’re unhappy with the call center,” Goldbloom says. “Everything comes down to a one-time decision the sponsor, and beneficiaries, are going to live with for 50 years.”
FAILING A FAIL-SAFE SYSTEM...
Pension benefits paid in retirement go on forever, or at least are meant to. In rare circumstances, however, the money can run out: An employer goes bust and is unable to make good on benefit obligations, or the insurance company engaged to pay out on annuities could become insolvent. In both cases, regulatory backstops are in place to provide ongoing payments to beneficiaries, but which arrangement gives retirees better security?
Making direct comparisons of the security of the two systems is difficult, as one is governed by the Employee Retirement Income Security Act (ERISA) and the other by insurance regulations of the various states. Moreover, the degree of protection depends on the facts of the case, concludes the National Organization of Life and Health Insurance Guaranty Associations (NOLHIGA) in a report this past May, “Consumer Protection Comparison: The Federal Pension System and the State Insurance System.” NOLHIGA emphasizes, however, that, when push comes to shove, both systems provide a high level of benefit protection, with the majority of participants protected 100%.
“The pension plan regime has two levels of protection,” explains Ed Root of Willis Towers Watson. “The first is the ongoing solvency of the sponsoring employer, and if it can’t put enough assets in the trust to pay benefits, the backstop is the Pension Benefit Guaranty Corporation [PBGC].” However, benefits paid by the PBGC have limits—in general, up to a maximum guaranteed payment of about $5,000 per month for retirees aged 65, with the possibility of additional nonguaranteed amounts from recoveries the agency can glean from the plan assets.
The insurance company regime has two stages, as well. “The first level of protection is the ongoing solvency of the insurer,” Root says, adding, “No one ever talks about how solid that can be. Insurance companies are heavily regulated, and they have to hold extra capital—typically they are funded 110% to 115% versus the liabilities from a pension plan perspective.” Moreover, insurance companies are obligated to invest very conservatively.
In the event of an insurance company failure, state guaranty agencies step in, providing a present value of aggregate benefits of $250,000, in most cases—although 14 states extend the coverage to $300,000, and two states to $500,000. “But remember, the insurance companies start out overfunded,” Root says. “Historically, failing insurance companies have been funded about 95% at insolvency, so there would still be plenty of assets to top up an individual’s benefits.”
The historical record favors the insurance framework. The NOLHIGA report points out that between 2008 and 2015, no active annuity insurer with unsatisfied obligations was liquidated, while failures befell 931 pension plans and their 560,000 beneficiaries. “Even with PBGC coverage, I’m sure some of those people had to take haircuts on their benefits,” Root asserts. “The first levels of protection for insurance companies are much stronger than the financial health of many pension sponsors, so I would argue that, overall, participants have greater security through annuities.” —JK