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Risk Reduction for Nonqualified Defined Benefit SERPs
Solving the risks with a single premium group annuity (SPGA).
Russ Proctor and Marty Menin, Directors of Retirement Solutions
How to de-risk a pension plan continues to be an important issue for plan sponsors. In fact, one of the most popular solutions—terminal funding and pension buyouts—continues to hit record highs. Now, some of the same solutions developed for de-risking qualified pension plans are being applied to non-qualified defined benefit (DB) supplemental executive retirement plans, commonly known as SERPs. Recently, PLANSPONSOR hosted a webinar in which Pacific Life addressed some of the key issues involved in de-risking non-qualified defined benefit SERPs. Marty Menin and Russ Proctor, directors in the retirement solutions division at Pacific Life, spoke about the risks and opportunities for de-risking these executive retirement plans.
PS: What risks are plan sponsors mitigating with the Buy-In contract?
Marty Menin: Often companies with qualified DB plans also offer a mirrored defined benefit SERP for their executives. Both of these plans face the same risks—investment risk, interest rate risk, liquidity risk and longevity risk. Just as the Buy-In contract was developed to mitigate these risks for the sponsor’s qualified plan, it will also help mitigate them for the non-qualified defined benefit plan.
The SERP liability that appears on the plan sponsor’s balance sheet is equal to the present value of the future promised benefits based on interest rates for high-quality corporate bonds. We all know how volatile interest rates have been, which in turn results in volatility in the SERP liability. The constant volatility in SERP liability impacts shareholder equity. Thus, if interest rates decrease, the SERP liability increases and shareholder equity decreases.
As companies have closed or frozen their qualified pension plans, they’ve likely done the same thing in their non-qualified pension plans. Although companies are not required to finance these non-qualified defined benefit SERPs by setting aside money in a rabbi trust, the benefits still need to be paid by the company on a regular basis. When the SERP was first set up, the monthly pension obligation may have been very low for several years. Now if the SERP is closed to new entrants, there is a static group of participants in the non-qualified executive pension plan who are aging and retiring, and it’s very likely that many plan sponsors are now writing larger checks to make those payments. Some of these sponsors may have no assets set aside to deal with the liquidity risk and are operating on a pay-as-you-go basis.
Also, the fact that people are living longer is increasing the cost for qualified plans. The mortality data indicates that well-educated, highly paid individuals are living significantly longer than the average population. Thus, the longevity risk for these executive retirement plans is even greater.
Our Pacific Secured Buy-In solution can be used to solve these risks for a non-qualified defined benefit SERP.
PS: How can Pacific Life help a plan sponsor?
Menin: The process is very similar to what many companies are doing on the qualified pension plan side—in other words, purchasing a group annuity contract to transfer the risk of those benefit payments to an insurance company.
One of the first steps is to understand the data. Who are the participants that you’re considering covering? We typically look at the retirees first. So we would get a census file from the plan sponsor listing the current retirees in the defined benefit SERP, and we would use that data to calculate the premium necessary to cover these participants. Once the plan sponsor agrees to move forward, we provide a contract, and the plan sponsor sends a single premium to Pacific Life.
A major advantage of the Buy-In contract is that we make a monthly bulk payment to the company or to the rabbi trust, because we don’t want to create constructive receipt for those participants in the defined benefit SERP. The monthly bulk payment we make is equal to those aggregate monthly benefit payments for all the participants covered in the annuity contract.
We are not making any direct payments to the executive participants and are not issuing annuity certificates to the participants. The company is always going to be responsible for the pension obligation. From the retiree perspective, there’s no visible change: The payments still come from the company. Also, the tax reporting is still being done by the company. The Pacific Secured Buy-In contract is simply an asset purchase by the company to provide guaranteed financing for the SERP obligation.
Russ Proctor: One of the key administrative services that Pacific Life provides to plan sponsors, and in particular to rabbi trustees, is the calculation of the monthly contract value. We provide a monthly valuation of the Pacific Secured Buy-In contract, because when a trustee turns over a single premium to us, he wants to know how much the asset is worth each month. So we provide a monthly contract value that the corporation or the rabbi trust can book as an asset. This asset will help offset the SERP liability on the balance sheet.
PS: For those looking at the non-qualified plan versus the qualified plan, is the Buy-In for qualified plans set up the same way?
Proctor: Yes, they are set up the same way. However, they may be used for different lengths of time. In the qualified plan area, the Buy-In may be used for a shorter period. A qualified plan usually wants to convert to a Buy-Out in the near future to completely transfer the liability, which then reduces or removes ongoing administrative expenses related to qualified plans such as PBGC [Pension Benefit Guaranty Corporation] premiums. The reason for using the Buy-In for a qualified plan may be because the plan sponsor is looking at locking down the cost of those qualified liabilities now but wants to defer the settlement costs. So, it uses the Buy-In when it has the money to cover the liability but doesn’t want to trigger a settlement. Then, a year or two later, the plan sponsor can convert the Buy-In to a Buy-Out.
With non-qualified SERPs, we anticipate that these contracts will remain as Buy-Ins and not convert to the Buy-Out, because by converting to a Buy-Out with the executives paid directly by the insurer that would trigger constructive receipt and immediate taxation. The Buy-In secures the risks for the plan sponsor, provides peace of mind for the executives and does so without triggering settlement and constructive receipt. With non-qualified plans, it is really a balancing act between de-risking and constructive receipt.
Menin: To summarize, we think using our Pacific Secured Buy-In for non-qualified defined benefit SERPs can help a plan sponsor in a variety of ways. One is by locking in future costs. With the Buy-In solution, you pay a single premium to lock in your costs and transfer interest rate risk, mortality risk, investment risk, and liquidity risk to the insurance company.
Another way is to provide the plan sponsor with a better asset/liability match. Because the non-qualified plan typically mirrors the qualified plan, you have, in the defined benefit SERP, an annuity obligation. By purchasing a Buy-In annuity contract and holding it on your balance sheet as an asset of the company, or inside a rabbi trust, the Pacific Secured Buy-In contract value tracks the SERP liability.
So, the Buy-In helps to reduce risk and provides an excellent asset/liability match. As always, we suggest that plan sponsors talk to their plan advisers, their accounting advisers and their tax advisers. There are many subtle issues here that need to be addressed, and getting all of those advisers involved in the conversation is very important.
Pacific Life refers to Pacific Life Insurance Company. Insurance products are issued by Pacific Life in all states except in New York. Pacific Life is solely responsible for the financial obligations accruing under the products it issues.