Pension Plan De-Risking (Part II) – A Closer Look at DB Plan De-Risking Options

There is a broad spectrum of pension de-risking options available to defined benefit (DB) plan sponsors and administrators. In this post (the second of a two-part series) I consider these options and some of the related legal and practical issues which may arise. (For Part I, a discussion of de-risking trends in Canada, see my June 5, 2013 post.)

De-Risking Options

1. Liability Driven Investing

At the one end of the spectrum, plan administrators may mitigate risk through investment strategies, such as liability driven investing (LDI). Most administrators are currently engaging in some form of LDI as a matter of prudence.

2. Plan design options

In the middle of the spectrum, there are plan design options that many sponsors have already implemented, or are considering alone or in combination, such as:

  • conversion to future service defined contribution (DC);
  • closing DB plan membership to new hires;
  • cessation of future service DB accruals, with or without a pensionable earnings freeze;
  • reducing the future service DB benefit formula;
  • reducing or removing expensive early retirement and other subsidised ancillary benefits, including pension indexing;
  • conversion to a target benefit or shared risk plan under which sponsors and members share funding obligations, and target benefits can be reduced if funding levels become unaffordable; and
  • traditional DB plan termination and fund wind up.

Accrued legacy DB benefits cannot normally be reduced or converted without individual member consent and therefore, other than plan wind up, these strategies may involve lengthy transition periods where legacy DB benefits remain in the plan with attendant ongoing funding/benefit security risks and little immediate impact on the employer’s bottom line.

3. Risk transference

At the far end of the spectrum, there are risk transference options under which a plan sponsor may fully or partially eliminate DB plan volatility and funding risks through lump sum transfers, ‘buy-in’ annuities, and ‘buy-out’ annuities affecting former member benefits.

Lump sum transfers. This involves the payment out of the plan of a cash settlement equal to the lump sum value of the member’s pension benefit. If 100% is paid while the plan is underfunded, a top up contribution may be required to preserve the plan funded ratio.

Annuity buy-ins. This is an insurance contract held as a plan investment and therefore can be acquired while the plan is underfunded without triggering any top up contribution. Once the annuity premium is paid, the insurer is responsible for benefit funding, but the plan remains responsible for payment administration.

Annuity buy-outs. This is a traditional annuity contract most often used in plan wind ups under which benefit liability risks are transferred from the plan sponsor to the insurer. Top up contributions are required if the annuity premium is paid from an underfunded plan.

4. Planning a de-risking strategy and assessing legal issues

There are key planning issues and legal/regulatory risks to be managed when considering and implementing any de-risking strategy, including regulatory approvals, identification of any legal restrictions or impediments, member communications and whether the desired outcome is achieved. The appropriate strategy could depend on a number of factors, such as the funded status of the DB plan, the business goals of the employer and the employer’s tolerance for legal risk and affected employee/former employee reaction. In a unionized setting, consideration must also be given to collective bargaining issues and whether union consultation/consent may be required or advisable.

Remember, a successful de-risking strategy must not only address sponsor risk issues, it must be implemented in a way which is compatible with the administrator’s fiduciary responsibilities to the plan. This is particular important to keep in mind when the employer acts as both sponsor and administrator.

Consideration of some key questions may assist in the process, including: What de-risking steps are permitted under applicable legislation and regulatory policy? What is the resulting impact of de-risking on the plan? What conversations are needed with the sponsor’s auditors regarding potential accounting impacts? What is the likely accounting impact on the sponsor? Do the above impacts satisfy the plan’s de-risking objectives? What implementation strategy best minimizes administrator risk?

5. A closer look at risk transference

Over the last few years, employers in the UK and the US have been leading the charge on pension risk transference options, with a number of employers seeking annuity buy-outs and implementing lump sum transfers. A word of caution – Canada is different.

Lump sum transfers. These transfers must be elected by the member and are generally permitted by Canadian pension regulators, including re-election by ‘deferred vested’ members who previously chose to leave their benefits in the plan. Once pensions commence, however, regulators appear reluctant to permit lump sum transfer elections, absent specific legislation (e.g., in Ontario, specific legislation was passed for Nortel retirees). This is significant, since pensioners are often the bulk of former member liabilities.

Clear and accurate disclosure of any lump sum transfer option will be important and should include a sufficiently detailed explanation of the potential member financial risks. Pension legislation in most, but not all, Canadian jurisdictions provides an express discharge to the employer from further liability in connection with lump sum transfers that are in compliance with statutory requirements.

Annuity buy-ins. Buy-ins may be unilateral (no member consent required) and can be used to reduce risk associated with both active and former members. However, while buy-ins may reduce contribution volatility, no statutory discharge is available and Canadian regulators consider the plan and the employer to ultimately remain liable for benefit funding in the event of any insurer default.

Annuity buy-outs. Buy-outs may also be unilateral. Like buy-ins, there is no statutory discharge available and pension regulators may consider the plan and the employer to remain responsible for annuitized benefits in the event of any insurer default. Does this mean that Canadian plan sponsors cannot achieve settlement accounting treatment for buy-out strategies similar to lump sum options? Perhaps, but it may be possible for sponsors to rely on express annuity discharge provisions in the terms of their plans to fully satisfy plan obligations in relation to annuitized benefits (see McLaughlin v. Ultramar Ltd. (1998), 16 C.C.P.B. 276 (Ont. Ct.)).

In addition, if annuities are purchased so as to fully protect the benefits under Assuris (policyholder insurer default protection) insurance limits (the prudent course in any event), the risk of sponsor default liability may be rendered sufficiently remote to result in settlement accounting treatment despite the technical regulatory view. This should be the subject of advance discussions with the employer’s auditors.

De-risking CPI indexed pensions may be more difficult. Quite apart from the expense, there currently appears to be no market in Canada for indexed annuities.

Consideration may be given to potential solutions, such as possible plan amendments which convert (perhaps even retroactively as a benefit enhancement - thanks to Deron Waldock at Aon Hewitt for this idea) such indexation to an actuarially-equivalent fixed rate, or possibly annuitizing the basic pension and leaving the indexing component in the plan, but there are tax, compliance and regulatory issues that would have to be addressed for a successful result.

This blog post was adapted from an article Ian McSweeney prepared for Financier Worldwide magazine. The full article will appear in the May 2013 issue of Financier Worldwide magazine. © 2013 Financier Worldwide.

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Julien Ranger

Partner, Pensions & Benefits