CONSIDERING GETTING OUT OF THE PENSION BUSINESS?

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1 CONSIDERING GETTING OUT OF THE PENSION BUSINESS? Annuities? Lump Sums? Terminations? Questions you need to ask and answer before you pull the trigger November 1, 2012 David Oaten, CEO, Pacific Global Advisors (212)

2 In a period of just six months, four corporate giants Ford Motor Company, General Motors (GM), Verizon Communications, and AT&T Inc. have changed the landscape for how companies think about pensions by taking bold but different steps. The diversity of the announced transactions is significant, given that the pension community is one that typically acts in lockstep. While each of the four companies has taken a different approach, the ostensible goal has been the same: to address the crushing burden of their pension plans. In April 2012, Ford announced it was offering lumpsum payments to approximately 90,000 salaried retirees as part of a long term strategy to de risk its global employee pension plans. In June, GM, through a combination of retiree lumpsum payments, a spin off of active and terminated vested salaried employees, and the termination of the residual retiree plan through an annuity purchase from Prudential Insurance Company (Prudential), announced it intends to remove approximately $26 billion in pension obligations from its balance sheet (in their recent 8 k report GM estimated the reduction in liability at approximately $29 billion). In October, Verizon announced that the fiduciaries of its salaried pension plan had entered into a definitive purchase agreement with Prudential to settle approximately $7.5 billion of pension liabilities through the purchase of a single premium annuity contract which would result in Prudential irrevocably committing to fund these liabilities for retirees. No lump sums were offered to retirees. Also in October, AT&T announced that it would, after obtaining the necessary approvals from the Department of Labor, contribute approximately $9.5 billion of preferred stock in the holding company for its wireless business to shore up the funded status of two of its pension plans. No lump sum or annuity purchase solution accompanied the extraordinary contribution. Many companies feel the strain of their pension obligations, especially as interest rates have reached record lows, dramatically increasing their liabilities. This in turn affects company earnings, stock price, credit ratings, and even the ability to focus on the core business. The clear trend that has emerged over the last few months is that plan sponsors are now ready, and far more willing to take real and dramatic action to address these obligations. We expect other companies to follow suit by announcing major strategic moves related to their pension plans. WHICH SOLUTION IS RIGHT FOR YOU? While companies should be applauded for this much needed focus on their pensions, management must resist the temptation to act too hastily. For example, starting from a very high risk return seeking strategy (the common starting point for most plans) and then abruptly reallocating to fixed income, or eliminating all risk by paying a premium to an outside party (e.g., purchasing an annuity), is careening from one extreme to the other. No two plans have the same circumstances and, therefore, one size does not fit all. There is a wide spectrum of solutions to consider. The four, starkly different, major transactions outlined above are but a subset of the available alternatives. Other possibilities are highlighted below. For example, a more surgical approach, one that combines alternatives in a strategic way, or a more sophisticated capital markets based solution, may be more appropriate for a plan sponsor s specific circumstances. With so many options 1

3 available, it is critical to find the best solution for a plan sponsor s specific situation. ERISA fiduciary issues, the potential for plaintiff s lawsuits, and Department of Labor scrutiny place a heavy premium on careful consideration of the alternatives and the ability to meet a plan sponsor s objectives. Answering the following questions will help you develop the best strategy for your company: 1. What specific problem(s) are you trying to solve? Are you trying to: Reduce the implied stock overhang and achieve a neutral to positive reaction from equity analysts? Obtain the cheapest cost/lowest risk to the plan sponsor? Achieve a neutral to positive reaction from the credit rating agencies? Mitigate the accounting settlement impact and reduce/eliminate future pension expense noise? Minimize employee/retiree adverse reaction? Insulate plan fiduciaries? 2. What solutions are available? Each of the four scenarios mentioned above is an option. And there are numerous other approaches, either on or off balance sheet. These include: Contribute to the plan and right size the interest rate, investment, and longevity risk in the plan based upon risk appetite of the plan sponsor and capital markets efficiency; Do it yourself annuitization, i.e., manage the plan yourself similar to how an insurance company would hedge the liability; Non termination alternatives; Spin off termination; Hybrid/structured/cost effective termination solutions; and Combinations of these and others, with or without insurance based solutions for some or all retirees. For example, let s say you are considering a spin off termination for retirees. An insurance company will largely buy bonds to back its policies the same bonds the plan could buy but the plan will pay the insurance company a higher amount to do so, plus incur other costs, including that of a profit for the insurance company. Of course, you are also paying to rid yourself of the risks associated with the pension plan, so the premium may be worth it. On the other hand, there may be structured solutions that could require more planning and add some complexity but may ultimately reduce the cost. Investing the time and energy in developing a more cost effective solution may well be the prudent course of action. 3. Is this the right time to pull the trigger with interest rates so low? The level of interest rates today, or your view of interest rates next year or the year after, should not be the deciding factor. While plan fiduciaries don t see themselves as making interest rate bets, they surely have done so by not hedging the interest rate risk of the pension liability. Many plan sponsors and plan fiduciaries have been hoping and waiting for interest rates to rise even though they are not in the business of predicting the direction of rates. Market participants in general are already incorporating the current economic environment, as well as future ones, when they make the decision to buy or to sell bonds. Some may argue the current level of interest rates is artificially low given central bank quantitative easing policies. However, interest rates could in fact remain low for an extended period of time, e.g. the Great Depression and more recently in Japan. It is very challenging to predict the future path of interest rates and the timing of any such moves. Many plan sponsors wish they had already executed the types of risk reduction strategies outlined above. Presumably, GM and Verizon have concluded that while interest rates are at historical lows, annuity pricing is fair and attractive to remove any further risk (i.e., the cost to transfer the risk to a third party is worth the premium). Some have considered today s interest rates too low and would prefer to wait for rates to rise to higher levels before implementing similar transactions. But waiting for interest rates to rise does not preclude an extraordinary 2

4 contribution, or limited lump sums, or annuitizing some portion of retirees. Understanding which of these paths to take and when, and which combinations work, and which don t, is critical. If you believe that interest rates will rise, consider taking that view at the corporate level and issuing low coupon debt at current levels to fund the pension plan. Significant tax, accounting, and cost benefits can be gained from this strategy. Alternatively, if you have a view that rates may decline further, there are ways to protect the pension plan from further declines in rates while leaving room to participate in gains from higher rates. 4. Are retiree lump sums the answer? Is the offer of lump sums to retirees brilliant or shortsighted? To make this determination, it is imperative to consider (a) possible adverse selection and (b) the number of retirees that actually choose to receive a lump sum (the take rate ). Adverse selection refers to the undesirable consequence from a cost perspective of retirees in poor health choosing to receive a lump sum, while retirees in good health continue to receive regular payments from the plan. Insurance companies will not overlook this possibility in pricing an annuity for the retirees that remain in the plan. In fact, an insurance company may not be willing to enter into an annuity contract with a plan that previously offered lump sums to retirees. With respect to the take rate, a plan sponsor will want a significant number of retirees to choose the lump sum to justify the considerable administrative and legal costs, time commitment and possible adverse publicity associated with the offer. It has been reported that GM s take rate was approximately 30%. These considerations demonstrate that the appropriate cost analysis is an analysis of the entire solution, not the lump sums in a vacuum. 5. Will insurance company capacity be depleted? Right now, only two insurance companies appear willing to participate in jumbo termination transactions as a single annuity provider. While realistically, there will be a limit to how many deals they can absorb, other insurance companies have capacity to participate in smaller transactions. Additionally, insurance companies may form syndicates to take pieces of large transactions. When companies in the UK sought to terminate pensions, some were shut out of the process because the window of opportunity had closed capacity had been depleted. But, there s no guarantee that the same situation will occur here. Don t let the fear of we have to move before it s too late force you into hasty action. 6. What are the legal risks? How can these be mitigated? Deciding how to proceed, and which members of management make that decision, can be fraught with legal issues. Case law is replete with examples of corporate officials with conflicts of interest making decisions for plans. There is a clear delineation between functions one takes as a plan sponsor so called settlor decisions for which the company does not owe a fiduciary duty to participants, and fiduciary decisions. Fiduciaries who rubber stamp corporate decisions made in the best interest of the company may find themselves litigating the propriety of their conduct under ERISA s fiduciary rules. What does it mean for a fiduciary to act solely in the interest of participants and beneficiaries? Can one protect oneself by amending the plan? Who selects the annuity provider and how does the safest available requirement work in practice? Who actually negotiates the terms of the annuity purchase the plan sponsor or the plan committee and will fiduciary responsibility attach to those actions? What advisors are needed? Is the advice provided to the plan sponsor, the plan fiduciaries, or both? The line between settlor and fiduciary functions can be unclear in a complicated solution that involves many parties. It s easy for management to get out ahead and usurp a fiduciary function, leaving their actions open to question. Independent fiduciaries may be necessary, but how can the plan use them most efficiently, and will generally required indemnification place the financial risk back at the plan sponsor s doorstep? It is important to clearly define roles and responsibilities, properly segregate duties, and work with sophisticated, non-conflicted advisors. 3

5 7. How will you judge that your solution is the right one? The most important part of the financial consideration is to avoid simply comparing the proposed solutions to the status quo. Most companies are taking too much risk in their pension plans and have been burned by that strategy, so just about all of the possible solutions look superior from a risk standpoint. But, you have to go farther. Make sure that the full range of solutions is considered, including the status quo. It s not an all or nothing proposition; taking some steps today, with a strategy that contemplates additional steps in the future, but takes into account how current actions may impact future costs or options, is optimum. Some of these solutions have a far more material impact on the company than M&A transactions, and can be even more complex. The level of diligence should be commensurate. If you make what seems like an obvious decision hurriedly, without an understanding of the facts and all the options available to you, you might not end up with the solution that best addresses your specific goals and provides the plan sponsor, the Board, and plan fiduciaries with the greatest legal protection. CAREFULLY CONSIDER YOUR SPECIFIC SITUATION Should you be paying attention to what other companies are doing with their pensions? Yes, but not with the intention of doing a me too transaction. Before making a final determination for your situation, remember the following: There are material differences among the announced transactions; Other, less expensive and/or less drastic solutions may be available; No two plans/plan sponsors are in the same situation; and It is imperative to identify your specific goals and objectives. Let these bold, high profile moves serve as a starting point in your own discussions, not the end point. 4

6 For more information please contact: David Oaten Chief Executive Officer (212) Bruce Jurin Chief Science Officer (212) Michael Economos Senior Actuary (212) Larry Pollack Senior Actuary (212) Timothy ( TJ ) Jennings Head of Client Management (212) timothy.jennings@pacificga.com Guy Coughlan Chief Risk and Analytics Officer (212) guy.coughlan@pacificga.com ABOUT Pacific Global Advisors (PGA) serves as a trusted advisor, registered investment advisor, QPAM (Qualified Professional Asset Manager) and risk manager to corporations, pension fiduciary committees and other institutions. PGA s business includes providing customized investment and risk management services to defined benefit pension plans, defined contribution pension plans, voluntary employees beneficiary associations, nuclear decommissioning trusts and other investment pools. Founded in 2005 as J.P. Morgan s Pension Advisory Group, the business was acquired by Pacific Life Insurance Company in July The management team has extensive experience in diverse disciplines such as pensions, investments, trading, risk management, custody and corporate finance. Coupled with extensive capital markets expertise, this enables PGA to deliver differentiated advice, insight and execution. PGA has a solid track record of leadership within the pension industry, including: Obtaining Department of Labor Advisory Opinion A, the main regulatory support in the United States for liability driven investing ( LDI ) techniques; Launching the pioneering LifeMetrics platform for longevity risk management, which includes a suite of mortality indices to facilitate the hedging of longevity and mortality risk within pension plans and insurance companies; Developing alternative solutions to traditional off balance sheet pension plan terminations; and Developing a suite of hedge fund investment strategies and indices. Please visit Pacific Global Advisors online at Pacific Global Advisors LLC and its affiliates do not provide tax advice. Accordingly, any discussion of U.S. tax matters included herein (including any attachments) is not intended or written to be used, and cannot be used, (a) in connection with the promotion, marketing or recommendation by anyone not affiliated with Pacific Global Advisors LLC of any of the matters addressed herein or (b) for the purpose of avoiding U.S. tax-related penalties. In addition, Pacific Global Advisors LLC and its affiliates do not provide accounting or legal advice. This report is provided for informational purposes only and should not be used as a primary basis for investment decisions. In preparing the information set forth herein, Pacific Global Advisors LLC ( PGA ) has relied upon and assumed, without independent verification, the accuracy and completeness of information provided by third parties, and PGA makes no representations as to the accuracy or completeness of such information. In preparing the information set forth herein, PGA may have made assumptions about market conditions. Actual events or conditions may differ from those assumed. In additxion, not all relevant events or conditions may have been considered in developing such assumptions. This report may not be used or relied upon as the basis for determining required contributions or GAAP accounting, or for any regulatory reporting or public disclosure. The plan sponsor should retain an independent actuarial firm to provide those calculations. 5