Participant Protections for Defined Benefit Plan Benefits: Benefit Security

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1 TOPICS IN Pension risk management Participant Protections for Defined Benefit Plan Benefits: Benefit Security As persistent economic and related market factors continue to keep volatility front and center for senior leaders, plan sponsors both large and small are considering actions of various types to reduce Defined Benefit (DB) plan driven volatility. There is a broad spectrum of actions. On one end are changes in investment approach, which have no effect on how benefits are provided and are not generally visible to plan participants. At the other end are programs that require active engagement from participants, such as lump sum settlement offers in exchange for releasing the sponsor from further responsibility for plan benefits. Well publicized aspects of some large plans transactions have brought the topic of plan participant protections into current focus for many sponsors and qualified plan practitioners. There are two key dimensions related to participant protections: benefit security and form of benefit. This Topic will focus on the first of these, benefit security, and review the protections afforded to current and former participants in DB plans in two primary settings. One setting is when participants are members of an ongoing plan, sponsored by a financially healthy plan sponsor. The other is when the sponsor, while still a going concern, has decided to purchase a group annuity contract from an insurer to provide benefits earned and related services to some plan participants, (a partial risk transfer) or all plan participants (a voluntary plan termination). 1 Under the first setting, benefit security is provided by the plan and its sponsor, through dedicated plan assets and ongoing contributions, as long as the employer remains in business. It is important to note that the premiums that plans pay the PBGC protect only against a sponsor s inability to pay benefits, and provide no protection against a sponsor s unwillingness to continue its plan. Under the second setting, persons whose benefits have been settled are no longer plan participants because the obligation to make payments has been transferred to an insurance company. In this case, benefit security is provided by the commercial insurer through the assets transferred to it. The insurer establishes reserves to ensure that it can meet all of the future benefit payments. In the very unlikely event a carrier experiences financial difficulties, a multi-layered state regulatory process begins that has as its goal that the company s policy and contract holders receive the benefits under their contracts or certificates. The differences between these regimes are important for both sponsors and participants to understand. There has been considerable attention paid to comparing the strength of the insurance industry s State november 2013

2 Guaranty Associations and the PBGC s pension benefit guarantee. This comparison is both incorrect and incomplete, as it takes both of these entities out of the actual context in which they operate. Instead, the correct comparison is between the guarantee of the plan sponsor, backstopped by the PBGC under certain specified circumstances, versus the guarantee of the insurance company, with the State Guaranty Association coverage under certain specified circumstances. For sponsors, this understanding may be a critical element in making settlor decisions. For participants, understanding is all the more important because while they do not have a choice or a voice in how the sponsor chooses to operate its plan or provide for its benefits, they have a clear interest in the security of their plan benefits. First setting: Participants are Members of an Ongoing Plan The sponsor of a defined benefit plan has a legal responsibility to set aside assets within the plan to pay promised benefits to participants, so long as it continues to operate the plan. While an adequate level of funding is a goal established by Department of Labor (DOL) regulations, annual funding obligations are balanced by the recognition that a DB plan is a very long-term obligation of what is presumed to be a healthy, ongoing company. Thus, regulations allow plans many years to make contributions to make up underfunding the extent to which assets fall short of future liabilities which generally makes sense and enables an orderly plan management regime designed to fit into normal course business planning. Funding regulations operate on an incentive system, with current tax benefits for contributions and financial and administrative penalties for underfunding. They also rely on implicit assumptions that a sponsor firm will continue to be a going concern, and that it intends to provide the benefits. The Federal regulations following the enactment of the Pension Protection Act set reasonable limits on assumptions, and tax law effectively prevents removing funds once contributed to the plan for any purpose other than benefit payments by imposing a punitive tax penalty on any fund reversions. At their core, plan funding regulations effectively represent a balance between the voluntary nature of the plan system and reasonable plan participant protections. For all of these reasons, a sponsor is permitted to insure a plan for its own participants, but is not permitted to do so for unrelated entities as a commercial business. In addition, the Financial Accounting Standards Board, by setting accounting rules, governs the determination of a plan s funding ratio, and by extension, the sponsor s contribution levels. This assures all parties that sponsors will use appropriate assumptions when calculating their contributions and funding levels, so that the plan s financial position is fairly determined. A well-funded plan gives plan participants additional security relative to a less well funded one because once assets become plan assets they must be used for benefit purposes, and depend on investment results rather than the ongoing business success of the sponsoring firm. While all sponsors are required by law to fully fund their plans over time, the better funded one will also more easily weather adverse economic periods, whereas poorly funded plans may experience benefit restrictions, such as optional lump sum payment forms, if the sponsor is not able to make substantial contributions. That said, a plan sponsor can, while operating within these requirements, maintain an underfunded plan, have a high equity allocation and operate without risk charges or capital requirements. Decisions related to managing a DB plan are the responsibility of the plan fiduciaries. The DOL states: The primary responsibility of fiduciaries is to run the plan solely in the interest of participants and beneficiaries and for the exclusive purpose of providing benefits and paying plan expenses. 2 The plan sponsor is the plan s

3 primary fiduciary and employees of the sponsor may serve in this role. Others, such as investment consultants and independent fiduciaries, are hired from outside the company, and may also serve in a fiduciary capacity with respect to the services for which they are retained. The fact that all of the fiduciaries responsibility is to the plan participants, not the plan sponsor, benefits the participants. It s also important to note that not all decisions affecting participants are fiduciary in nature. For example, the decision to terminate a plan or to settle benefits through the purchase of annuities, is legally a business decision these are called settlor functions or decisions. Similarly, while a decision about the level of plan funding would be a settlor decision, the adoption of a plan s investment policy statement and a target asset allocation is generally viewed as a fiduciary decision. The two types of decisions recognize that the sponsor will make up any investment losses through increased contributions, if necessary, so long as the plan remains in effect. As a result of these safeguards and incentives, most plans are adequately funded and will meet their liabilities. It is important to note that as long as the sponsoring firm remains in business, participants have no insurance or security other than their plan s assets and the sponsor s ability and willingness to continue the plan and to make contributions. Its ability to do so may be loosely correlated to its credit rating. Should such an employer decide to no longer sponsor a plan, it is required to fund up the plan so that a fully funded plan can be administered by an insurance company, settled through lump sum payments to participants or a combination of both. The only time that a PBGC guarantee becomes effective is if the sponsor ceases doing business as an enterprise and a court 3 determines that the plan is underfunded. These distress terminations are generally administered by the PBGC because a commercial insurer cannot assume a liability without adequate consideration being paid. Scenario Two: Annuities Purchased From An Insurer Plan sponsors purchase annuities from insurance company for two basic reasons: > They are terminating their plans and have to settle liabilities or > They want to reduce the riskiness of the plan, the size of the plan and/or the ongoing expenses of the plan Once the plan has purchased an annuity to provide all of a plan s benefits due a group of participants those participants become annuitants and are no longer plan participants. The sponsor no longer pays PBGC premiums on these lives, and PBGC coverage of these liabilities stops, as the risk against which the PBGC insures insufficient assets to pay liabilities doesn t exist for the sponsor or participants once the obligation is transferred. Some plan sponsors and many plan participants may not know that the sponsor is required to provide the insurer sufficient assets to pay all benefits in order to enter into an annuity transaction. The rules governing the selection of an annuity provider recognize the paramount importance of benefit security for participants and are constructed to ensure that any insurer selected for this responsibility will be able to meet its obligations to their policyholders. Plan sponsors and participants often focus on the insurance industry s guaranty association coverage amounts rather than the context in which they operate. In fact, understanding the operation of both is as important as understanding the contingency against which the PBGC is protecting. Insurance companies are the only entities specifically regulated for long term solvency and which place the financial interests of their contract and policyholders before those of other constituents, including stock and bondholders. The Guaranty Association is only one element of the insurance industry s solvency regulation.

4 Factors That Limit Risk to Annuitants 1. Financial safety is embedded in the carrier qualification and selection process When a group annuity contract secures a DB plan benefit, the carrier s financial strength comes into play. The selection of an annuity carrier for a Defined Benefit plan by a sponsor entails fiduciary responsibility, and as such, the plan s fiduciaries have personal liability for proper execution of their duties. The Department of Labor provided guidance to sponsors almost 20 years ago in Interpretive Bulletin 95-1 (DOL 95-1) that established what s generally called the Safest Available Annuity Provider standard. The only carriers eligible for consideration under the DOL s IB 95-1 standard are the very strongest in the entire industry, generally with AA ratings for financial strength. For perspective, of all firms rated by S&P 4, less than 5% are rated AA or higher, and less than a quarter are rated A or higher. In short, DOL 95-1 has resulted in only the very strongest of all life insurance carriers being considered for an annuity provider role in DB transactions. Generally, the carrier financial rating is at least as high as, and is often higher than, the plan sponsor s. This ensures that the participants whose benefits are secured through a group annuity carrier guarantee have a level of long term security at least as high, and in many cases higher, than when they were participants in the ongoing plan. Additionally, the benefits are secured by a firm whose core business is guarantees, and whose risks are much more diversified, than can be the case even with the largest and well-funded of single employer plans. 2. Life insurance companies are regulated for solvency All insurance carriers are regulated for long term solvency and this regulation continually evolves to reflect market changes and developments. For a guarantee to a participant to be compromised, the entire insurance firm would need to fail, and even then the state guaranty association would provide a backstop, funded through insurer assessments, to the extent that a failed carrier s assets were insufficient to cover all of its covered contracted benefit payments. Insurance carriers are required to maintain what, in plan sponsor terms, would be a an overfunded plan at all times, backed by an asset portfolio that matches assets to liabilities, and which maintains extra capital for extreme market scenarios as standard practice. The regulatory regime under which insurers are required to operate also requires that carriers provide large amounts of information about every aspect of their business to state insurance regulators every quarter. This enables the regulators to monitor the carrier s financial condition in depth, and to intervene promptly in the event that a problem begins to emerge. This system aims to solve problems early enough to keep troubled carriers out of receivership. The progressive nature of this enhanced supervision also ensures that, in the rare circumstances when receivership is unavoidable, there are still assets to cover the vast majority of the company s liabilities. For those reasons, it is not surprising that insurance companies weathered the great recession quite well, as all but a handful of quite small insurance companies 5, including insurance subsidiaries of parent companies, met all of their obligations, kept very high ratings and remained well capitalized. 3. State regulation and the guaranty system State insurance commissioners have placed life insurers into receivership, though that has been a rare event in general and particularly so for larger insurers. Receivership for a life insurance company means that the

5 carrier is controlled by the insurance commissioner, and is a last step in a lengthy process. When a receivership does occur, state guaranty associations work together (through the National Organization of Life and Health Guaranty Association or NOLHGA) to make sure that policyholder claims under the contracts issued are paid to the greatest extent possible. One of the least understood aspects of the insurance regulatory system is the role of the state guaranty associations and how their statutory benefit provisions operate. The key is that carriers normally carry reserves (assets) far higher than the benefits guaranteed by their contracts. The point at which a carrier is placed under state control occurs when its assets and liabilities are approximately equal. This ensures that the great majority of benefits continue to be funded by the carrier s assets. The various state guarantee benefits are available if and as needed to supplement the carrier s funding, and should be viewed as a floor of coverage rather than as a benefit ceiling. If necessary, the insurance commissioners collect the capital needed to complete the failed insurer s obligations from all carriers doing business in the applicable state(s). The same information collected to oversee each carrier provides the commissioners with the information they need about the assessment capacity of the industry. Such assessments are a requirement of operating as a carrier. 4. Policyholders are paid first For insurance companies, policyholder obligations take precedence over general obligations to creditors. This distinguishes life insurance company receiverships from the process applicable to other types of companies and banks. Even experts sometimes are unaware of the differentiation between the ability of an insurer to meet its policyholders claims and the ability of its owner to pay its bondholders which can be very significant. The power of insurance commissioners over insurers gives policyholders the advantage over every other type of potential stakeholder. Conclusion In considering the safety of their Defined Benefit plan benefits, sponsors and plan participants should take into consideration the combination of two layers of protection the strength of the primary backer (the plan sponsor or the insurer) and the secondary backer (the PBGC or the State Guaranty Association), together with the processes that govern how the amount of benefit protection is determined and how it is ensured. When looked at in combination, an insured approach utilizing a highly rated carrier with benefit protection from NOLHGA offers at least as much protection, and for many participants, perhaps arguably greater protection than a traditional reliance on a plan sponsor and the PBGC. We hope this paper has provided a helpful review of the protections afforded to those who receive or look forward to receiving benefits through or arising from a Defined Benefit plan. We think that the proven ability of both DB plan sponsors and insurers to meet their obligations even in the face of the Great Recession should help both sponsors and their participants better understand how the laws that provide for voluntary termination have made participant protection paramount through their reliance on the robust regulatory regime under which the insurance industry is required to operate.

6 > Please contact your MetLife representative or call if you would like to discuss pension risk management solutions. 1 Note that the case of a corporate sponsor undergoing bankruptcy where a distress plan termination is involved is beyond the scope of this Topic. Distress terminations are handled under different rules than voluntary plan terminations, and may involve reduced benefits for some plan participants even if bankruptcy occurs, this does not necessarily mean that plans will be terminated, let alone that the PBGC will become involved in providing benefits. While the goal of the sponsor and the PBGC is frequently to maintain the plan if the corporation is in chapter 11 (reorganization) bankruptcy, in some cases especially chapter 7 (liquidation) the only choice is to terminate the plan. If that s the case, and if the plan meets the criteria for a distress termination this requires that a bankruptcy court find that the company will not be able to reorganize without relief with (pension) plan intact only then does the PBGC will assume responsibility for payments up to its statutory limits. 4 For perspective, overall, 47.4% carry investment grade ratings, with over half of all rated firms either below investment grade or not rated. Among the S&P 500 Index firms, less than 5% are rated AA or higher, 33% are rated A, and 50% are rated BBB, for 88% investment grade overall. 5 During , there were only 8 insurer receiverships in which NOHLGA was involved. All were small carriers and represented an aggregate total of $800 million in total liabilities, all of which were fully covered by the insurer estate assets and Guaranty Association coverage. Peter Gallanis, ERISA Advisory Council Hearing, 8/29/ L [exp1215][All States][DC] 2013 METLIFE, INC. Metropolitan Life Insurance Company 200 Park Avenue New York, NY