Consulting Retirement Pension Settlement Trend Accelerates with Verizon Annuity Purchase Insights Into the Evolving Pension Transfer Environment October 2012
Verizon Announces $7.5 Billion Pension Settlement On October 17, 2012, Verizon Communications Inc. (Verizon) announced a $7.5 billion pension settlement for management retirees and beneficiaries. This action involves the purchase of a group annuity contract from Prudential Insurance Company of America (Prudential) to cover approximately 41,000 retirees and beneficiaries. The transaction is expected to close in December of 2012. With this announcement, Verizon adds to the growing trend of pension transfer or settlement actions among major employers. Other significant actions include those announced by Ford Motor Company (Ford) and General Motors (GM) earlier this year. However, unlike other recent actions, including those by Ford and GM, Verizon is not offering participants a lump sum payment option. Pension benefits for all affected retirees and beneficiaries will be transferred to Prudential without any changes to benefits. The $7.5 billion announced by Verizon represents the Projected Benefit Obligation (PBO) currently carried on its balance sheet for the portion of the obligation being settled. Verizon s 8-K filing noted cash contributions totaling $2.5 billion in connection with the transaction. During Verizon's third quarter 2012 earnings call, the company did not discuss the estimated accounting impact of the transaction, including any settlement charge or ongoing earnings impact. Other Plan Sponsors are Taking Bold Steps The size of pension settlement actions announced in 2012 has redefined the market. In the U.S., the amount of pension liabilities annuitized in recent years has not exceeded $1 billion per year, and no single transaction has exceeded $1 billion since the 1980s. The transactions by Verizon ($7.5 billion) and GM (expected to be a large portion of the $26 billion in liabilities it intends to settle) are an order of magnitude larger than this. In addition to the actions described above, dozens of U.S. pension plan sponsors have implemented lump sum windows for terminated vested employees in order to shrink their pension plans. Others have taken advantage of ultra-low borrowing costs to finance large pension contributions. Some plan sponsors are considering other alternatives for funding pension deficits, such as making non-cash pension contributions. For example, on October 19, 2012, AT&T Inc. announced that it intends to contribute a $9.5 billion preferred equity interest in its AT&T Mobility unit to significantly improve the funding of its pension plans. After years of watching their pension deficits swell due to falling interest rates and lagging equity returns, plan sponsors have unleashed a wide array of bold measures to gain control of this problem. This Aon Hewitt report includes an overview of the actions announced by Verizon, Ford, and GM. We have also included discussion of important considerations for pension settlement and other financing strategies. Please note that all information summarized in this document regarding specific pension settlement programs is based on publicly available information. Aon Hewitt 1
Comparison of Major 2012 Pension Settlement Actions As a review, the following provides a side-by-side comparison of this year s major pension settlement actions from public disclosures. Ford GM Verizon Announcement Date April 27, 2012 June 1, 2012 October 17, 2012 Participants Affected 90,000 118,000 41,000 Eligible U.S. salaried retirees and U.S. salaried former employees Current retirees and beneficiaries (about 42,000 are lump sum eligible) Management retirees who began receiving payments before January 1, 2010 Settlement Approach Lump sums Lump sums and annuity purchase Annuity purchase Insurance Companies Involved None Prudential Prudential Approximate Amount to be Settled Approximate % of Total Pension Liability Settled 1 Up to $18 billion $26 billion $7.5 billion Depends on actual lump sum election percentage Some to be settled via lump sum and remainder to be settled via annuity purchase All settled via annuity purchase Up to 25% 20% 25% Cash and Financial Statement Impacts Bob Shanks Ford CFO, noted:... minimal impact on operating income... noncash special item charges... no impact to company cash.... From GM s June 1 announcement:... cash contribution... to effect these actions will be in the range of $3.5 to $4.5 billion... net special charges in the range of $2.5 to $3.5 billion...... ongoing annual impact to earnings will be approximately $200 million unfavorable due to a decrease in pension income. From Verizon 8-K disclosure on October 17: Verizon currently intends to contribute... $2.5 billion to the Plan in connection with the transaction.... [Aon Hewitt Note: Verizon currently uses mark-tomarket pension accounting.] 1 Amount to be settled as a percentage of total 2011 year-end pension benefit obligation from company 10-K filing. Aon Hewitt 2
Important Considerations for Pension Settlements Our experience and discussions with plan sponsors suggest that the pension settlement environment will remain active. Analyzing plan settlements is a logical extension of implementing pension de-risking strategies, especially those including plan freezes or redesigns, and new investment strategies including glidepaths. Organizations with sizable legacy benefits and aging participant populations should actively consider transition end game strategies for their pension plans, including various pension settlement options. Below, we discuss issues that should be considered and reflected in such an analysis. Prevalent Settlement Options and Strategies The Verizon settlement approach differs from the Ford and GM strategies, in that lump sums are not being offered to plan participants. Benefits for all affected retirees and beneficiaries will be settled via an annuity purchase. In addition to Ford and GM, a number of other plan sponsors have also announced pension settlement programs involving lump sum offers. These lump sum windows often include only terminated vested participants, rather than retirees. Examples of companies offering such windows this year include Sears Holdings Corporation, NCR Corporation, and The New York Times Company. In determining whether to offer lump sums, and whether to settle retirees only or retirees and terminated vested participants, plan sponsors should consider the relative advantages of each strategy. Settlement Strategy Group annuity purchase for retirees Lump sum offer for retirees Lump sum offer and group annuity purchase for retirees Lump sum offer to terminated vested participants Key Advantages Sponsor controls amount settled Participant is not required to make an election, simplifying execution and eliminating adverse selection costs Lifetime income protection is preserved Purely voluntary for participants Retirees usually the largest portion of the inactive liability Sponsor controls amount settled Participant has choice of insured or uninsured settlement Purely voluntary for participants Terminated vested participants may prefer lump sum Typically most cost-effective way to settle deferred pensioner liabilities Little to no adverse selection cost Regulatory approval (e.g., private letter ruling) likely not needed Copyright Aon 2012 3
Potential Adverse Selection Costs Any settlement strategy that offers employee choice creates potential adverse selection costs. For instance, when a choice of annuity or lump sum is offered, healthier participants will tend to prefer the annuity. The additional cost that the plan incurs over the life of those participants can be estimated using actuarial methods, as in the model developed and maintained by Aon Hewitt. In some cases, this cost will be significant. If so, the sponsor may decide to modify the choice being offered in order to control potential adverse selection costs. Insurance Industry Capacity $60 80B Per Year $5 Total Premium for Annuity Placements $30.0 $20.0+ Total Premium (billions) $4 $3 $2 $1 $0.6 $1.8 $2.7 $2.3 $0.8 $0.7 $0.9 $0 2005 2006 2007 2008 2009 2010 2011 Proj. 2012 Year Source: Hewitt EnnisKnupp Global Institutional Annuity Market Update, as reported by insurance companies surveyed. The most recent survey included 10 significant U.S. insurers. Only a small percentage of U.S. life insurance companies are currently in the pension settlement business. As annuity purchase demand increases, new carriers are expected to enter the market to satisfy this demand. Smaller carriers with lower capacity levels may jointly underwrite business with other such carriers. Reinsurance companies interested in increasing their longevity exposure may also play a role in expanding industry capacity. Even in the wake of the Verizon and GM transactions, we believe market capacity will be available if more plan sponsors pursue annuity purchases as part of their pension settlement strategies. With $30 billion in expected premiums, 2012 is a landmark year for insured pension settlements in the U.S. But with over $2 trillion in estimated pension obligations in U.S. corporate defined benefit plans, we could see even greater activity in future years. Annual capacity among ten large insurers currently active in this market is estimated at $60-80 billion. Copyright Aon 2012 4
Benefit Protection Available in Insured Settlement Solutions As plan sponsors and fiduciaries contemplate the impact of an annuity settlement on participants, benefit security is a primary concern. While the actual monthly benefit does not change when an insurer assumes responsibility for payment, the protections do change. Important due diligence about the financial health of the insurer(s), the structure of the annuity contract and the protections in the unlikely event of insolvency must be performed. Some plan sponsors hire an independent fiduciary to perform this analysis and to ensure that the participants' interests are being protected by an expert third-party. Plan sponsors are generally familiar with the nature of the security provided to benefits paid from a PBGCinsured pension plan. However, some may be less familiar when insured products are used. Below, we highlight two specific protections for insured products that merit particular consideration. Use of Insurance Company Separate Accounts The vast majority of annuity settlements are backed by the insurance company's general account. A separate account structure can also be used to insulate the underlying assets from an insurer s other policyholders and creditors. If the insurer becomes insolvent, insulated separate account assets are typically secure from general account obligations. More importantly, in an insolvency participants in those accounts have exclusive, first priority rights to those assets to cover their payments. In 1995, the Department of Labor issued Interpretive Bulletin No. 95-1 as guidance for plan sponsors to use when selecting a Safest Available Annuity provider. One of the criteria in the Bulletin is the structure of the annuity contract and guaranties supporting the annuities, such as the use of separate accounts. Each issuing state may have different rules about the development and operations of insulated separate accounts, so careful review is necessary. State Insurance Guaranty System When a plan sponsor enters into an insured pension settlement, participants benefits are no longer backed by Pension Benefit Guaranty Corporation (PBGC). Instead, these safeguards are replaced with the state insurance guaranty funds. These protections vary by state and are typically based on the annuitant s state of residence. Qualified annuity providers generally have A to AA credit quality ratings, and are subject to regulatory safeguards including Risk-Based Capital levels, statutory reserve standards, cash flow testing methods, and other rigorous requirements. In addition, they are backed by the state guaranty associations. Each state (and Puerto Rico and the District of Columbia) has a guaranty association, operating under individual state laws, to safeguard policyholders in the event of insurance company non-performance. In the event of insurer insolvency, participants benefits will generally be covered by the applicable state insurance guaranty first, and then any additional benefits beyond the guaranty coverage limit will be funded from the net assets of the insurer. An analysis 1 by the National Organization of Life & Health Insurance Guaranty Associations (NOLHGA) suggests that, even if an insurer fails, minimum net asset levels might typically produce 90% to 95% funding of insured benefits. NOLHGA found that the vast majority of policyholders have been made whole or nearly whole in past insolvencies, regardless of state guaranty limits. Additionally, the states have assisted distressed insurance companies prior to and during the insolvency process in an attempt to fully protect policyholder benefits. 1 NOLGHA Testimony for the record, Hearing Entitled Insurance Oversight and Legislative Proposals November 16, 2011. Copyright Aon 2012 5
Financial and Investment Considerations Underlying these recent settlement transactions is the sponsor s desire to decrease their pension financial risk by shrinking the size of their pension plan. But when viewed through the lenses of accounting, cash, or even investments, this can become anything but straightforward. Here are just some of the issues that sponsors will need to understand as part of this process: Issue Considerations Observation Accounting costs Current interest rates Fully Loaded liability cost Preparing the investments for settlement Immediate recognition of a portion of unrecognized losses (and gains) when plan liabilities are settled may materially impact earnings and earnings-related or stock-related compensation. By settling now, plan sponsors may fear locking in higher liability and ultimate costs in today s ultra-low interest rate environment. In deciding whether annuities and lump sums are too expensive, sponsors should consider the full cost of providing pension benefits, including administrative and investment fees, PBGC premiums, and potential measurement changes (e.g., life expectancy improvements). Plans must manage large interest rate exposure while maintaining liquidity to support the transaction. Lump sum acceptance rate is a critical planning variable where applicable. For Verizon, the 2012 action will likely result in a different settlement charge than most other companies would have due to their 2010 adoption of mark to market pension accounting. Impact on ongoing pension expense and P&L will depend on a variety of factors including any additional funding and the mix of investments in the trust post-settlement. Sponsors may choose a phased approach to mitigate this risk as well as the impact of any accounting settlement charges described above. Aon Hewitt s modeling indicates that a typical fully loaded pension obligation is now 0.3% to 1.5% higher solely due to recent increases in PBGC premiums, making settlement actions more appealing. In-kind portfolios are often used in larger deals to minimize transaction risk to both sponsor and insurer. Copyright Aon 2012 6
Administration and Communications In a typical retiree buyout program without lump sum solicitations, participants will not need to make any decisions or sign any forms. The insurer will simply assume responsibility for all future benefit payments for the specified retiree group. Most other large settlement programs this year have included a lump sum offer, which requires a great deal more effort from both the plan administrator and the participant. Regardless of the approach chosen, proper communication is critical to a successful outcome. Here are just a few of the issues administrators can expect to encounter: Issue Considerations Observation Communicating to annuitized participants Sponsors must communicate the change in source of payment and shift from PBGC to state insurance guaranty fund. Sponsors may provide additional background to help retirees understand why the change is occurring, as well as any changes to retiree medical coverage or ancillary pension benefits. Communicating a lump sum offer to inactive participants Administration Participants need unbiased information to understand the available options and make choices based on their own financial situation. Multiple forms may need to be completed properly, signed and notarized, and returned in a timely fashion. All aspects of administration must be transferred to insurer. Working with retirees, as well as locating and effectively communicating with former employees can take much more time and effort than pension administration for an ongoing steady state plan. Requires considerable preparation to ensure optional forms, QDROs, payment processes, and deductions are preserved. Compliance and Fiduciary Obligations Proper management of compliance and fiduciary risks begins with the proper assignment of responsibilities. All parties should understand the distinction between the settlor and fiduciary roles, and decisions should be made by the appropriately assigned authority. Issue Considerations Observation Compliance risk management Compliance issues include nondiscrimination testing and the potential need for a private letter ruling if, for example, a lump sum is being offered to retired participants. Early involvement of legal counsel in planning discussions is crucial. Settlor role Fiduciary role Settlor decisions are made by the sponsor, and include whether to terminate the plan, whether to offer lump sums, and to whom. Fiduciary decisions are made solely on behalf of plan participants, and include evaluating alternative safest available annuity providers. Starting with the settlor analysis allows the company to develop a strategy that balances all parties needs. Sponsor should maintain separation of settlor and fiduciary activities, including hiring a separate advisor to advise the plan on fiduciary matters. Copyright Aon 2012 7
Appendix Overview of Specific Settlement Actions Copyright Aon 2012 8
Recap of Ford Settlement Actions The charts below provide an overview of the Ford settlement action and the potential size of the settlement relative to the remaining liability for the Ford Motor Company General Retirement Plan. Liabilities and Participants Reported for Recent Plan Year Funding Target Liability (in $billions) Participant Count 2.9 21,900 0.9 13.7 13.7 65,962 Terminated Vested In Payment 65,962 33,038 Source: Data from Ford Motor Company General Retirement Plan Form 5500 for plan year ending December 31, 2011 (Department of Labor website). Updated numbers presented elsewhere in this document were disclosed by Ford on April 27, 2012. Ford Settlement Offer Lump Sums to Retirees and Terminated Participants What Lump sum offer to approximately 90,000 salaried retirees and terminated vested participants. Retirees and Terminated Vested When Series of election periods through 2012 and 2013. Why Allow additional choice and flexibility to inactive participants, and allow company to reduce volatility and administrative costs related to pensions. Potential lump sum settlement Copyright Aon 2012 9
Recap of GM Settlement Actions The following provides a step-by-step overview of the steps GM is taking to complete its pension settlement transaction. Liabilities and Participants Reported for Recent Plan Year Funding Target Liability (in $billions) Participant Count 3.0 0.8 26,547 29,376 25.8 124,310 Terminated 124,310 Vested In Payment 25.8 Source: Data from GM Salaried Retirement Plan Form 5500 for plan year ending September 30, 2011 (Department of Labor website). Updated numbers presented elsewhere in this document were disclosed by GM on June 1, 2012. Copyright Aon 2012 10
GM s Transaction Steps Step 1 Offer Lump Sums Offer lump sum payments to 36% of the retiree and beneficiary population (about 42,000 participants). This is generally the group which retired on or after October 1, 1997 and before December 1, 2011. When Lump sum elections provided to eligible retirees and beneficiaries after the announcement, with a required return date of July 20, 2012. Terminated Vested Retirees Not Lump Sum Eligible Retirees Lump Sum Eligible Step 2 Split the Pension Plan Create a new plan for active and, presumably, terminated vested participants. When Late 2012 Lump Sum Distributions Terminated Vested Retirees to be Annuitized Step 3 Terminate and Purchase Annuities Terminate retiree/beneficiary plan for those participants not receiving a lump sum payment and buy annuities from Prudential. Lump Sum Distributions When By the end of 2012 Terminated Vested Annuity Purchases Copyright Aon 2012 11
Recap of Verizon Settlement Actions Liabilities and Participants Reported for Recent Plan Year Funding Target Liability (in $billions) Participant Count 3.0 22,310 57,901 7.3 7.3 1.4 57,901 Terminated Vested In Payment 26,109 Source: Data from Verizon Management Pension Plan Form 5500 for plan year ending December 31, 2011 (Department of Labor website). The figures shown above reflect the merger of several union plans into the Verizon Management Pension Plan during 2010. Updated numbers presented elsewhere in this document were disclosed by Verizon on October 17, 2012. Verizon Settlement Purchase Annuities for Retirees What $7.5 billion liability settlement from Prudential for employees retiring before January 1, 2010. When By the end of 2012. Terminated Vested Retirees to be Annuitized Retirees Not Being Annuitized Why Reduce volatility associated with pension plan, reduce administrative costs, and allow greater focus on core business. $7.5B liability settlement Copyright Aon 2012 12
Contact Information For more information, please contact: Rick Jones Senior Partner and Leader of Retirement Consulting National Practices rick.jones@aonhewitt.com 847.295.5000 Eric Keener Partner and Chief Actuary eric.keener@aonhewitt.com 203.852.1100 Alan Parikh Associate Partner and Pension Risk Specialist alan.parikh@aonhewitt.com 847.295.5000 About Aon Hewitt Aon Hewitt is the global leader in human capital consulting and outsourcing solutions. The company partners with organizations to solve their most complex benefits, talent and related financial challenges, and improve business performance. Aon Hewitt designs, implements, communicates and administers a wide range of human capital, retirement, investment management, health care, compensation and talent management strategies. With more than 29,000 professionals in 90 countries, Aon Hewitt makes the world a better place to work for clients and their employees. For more information on Aon Hewitt, please visit www.aonhewitt.com. Copyright Aon 2012 13