Securing Retirement Outcomes - Mercer 2014

TerminaTed VesTed CashouTs oVerComing Common misConCepTions

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TerminaTed VesTed CashouTs — oVerComing Common misConCepTions

in the past few years, a growing number of defined benefit pension plans have been opting to transfer risk from the balance sheet through lump sum cashout windows and annuity purchases from insurers. While a few high-profile retiree annuity purchase transactions were made in 2012, the most common form of risk transfer to date has been lump sum cashout windows1 for terminated vested2 participants.

The advantages to the plan sponsor of a lump sum cashout can be numerous, and the economics of such an exercise are often very compelling. Furthermore, increases in interest rate levels and improvements in funded status during 2013 may make 2014 an opportune time to capitalize on these advantages. Benefits to the plan sponsor of offering a terminated vested cashout window include:

• reduced pension liability, leading to lower plan financial risk and volatility.

• eliminated pBgC premiums for participants electing a lump sum (pBgC per-participant premiums are scheduled to increase from $35 per participant in 2012 to $64 by 2016 and continue to increase thereafter).

• eliminated ongoing administrative costs for participants electing a lump sum.

• reduced investment management costs for the funds used to cashout.

• ability to make lump sum payments before updated statutory mortality tables increase costs (recently released mortality tables by the society of actuaries could increase terminated vested liabilities by 5%–10% or more).

• potential interest rate arbitrage in 2014, depending on the relationship between lump sum rates and market-based rates.3

at the same time, these programs tend to be popular4 with participants. many participants use the opportunity to consolidate their retirement assets into an individual retirement account (ira) or other tax-advantaged vehicle, allowing them to take more control over their retirement planning.

For these reasons, we saw many plan sponsors embark on cashout projects beginning in 2012, and this trend seems to be intensifying in 2014. Keep in mind, however, that the business case for a project of this nature is driven by the unique circumstances of the plan sponsor, and a cashout will not make sense in every situation. That said, some sponsors for whom a cashout might be appealing are waiting on the sidelines, hesitant because of perceived concerns about offering a window. in this mercer point of View we identify some common concerns and discuss how they might be addressed to allow for a successful risk transfer project.

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some sponsors have expressed a concern that by paying out lump sums to participants, they are losing the opportunity to generate returns in excess of the liability growth rate, which could impact their p&L expense. Whether or not this is true depends upon which assets are used to pay out lump sums. if lump sums are paid proportionally from all asset classes, then there is an opportunity cost in the form of lower potential future returns, which can manifest as an increase in p&L expense. some sponsors are comfortable with this because there is a corresponding risk reduction for the plan.

But plan sponsors who feel that they are already taking the appropriate level of risk in the plan might instead pay all lump sums out of fixed income assets of a comparable duration. This trades out a fixed income asset for a fixed income liability, leaving the plan roughly neutral on a risk basis and preserving the same level of growth assets. For example, if you were to consider the cashout as an asset class, cashing out the obligation from fixed income assets effectively “immunizes” that portion of the portfolio from risk — in other words, it acts as an extension of the fixed income portfolio. The following illustration shows this concept:

in this example, lump sums are paid from fixed income assets. Therefore, the growth portfolio and risk level remain the same in dollar terms, even as they become a larger portion of the investible portfolio.

Impact of risk transfers on relative portfolio

LDI portfolio

Growth portfolio

BEFORE AFTER

60%

40%

50%

50%

1. “inTeresT raTes are Too LoW righT noW” 2. “i WiLL inCur an opporTuniTy CosT in my asseT porTFoLio”

Impact of risk transfers on relative portfolioLDI portfolio Growth portfolio

a lower interest rate leads to a higher lump sum value. While this is good for participants, some sponsors worry that they are paying out lump sums at the “top of the market”. interest rates have increased by around 75 basis points from their 2012 lows, but they remain low relative to historical norms. some plan sponsors have strong feelings that interest rates (and corresponding lump sum rates) will increase and therefore result in a more opportune time to execute in the future.

While reasonable people can have different expectations for interest rate directions in the short term, waiting for a rise in interest rates to take action is a bet on the direction of interest rates. many plan sponsors already have a significant position in their plans that would be rewarded with rising rates (or penalized with lower rates) because their portfolios have low fixed income holdings and/or short fixed income durations compared to the plan’s liabilities. in addition, if a plan sponsor were looking to profit from the expectation of rising rates, there are generally more efficient ways to do so than carrying terminated vested liabilities. For example, a sponsor could express the same view on interest rates by selling bonds or shortening the duration of its fixed income portfolio at a cost that may be significantly less than retaining the terminated vested obligation and the associated holding costs (pBgC premiums, administration costs, longevity increases, etc).

Furthermore, it is important for plan sponsors to consider when and how interest rates are set for purposes of a cashout. many plans lock in lump sum interest rates for a full year based on a “lookback.” if the locked-in lookback interest rate is higher than current market rates, then the lump sum paid is typically lower than the market value of the liability released, resulting in an economic gain. For example, for a typical calendar-year plan, rates have declined by 30–50 basis points since late 2013. This could translate to lump sum payments being 5%–10% lower than the employer liability.

This difference could get bigger, smaller, or reverse depending on interest rates. even if the actual payout of lump sums takes several months, plan sponsors can often take steps immediately through investment policy to preserve the difference.

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3. “my Funded sTaTus WiLL deTerioraTe iF i am aLready underFunded”

it is true for an underfunded plan that paying out a dollar of assets and a dollar of liabilities reduces the funded status on a percentage basis. There are potential funding and reporting implications to this that should be understood by the employer prior to executing a lump sum cashout. That said, the unfunded amount in dollar terms would generally remain about the same.

in addition, the funded status (as measured by accounting assumptions) may understate the true economic cost of carrying the liability, as it does not include costs of holding the liability, such as administrative and pBgC costs. and if sponsors capture tactical opportunities (such as the arbitrage opportunity discussed above), the lump sums paid may be less than the liability released. The combination of these two factors can often neutralize any decline in funded status percentage.

plans — especially those using a “glidepath” approach for investments — will want to revisit the impact of a cashout on their investment policy to determine whether some of the funded status triggers or target allocation percentages will need to be adjusted following the payout of lump sums.

4. “paying Lump sums WiLL Trigger a p&L seTTLemenT Charge and impaCT our share priCe”

if the total lump sum payout exceeds certain thresholds, settlement accounting is triggered. Because most plans today hold a large unrecognized loss on the balance sheet, settlement accounting for these plans generally leads to a p&L charge under us gaap5 although the net balance sheet is largely unaffected.

if settlement accounting is truly undesirable, lump sum windows can be constructed in “tranches” such that the settlement accounting threshold is not breached in any year. such tranches can be constructed by lump sum value, business unit/division, or other reasonable methods6 that produce the desired result — maximizing the value of a cashout window while eliminating settlement recognition.

Keep in mind, however, that a settlement charge is not always a bad thing. First, the market has become more savvy about adjusting earnings for pension expense and is less likely to penalize an organization for taking prudent steps to manage risk within its pension plan just because the one-time accounting outcome happens to be negative. When looking at the underlying economics of the plan, a settlement has no impact on the true financial condition of the plan or the company — and a cashout window is arguably favorable from an economic standpoint. second, some CFos view a settlement charge as a good thing, because it “clears out” some of the unrecognized loss from the balance sheet, thus reducing the headwind to pension expense on a go-forward basis. in fact, some sponsors have moved to a “mark-to-market” accounting approach that removes these

unrecognized losses entirely.

5. “my ConTriBuTions WiLL go up”

in the long run, contribution policy is generally an issue of “pay me now or pay me later” — the ultimate level of pension contributions is always equal to the total benefits paid out, less any investment earnings net of expenses. To the extent that lump sums paid out are less than the economic liability, we would expect long-term contributions to decrease. But it is true that the timing of contributions can accelerate modestly following a cashout exercise, largely due to the current status of funding relief (map-21). Keep in mind that under map-21 funding relief, the funding target is calculated using high interest rates that are currently disconnected from the true “market value,” and this will reverse itself over the next few years.in any event, we typically find that this contribution acceleration is small relative to the potential cost savings of removing participants from the plan, but each plan sponsor should evaluate their situation individually.

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6. “i don’T WanT my empLoyees To squander Their pensions”

some plan sponsors express paternalistic concerns that participants will lose the longevity and investment protections of an annuity benefit if they elect a lump sum. This is a valid concern, as lifetime annuities are an effective way to ensure that individuals won’t outlive their money in retirement. however, keep in mind that terminated vested participants, by definition, were not “career employees” at your organization. so for many, the deferred vested pension may make up only a small part of their total retirement savings.

participants may find that their retirement planning may be made easier by combining their lump sum with their other retirement savings. in fact, we see evidence that participants are doing this. our experience has been that over 80% of lump sums over $50,000 are rolled over into an ira or other tax-qualified vehicle. Furthermore, providing participants with the flexibility to make individualized decisions with their retirement funds promotes the opportunity for building wealth based on their individual financial goals and preferences. Finally, keep in mind that a lump sum program is voluntary — participants who prefer the security of a lifetime annuity can keep it.

7. “We are going To FuLLy TerminaTe The pLan soon anyWay”

many frozen-plan sponsors intend to eventually terminate their plans once funded status improves. a terminated vested cashout project can align very well with that goal for several reasons:

• plan termination is a lengthy process that can take 12–24 months or longer. paying out lump sums now reduces risk and carrying costs over this period, and it ensures that payment occurs before the new (more expensive) mortality tables take effect for lump sums.

• paying out a lump sum during plan termination carries an onerous administrative burden, as the pBgC requires disclosure of participant-level data that can be difficult to find, particularly for participants who terminated decades ago. paying lump sums while the plan is operationally active can be less complex and less costly. sponsors should be cautious not to implement a cashout window too close to actual termination to avoid the appearance that they are trying to circumvent pBgC plan termination processes.

most sponsors looking to terminate are looking for opportunities to support or accelerate the process, so a cashout window could be thought of as a phased termination step.

8. “my parTiCipanT daTa is noT CLean enough”

many plan sponsors struggle to maintain accurate data for terminated vested participants, especially those who terminated employment many years ago. The prospect of cleaning data up to facilitate lump sum payouts can feel daunting.

however, this is actually a good reason to execute a lump sum cashout window now, rather than waiting until these participants retire and then individually researching and cleaning up their benefits. doing the cleanup as a batch is typically more efficient and less costly than on an “ad hoc” basis, and the more time that has passed since termination of employment, the harder researching these participants will become. This data clean-up project will eventually have to be done regardless of direction, and if the financial business case for a cashout window is compelling, it may suggest no better time than the present.

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9. “i don’T haVe The BandWidTh To handLe This, and iT’s Too expensiVe To hire a Third parTy To do iT”

human resource functions are constantly being asked to do more with less, and executing a lump sum cashout is a major initiative. Beyond just the calculation of benefits, significant communications need to occur with former employees, and our experience has been that plan sponsors receive more phone calls than participants in the window.

For this reason, most sponsors look for external support to execute these projects. While costs vary depending on the size of the group and the level of support needed, many plan sponsors find that: (1) the cost of the cashout is equivalent to or less than the cost of doing “ad hoc” calculations as participants retire, and/or (2) the cost of such a project pays for itself quickly in administrative, pBgC, mortality increases, and other savings. many sponsors have found the roi on these projects to be upward of 50% per annum (on an internal rate of return basis) after considering the one-time cost of implementation and the expected annual savings that would result. in other words, the “break-even” time horizon may be very short. however, every situation is different, and plan sponsors should evaluate the costs and benefits applicable to their program.

10. “morTaLiTy Changes Won’T happen unTiL 2016, so There is no reason To aCT noW”

in many cases, given declines in interest rates during the first quarter of 2014, the financial business case may be compelling at the moment (lump sums may be lower than the obligation released), and this opportunity can be captured and executed on in 2014. however, it is unclear what the relationship will be after 2014, which leaves the possibility that this opportunity will be missed. additionally, it seems likely that auditors may insist on some recognition of improved mortality tables for 2014 or 2015 financial disclosures.

even assuming the statutory requirements for cash funding and lump sum payments will reflect increased longevity after January 1, 2016, plan sponsors may need to move soon. While 2016 may seem like a long way away, executing a successful cashout exercise takes significant time, planning, and effort. Just the process of calculating benefits, mailing, and recording elections typically takes around six months. and prior to that, many sponsors will need to clean up data to prepare, as well as build consensus and get buy-in from key stakeholders in the program. This process can take many months or even over a year. a delay could mean paying larger lump sums based on the new statutory mortality table, although the other potential savings discussed above would still be available.

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ConCLusion

in this point of View we have addressed many of the misconceptions around cashouts, so that plan sponsors can better assess the opportunity to de-risk. We believe that for plan sponsors that can get past these misconceptions, the benefits of a lump sum window may be compelling. however, each organization’s specific circumstances need to be considered when making the “go/no go” decision. mercer has a great deal of experience helping plan sponsors review the formal business case for a lump sum cashout window.

We suggest that a formal review include:

• exploring the financial implications through three lenses — economics, accounting, and cash — and helping to put the cashout exercise in the context of broader risk management strategies that the sponsor may employ.

• quantifying the specific level of potential expense savings (annually and present value).

• reviewing the cost of executing a cashout project and determining the specific implementation steps.

• Formalizing the business case — is the roi compelling?

• reviewing any barriers to a successful project

• Considering the “fit” of a cashout project within your broader financial strategy.

• assisting with asset allocation decisions such as which assets to pay benefits from and what the asset allocation should look like after the cashout program.

• Launching a data clean-up project to make sure complete and accurate calculations exist for former employees.

• Building a formal project plan with clear roles and responsibilities to promote a successful project.

mercer consultants are very well versed in all aspects of cashout and risk management projects, and we have a great deal of experience helping plan sponsors explore the business case and ultimately execute if the opportunity is compelling.

MAKING ACCOUNTABILITY WORK

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ConTaCTs

JonaThan Barry parTner +1 617 747 9676 [email protected]

riChard mCeVoy parTner +1 212 345 3194 [email protected]

sCoTT JarBoe parTner +1 202 331 2523 [email protected]

maTT mCdanieL prinCipaL +1 215 982 4171 [email protected]

FooTnoTes1an offer of lump sums to terminated vested participants could be done either as a permanent plan feature or as a

one-time window. however, amending the plan to allow for permanent lump sums becomes a protected benefit that cannot be removed, causing potential future administrative and cost concerns. For this reason, most sponsors elect to pay lump sums as a one-time window opportunity.

2a terminated vested participant is a former employee who worked long enough to earn a vested benefit but has not yet begun collecting a monthly pension.

3 most plans set interest rates once per year using a “lookback” method to a month prior to the beginning of each plan year. That rate is then locked in for all lump sums paid during the year. if rates fall significantly during the year, the plan sponsor has an opportunity to pay out lump sums using the older (higher) interest rate, leading to a potential gain to the plan: where the value of the lump sums paid is less than the value of the liability released. For calendar-year plans, this was generally true through the first quarter of 2014.

4a cashout exercise cannot be mandatory — the participant must elect to receive a lump sum. our experience indicates that most cashout exercises achieve a takeup rate between 40% and 60%.

5This discussion applies to plans reporting under us gaap. under ias 19r, settlement accounting is typically not as large an issue — the charge (or credit) is generally simply the difference (if any) between lump sums paid and liability settled.

6note that plan amendments to allow lump sums have to meet nondiscrimination rules for timing and effect.

imporTanT noTiCes

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Economy & Finance

Securing Retirement Outcomes - Mercer 2014