Pension de-risking.

• Author: Secunda, Paul M.

ABSTRACT

The United States is facing a retirement crisis, in significant part because defined benefit pension plans have been replaced by defined contribution retirement plans that, whatever their theoretical merit, have left significant numbers of workers unprepared for retirement. A troubling example of the continuing movement away from defined benefit plans is a new phenomenon euphemistically called "pension de-risking."

Recent years have been marked by high-profile companies engaging in various actions designed to reduce the company's exposure to pension funding risk (hence the term "pension de-risking"). Some de-risking strategies convert a federally-guaranteed pension into a riskier private annuity. Other approaches convert the pension into cash for the beneficiary, which may be insufficient to provide lasting retirement income. These strategies have raised many concerns that participants are being disadvantaged and that pension de-risking is undermining the statutory purpose of ERISA.

Regulators are only beginning to consider ways to appropriately police pension de-risking behavior. We propose that the government should take an aggressive stance in regulating such conduct. Participants as a class should not be made worse off by a pension de-risking transaction, and the relevant de-risking rules should so reflect. More specifically, regulators should: (1) encourage desirable forms of de-risking by establishing regulatory safe harbors; (2) require a battery of procedural safeguards for annuitization transactions; (3) require improved disclosures for cash buyouts; and (4) limit cash buyouts when beneficiaries are not likely to meaningfully understand the potentially adverse consequences of trading a pension for cash.

TABLE OF CONTENTS INTRODUCTION I. CONCEPTUALIZING PENSION DE-RISKING A. ERISA & Pension Basics B. Internal De-risking C. External De-risking D. Why Pension De-risking Will Accelerate II. DE-RISKING & RETIREMENT SECURITY A. Performance & Delivery B. Non-ERISA Annuities: An Under-performance Problem C. Non-ERISA Lump Sums: An Under-delivery Problem III. THINKING ABOUT REFORM A. The Comparative Strength of Regulators B. Legal Framework for De-risking C. Proposals 1. Promote Internal De-risking 2. Procedural Safeguards for Annuitization 3. Disclosure Safeguards for Lump Sums 4. Restricting Lump-Sum Distributions to Retirees CONCLUSION INTRODUCTION

Retirement planning is not only difficult, but also dangerous. It is dangerous for individuals because poor planning can mean post-employment penury. It is dangerous for companies because it is much easier to make promises than to keep them. It is dangerous for elected officials because they will take the blame if elderly poverty is widespread. We therefore are living in dangerous times: too many Americans are saving too little for retirement. (1)

One reason for that is recent history. In the last thirty years, employers have transitioned away from "defined benefit" ("DB") plans (where a worker earns a monthly pension for a lifetime of work) to "defined contribution" ("DC") plans (where a worker builds up a retirement savings account, invests the principal, and then draws down the account in retirement). (2) Whatever the theoretical appeal of DC plans, the real world result has been disappointing. Workers have neither saved enough nor invested those savings wisely. (3)

Many large companies, interestingly, still have "legacy" DB plans: retirement plans applicable to older employees that were in place before the company transitioned into a DC plan for newer employees. (4) The burden of funding and maintaining those plans is substantial. (5) A growing number of firms are seeking to creatively manage those obligations in ways designed to reduce the company's exposure to funding risk. (6) The industry term for those risk-reducing strategies is "pension de-risking." (7)

Some "de-risking" strategies are internal, meaning that the pension obligation is retained by the company but managed differently. (8) Other solutions are external, meaning that the pension obligation is offloaded from the company to another party. (9) Observers are particularly worried about external de-risking, and rightly so. For example, the "annuitization" approach converts a federally-protected pension into a riskier private annuity; (10) and the "lump sum" approach converts the pension into cash for the beneficiary, which may be insufficient to provide lasting retirement income. (11) Neither approach prioritizes beneficiary welfare consistent with the dictates of the Employee Retirement Income Security Act of 1974 ("ERISA"). (12)

Like many pension matters, de-risking sounds arcane but involves obscene amounts of money. In the last few years, for example, Verizon, General Motors, Ford, Motorola, and Bristol-Myers Squibb have all undertaken pension de-risking transactions. Together, these transactions were worth over $100 billion and affected hundreds of thousands of workers, retirees, and their beneficiaries. (13) More de-risking is sure to come, and the number of persons affected will continue to rise.

This Article is the first treatment of pension de-risking in the legal literature. In Part I, we offer a succinct explanation of what pension de-risking is and why it will accelerate. In so doing, we clear away the complex regulatory brushwood that so often impairs mainstream consideration of pension issues and provide an accessible foundation for future de-risking discussions.

In Part II, we offer a policy frame that clarifies the problem pension de-risking poses. Pension regulation should promote retirement security. By converting federally-protected pensions into private annuities or cash, pension de-risking does the opposite. Regulators should keep that in mind.

In Part III, we offer a roadmap for reform. In many pension contexts, robust regulation may deter employers from offering voluntary retirement plans in the first place, so regulators need to balance protecting beneficiaries against employer flight. (14) No similar pressure exists here. No employer will be deterred from offering a DB plan on account of strict de-risking rules because virtually no employers are offering new DB plans in the first place. (15) Accordingly, regulators can realistically prioritize protecting beneficiaries.

After describing the legal framework for de-risking, we make four suggestions. The government should: (1) encourage internal de-risking by establishing regulatory safe harbors; (2) require a battery of procedural safeguards for annuitization transactions; (3) require improved disclosures for cash buyouts; and (4) limit cash buyouts when beneficiaries are not likely to meaningfully understand the potentially adverse consequences of trading a pension for cash.

1. CONCEPTUALIZING PENSION DE-RISKING

   On its own, the term "pension de-risking" is too vague to do much useful work. Below, we develop a vocabulary that will make discussion of the phenomenon, and potential reforms, intelligible. We also explain why pension de-risking demands immediate attention: because it is likely to accelerate.

   1. ERISA & Pension Basics

      ERISA, with narrow exceptions, governs retirement promises made incident to employment. (16) ERISA requires such pension promises to be effectuated under what the statute calls a "plan" that is created by the sponsoring employer. (17) Those plans, for our purposes, come in two varieties: the "defined benefit" plan and the "defined contribution" plan.

      A defined benefit plan is where the retirement promise is defined in terms of what the employee can expect to receive upon retirement (e.g., a fixed, periodic payment based on the employee's years of service and average salary). (18) A DB entitlement is functionally an annuity earned through service and paid for by foregone wages. A DB benefit is what most people think of when they hear the word "pension." ERISA heavily regulates DB arrangements. (19)

      A defined contribution plan, in contrast, is where the retirement entitlement is defined in terms of what the employee (and sometimes the employer) "contributes" to a retirement savings account, plus any investment appreciation on those contributions. (20) A DC arrangement is functionally a constrained savings account. A classic example of a DC arrangement is a 401 (k) plan. ERISA regulates DC arrangements, but far less strictly than it does DB plans. (21)

      Pension de-risking involves DB plans, and for all forms of de-risking, the underlying motivation is the same. An employer made a DB promise long ago. Afterward, it determines that its current strategy for keeping the pension promise is too costly or too afflicted with uncertainty. (22) So the company considers a number of alternate strategies to handle its pension obligation. Thus, at the broadest level, pension de-risking refers to any strategy a company undertakes to mitigate the risk associated with carrying a DB pension obligation. (23)

      As we discuss below, some de-risking strategies are "internal," meaning that the pension obligation is retained within the company, but the plan is managed differently. (24) Other solutions are "external," meaning that the pension obligation is offloaded to another party. (25) The focus of this Article is largely on external de-risking; external strategies particularly worry observers because they transfer risk to beneficiaries and are only partially subject to ERISA. (26) Internal strategies, in contrast, are less worrisome because they do not transfer any risk to beneficiaries and are entirely governed by ERISA. (27) To the extent, however, that regulatory uncertainty regarding the permissibility of internal de-risking strategies will motivate some employers to pursue external de-risking strategies instead, we pause to discuss internal de-risking.

   2. Internal De-risking

      An internal de-risking strategy is any strategy in which the plan retains the underlying DB obligation but adjusts its mix of...