There are instances when, after looking at the hits to the company’s balance sheet, a plan sponsor may find that a pension risk transfer (PRT) to terminate a defined benefit (DB) plan may not be affordable.
Tom Swain, principal at Findley, based in Brentwood, Tennessee, points out that in a DB plan termination, the common forms of distributions are lump-sum window offerings and the purchase of an annuity to transfer assets to an insurance company. The hit to a company’s balance sheet from lump-sum distributions depends on the interest rate used to calculate them and plan provisions, but an annuity purchase will be a bigger hit, he says.
The cost to pay out lump sums and to purchase an annuity is greater than the DB plan liability on a company’s balance sheet, so the economic impact to an organization is real. “Looking at the estimated funding needed to pay off liabilities to terminate a plan is often the stopping point for a plan sponsor,” Swain says. “It may be too much, and the plan sponsor will need to continue to plan for achieving the funding needed for plan termination.”
He adds that it is rarer for a DB plan to be overfunded—having additional assets to pay for the annuity purchase cost—because there are excise taxes associated with overfunding, so most plan sponsors try to be close to full funding. This means there will have to be an additional contribution at plan termination to have sufficient funding for plan liabilities. Swain says this has a cash flow impact and a balance sheet impact, and the issue should be addressed in the planning process for termination.
So, as Brian Donohue, partner at October Three Consulting, based in Chicago, explains in a blog post, purchasing an annuity to settle plan liabilities causes the first two “hits” to a plan sponsor’s financials: Hit #1- Plan liabilities may have to be written up, reducing net worth; and Hit #2 – That write-up typically will have to be run through the income statement, generating a (non-recurring) expense and reducing net income.
Donohue points to another hit: Unrecognized losses may also have to be run through the income statement. He explains that in a year when the plan has poor asset returns—for example, in 2018, a typical pension plan lost 5% on investments—the plan sponsor doesn’t record the charge in the current year. Instead the loss goes into account called “unrecognized loss” and a piece is recognized on the balance sheet over time.
In addition, the blog post says, “The long-run decline in interest rates (from 1982 to the present) has, for DB plan sponsors, generated interest rate-rated losses on plan liabilities… Any remaining ‘deferred losses’ are recognized on the income statement at plan termination.”
Swain says there may also be plan amendments that generated prior service costs that were amortized over time.
For a DB plan that is overfunded, one last hit that will occur with a PRT to terminate a plan is that any “pension income” generated by the plan surplus will disappear—reducing future net income. In his blog post, Donohue provides an example of a company with a DB plan that has (as of year-end 2019) $12.5 billion in liabilities and $15.0 billion in assets. It also has $3.0 billion in unrecognized losses, which Donohue says is the typical situation for pension sponsors and is due to declines in market interest rates and underperformance of plan assets over the past two decades. The plan will take a $5.5 billion hit to its 2019 income statement, and the pension income the overfunded plan was generating will, after the 2019 plan termination, disappear from future income statements.
Swain says he’s seen some plan sponsors not motivated to terminate their plans because it’s generating income. “The plan is manageable. The pension income offsets PBGC premiums and administrative expenses.”
Donohue says there are companies that manage to terminate their plan even with big balance sheet hits. He compares it to the handful of DB plan sponsors that have adopted complete mark-to-market accounting. “They took a big charge when they changed to mark-to-market accounting. It’s sort of like restructuring charges; there was a time when companies would reengineer and take the losses and their financial statements going forward were cleaner.”
But, some companies can’t handle big balance sheet hits. Donohue says October Three has seen, for example, that banks are more sensitive to losses.
Swain says there is no rule of thumb for an amount or percentage hit a company can afford. “In the typical process, the company prepares its best estimate of what it will take to fully distribute all liabilities for plan termination. There is a conversation with the CFO to see if the company has the cash flow or balance sheet strength [to terminate the plan via pension risk transfer]. If it’s not doable immediately or in the near-term, the plan sponsor can take steps to be in a better position, like de-risking,” he says.
Partial PRT actions
Companies can and have done PRTs with only parts of their plan liability—for example, transferring $3 billion in retired participant liability, Donohue points out. He says plan liabilities may have to be written up, reducing net worth, in a partial PRT.However, when only settling a portion a portion of plan liabilities, it’s possible a plan sponsor won’t have to recognize anything it’s been delaying, according to Donohue. “If the amount settled is less than the service cost and interest cost, the plan sponsor won’t have to recognize anything. Many plan sponsors do a small-scale PRT so they won’t have to recognize anything they’ve been delaying,” he says.