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Letter from the US: A new way of thinking

Three years ago car makers Ford and General Motors opened the way to a new means of de-risking defined-benefit (DB) pension plans. They offered a lump sum to participants who were receiving benefits. In a private letter ruling, the Internal Revenue Service (IRS) concluded that the strategy was legal. But in July the IRS changed its mind and banned the practice. The ruling surprised US plan sponsors and forced them to rethink their behaviour.

On the one hand, it will not stop all offerings of lump sums, according to legal experts. On the other hand, it is likely to encourage the alternative of annuities buyouts, which could become a $500bn (€460bn) business by 2016 if interested plan sponsors annuitise just half of their liabilities, according to Mercer. It estimated that if these interested sponsors chose annuities for at least half of their liabilities, the total amount could reach as much as $500bn (455bn).

Several organisations, including the Pension Rights Center (PRC), a consumer group, have been pushing for a ban of lump-sum buyouts since 2012. Lump-sum buyouts are “one of the most cynical and dangerous pension abuses we’ve seen”, according to the PRC. They “erase the federal private pension protections of ERISA (the Employee Retirement Income Security Act of 1974), turn guaranteed lifetime retirement income into a one-time chunk of money that can easily be outlived, and often result in a significant loss of retirement wealth for elderly Americans.” 

Norman Stein, senior policy adviser to the PRC, says: “Retirees who choose a lump sum have to invest the money at the same time they are drawing it down, which is even harder than investing money before retirement. They will have to pay new fees, which will reduce their account balance, and fluctuations in the markets can destroy their investment portfolio with no time to make up the losses.”

Offering lump sums to retirees who already receive benefits is only one of the de-risking strategies being adopted by corporations – and it is the only one banned by the IRS. It is still legal to offer such buyouts instead of pension payments to active employees who are retiring or to former employees who have not received any benefits. Since 2012, more than 400 companies have offered lump sums, including Boeing, Hartford Financial Services Group and CSX, according to Towers Watson. Some 45% to 65% of workers accept a lump sum, according to a report in January by the Government Accountability Office, but they often lack “key information” needed to “make an informed decision”.

According to lawyers Belinda Morgan and Erik Vogt at Foley & Lardner, the IRS guidance removes one approach to de-risking, but leaves others in place. They say the guidance is unlikely to slow the use of de-risking strategies by sponsors struggling to control growing liabilities.

Alternatives include shifting a significant portion of pension investments from equities to long-term bonds and fixed income, and purchasing deferred annuity contracts to fund the plan’s promises. The latter move is becoming increasingly popular, even though most sponsors believe annuities buyouts are expensive, according to Mercer’s survey of 200 US financial executives. More than one third of respondents said they were likely or very likely to purchase an annuity in 2015 or 2016.

Several factors support this trend: the new mortality tables that the IRS will adopt next year and an increase in premiums to be paid to the Pension Benefit Guaranty Corporation. It will also become more attractive to offer annuity buyouts if interest rates start to rise, according to Dallas Salisbury, president of the Employee Benefit Research Institute, who observed that “the logical extension” of the IRS notice would be guidance from the Department of Labor (DOL) that sponsors “should be doing more annuities in their DB plans”.

A few days after the IRS ban, the DOL said that an employer’s fiduciary duty to monitor an insurer’s solvency generally ends when the plan no longer offers the annuity as a distribution option, rather than when the insurer finishes making all promised payments. Today, less than 20% of sponsors offer lifetime income annuities: the White House hopes that their number will increase thanks to the DOL’s new guidance.

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