GAME OF PENSION RISK
July 2014
Philip J. Koehler, Esq.

General Motors CEO, Mary Barra, said in an interview recently that, despite her 30-year tenure, she didn’t know when GM’s ignition switch defect was first recognized as a safety issue inside the company because GM’s employees have historically operated within so many “information silos” that critical communication simply broke down.  “[A]s information was known in one part of the business, for instance the legal team, it didn’t necessarily get communicated as effectively as it should have been to other parts, for instance the engineering team,” Barra told a Congressional committee in April.  The month-long independent review conducted by former US attorney Anton Valukas specifically mentions GM’s “information silos” as a “root cause” of “a pattern of incompetence and neglect” that resulted in a global recall crisis and the deaths of at least 13 people.  This month GM added 3 million vehicles to its defective ignition switch recall and increased its charge to earnings for FY 2014 from $700 Million to $1Billion.

Wikipedia defines an “Information Silo” as a “management system incapable of reciprocal operation with other, related management systems.” That sounds about right as far as it goes.  Information silos develop within organizations for a variety of understandable, albeit generally dysfunctional, reasons.  Some emerge informally due to intra-organizational jealousies or mistrust.  Others form when a special project or functional unit is created in isolation from normal internal controls and procedures and left to operate in an ad hoc management-by-exception environment. Viewed as having a more or less tenuous relationship to the company’s business objectives, if left unchecked, these fiefdoms develop their own insular cultures and readily fly below the management radar.  A common example is the information silo that forms around the insiders and vendors responsible for managing a company’s 401(k) plan.

With a few exceptions, ERISA requires the sponsor of a pension benefit plan to hold plan assets in a nonreversionary trust fund for the exclusive purpose of paying benefits to participants and their beneficiaries.  This mandatory separation of corporate assets and plan assets, intended to insulate the plan assets from the claims of the company’s creditors and insure that they are prudently invested, misleads many companies to accept a false paradigm that the plan is an autonomous entity, which for compliance reasons operates with only minor and formalistic management interfaces, i.e. a classic information silo.

Ms. Barra’s problems at GM with information silos are on another scale of disaster, but any retirement plan information silo is generally incapable of reciprocal operation with two “settlor” functions critical to the success of the plan:  (1) the application of corporate internal controls and procedures for financial reporting and (2) the integration of all pension risks within the corporate enterprise risk management system.  We have only to read the 81-page Trial Order in the now infamous Tussey v. ABB to see the damage wayward plan fiduciaries can inflict on a large and sophisticated plan sponsor, as well as the participants, when they operate beyond the reach of the company’s internal controls and risk management system.  There, the plan’s information silo was supported by a toxic culture in which participant complaints didn’t matter, vendor relationships with insiders were unmonitored and ABB’s internal audit staff, compliance personnel and board level audit committee we’re left in the dark about Fidelity’s highly problematic cross-subsidization fee arrangement. 

Last month our newsletter focused on improving plan governance outcomes by extending the plan sponsor’s system of internal controls for financial reporting to control sources of indemnified fiduciary losses as it does any other potential financial loss to the company.  This month, we continue this discussion by considering the plan governance benefits of applying the plan sponsor’s general risk management principles to identify and control all of its pension risks.  As we have stressed, this does not call for a bold, new management initiative.  To the contrary, for plan sponsors who have already implemented these systems, they need only to revisit the scope of the system to insure that they have properly integrated pension risks with the enterprise’s global risk portfolio.

RATIONALIZING PENSION RISK MANAGEMENT 

In a bygone era, the relatively low life expectancies of industrial workers meant that, more often than not, they worked until they dropped dead.  As life expectancies improved in the latter half of the nineteenth century, employers slowly began to view funding employee retirement benefits as the financial equivalent of the cost of depreciation of human capital, which could be absorbed as part of a competitive compensation package.  By the mid-twentieth century, post-retirement income was a financial necessity for virtually all employees and employers became receptive to the notion that adopting a formal pension plan would advance shareholder interests in “incentifying” and retaining their workforces, thereby helping to control their costs of turnover, training and recruitment.

The Internal Organization for Standardization (“ISO”), which has codified a family of standards relating to risk management, defines the term “risk” to mean ”the effect of uncertainty about the future attainment of an objective (which may or may not happen) caused by ambiguity or lack of information that will eventually result in a net gain or a net loss.”  See ISO 31000.  Uncertainty about the adequacy of post-retirement income for the workforce as a whole forms a macro profile of pension risk.  A plan sponsor’s commitment to controlling this risk was often touted as the core value of the plan.

Throughout the 50s, 60s and 70s, the employee pension benefit landscape of the “for profit” business community was thick with defined benefit plans.  In those days achieving a pre-determined “replacement ratio” objective, i.e. a specific percentage of a hypothetical career employee’s career average or final average earnings, overshadowed other plan design considerations.  In plain English, this objective answered the fundamental participant question: “How much of a monthly lifetime pension do I get when I retire?”  A plan that could not answer this question could not control the fundamental pension risk.  The legacy of the “replacement ratio” objective still lingers in most plan design exercises.  Even though defined contribution plans are functionally incapable of adopting an explicit “replacement ratio” objective, it retains considerable influence as a plan success metric.  Many a pension consultant has tied himself into knots trying to convince his client that a 401(k) plan still embraces this core value.

Regarding employer sponsored pension plans with an explicit “replacement ratio” objective, there are nine prominent categories of risk:

  1. Investment risk: the plan sponsor’s risk in a defined benefit plan of achieving a return on plan assets below the minimum rate of return necessary to pay normal retirement benefits at or above the pre-retirement earnings replacement ratio target,
  2. Longevity risk:  risk of plan participants achieving an actual life span greater than the actuarial mortality assumption applied to estimate the length of the benefit payout period,
  3. Regulatory risk: the plan sponsor’s risk of failing to maintain the plan’s compliance with prevailing legal requirements,
  4. Operating risk:  the plan sponsor’s risk of failing to administer the plan in accordance with its terms,
  5. Maturity risk: the plan sponsor’s risk in a defined benefit plan that the accrued liabilities associated with retired lives rises significantly above the active lives
  6. Financial risk:  the plan sponsor’s risk of failing to satisfy the plan’s statutory minimum funding requirements,
  7. Accounting risk:  the plan sponsor’s risk of absorbing a charge to earnings on its GAAP financial statements,
  8. Plan success risk:  risk of failing to provide an ultimate pension benefit that achieves the plan sponsor’s replacement ratio target when all other risks are avoided.  The participants are exposed to the risk of loss of retirement income insecurity, while the employer is exposed to risk of failing to achieve its workforce incentive and retention goals, thereby, increasing the company’s marginal cost of turnover, training and recruitment, with negative effects on productivity, and
  9. Insolvency/transaction risk:  a participant’s risk of the loss of accrued or future pension benefits due to the plan sponsor’s failure to continue as a profitable business enterprise or its decision to sell the business to another party as a result of which the employee loses employment or the new owner discontinues the plan in one form or another.

In its 2004 whitepaper, “Enterprise Risk Management – Integrated Framework,” the Committee of Sponsoring Organizations of the Treadway Commission (“COSO”) identifies a company’s range or risk responses to include:  avoiding, accepting, reducing or sharing.  After a particular risk has been assessed a company following the Framework would determine its preferred risk responses in alignment with the company’s overall risk tolerance and appetite, bearing in mind that these pension risks are interrelated.  The company must “game out” the interplay between each risk in determining its response.  As we discuss below, any risk the plan sponsor accepts tends to be increased by the steps it takes to avoid, reduce or share the other risks.  For lack of a better term, we can call this ”squeezing the pension risk balloon.”

THE DEFINED BENEFIT PLAN MODELOF RISK ALLOCATION

Preliminarily, a defined benefit plan sponsor accepted the first seven risk categories, while sharing the eighth with the participants.  This was seldom questioned because this risk posture fell in line with the funding of other employer-provided benefit plans, it was simple to track the plan’s success and the plan benefit was conceptually straightforward and easy to communicate to participants.  Furthermore, the participants, to a large extent, avoided the insolvency risk by shifting it to the Pension Benefit Guaranty Corporation (“PBGC”) by statute.  Such a risk posture can be summarized as follows:


Defined Benefit Plan

Owner of Risk

Plan Sponsor

Participants

PBGC

1 Investment Risk

X

2 Longevity Risk

X

3 Regulatory Risk

X

4 Operating Risk

X

5 Maturity Risk

X

6 Financial Risk

X

7 Accounting Risk

X

8 Plan Success Risk

X

X

9 Insolvency/Transaction Risk

X

X

 

Back then insurance companies heavily promoted defined benefit plans because this created a huge de-risking marketplace, where plan sponsors could be persuaded to shift the investment and longevity risks to the insurance company in the form of annuity purchases.   In its earliest formulation, defined benefit plan de-risking was accomplished through a Group Deferred Annuity contract, under which the plan sponsor automatically purchased the annual benefit accrual for each participant in the form of a paid-up deferred annuity based on annuity purchase rates guaranteed in the contract.  For the vintage defined benefit plan, such a mechanical system of funding benefit liabilities not only avoided both the pre and post-retirement investment and longevity risks by transferring them to the insurance carrier, it transferred the entire benefit obligation as well, which effectively transferred the plan’s benefit liabilities for active lives.  Use of a Group Deferred Annuity contract also had the effect of reducing, or at least stabilizing, the regulatory and operating risks.   As long as the plan sponsor kept writing those checks to the insurance carrier each year, there wasn’t much that could go wrong.  This new risk posture resembled the following:


Defined Benefit Plan
(Group Deferred Annuity)

Owner of Risk

Plan Sponsor

Participants

PBGC

Insurer

1 Investment Risk

X

2 Longevity Risk

X

3 Regulatory Risk

X (reduced)

4 Operating Risk

X (reduced)

5 Maturity Risk

X (reduced)

6 Financial Risk

X (increased)

7 Accounting Risk

X (increased)

8 Plan Success Risk

X

X

9 Insolvency/Transaction Risk

X

X

 

Eventually the market realized that a Group Deferred Annuity contract is laden with high contract charges, expense loads and other costs that increased the plan sponsor’s statutory funding obligations compared to approaches that didn’t entirely transfer these risks and, therefore, this approach increased the financial and accounting risks.  The market’s tolerance for risk was evolving and the insurance companies started offering group contracts to satisfy a growing range of risk appetites:  Deposit Administration, Direct Rated Deposit Administration, Investment Performance Guaranteed and Group Investment Contracts (“GICs”) each had its heyday.  As the plan sponsor market gravitated to retaining ownership of these risks as the optimal pension risk posture, the popularity of group investment funding vehicles increasingly narrowed the level of risk transfer, with the GIC effectively providing no risk transfer.

401(k) PLANS:  DEATH OF THE “REPLACEMENT RATIO” OBJECTIVE

The forerunner of 401(k) plans, known simply as a salary reduction arrangement, was designed to supplement the monthly pensions provided by a plan sponsor’s defined benefit plan “mothership,” giving employees the opportunity to set aside additional funds for retirement.  In the 1980s, insurance companies and mutual fund companies observed the underlying appeal of these plans during a period of rapid increase in new business formation and successfully lobbied Congress to codify the tax-quailed status of these plans.

To gin up sales, these organizations also marketed 401(k) plan strategies to defined benefit plan sponsors as a de-risking transaction in which the defined benefit plan was frozen or terminated and replaced with a 401(k) plan tricked out with an employer profit-sharing contribution.  This, it was argued, would not only allow the company to eliminate its financial and accounting risks (because 401(k) plans are not subject to statutory funding requirements or a mandatory charge to earnings for GAAP financial statement purposes), it also “shifted” the investment and longevity risks to the participants for “free.”   The defined benefit plan replacement risk posture looks like this:


401(k) Plan
(Replacing DB Plan)

Owner of Risk

Plan Sponsor

Participants

PBGC

1 Investment Risk

X

2 Longevity Risk

X

3 Regulatory Risk

X (increased)

4 Operating Risk

X (increased)

5 Maturity Risk
6 Financial Risk
7 Accounting Risk
8 Plan Success Risk

X (increased)

X (increased)

9 Insolvency/Transaction Risk

X (increased)

 

While, on its face, the 401(k) plan replacement strategy appears to offer attractive risk shifting features, one might well ask:  if the “investment risk,” for example, is not acceptable to the plan sponsor, who is in a far better position to control it, why should it be acceptable to participants?  For that matter, in what sense does a 401(k) plan actually “shift” this risk?  It’s far from clear that a plan sponsor’s employees, who are obviously an indispensable component of the plan sponsor, can play the role of a third party transferee.  The maturity, financial and accounting risks are eliminated.  However, the principal thrust of the strategy is not shifting investment risk per se, but avoiding this trio of other risks at the cost of purging the plan of the “replacement ratio” objective.  Untethered from this fundamental objective, a 401(k) plan’s success risk becomes inherently unstable, attenuating the plan’s incentive and retentive influences on the workforce and rendering it far less effective in controlling the plan sponsor’s marginal costs of turnover, training and recruitment. 

From a compliance standpoint, 401(k) plans have a lot more moving parts than a defined benefit plan, which significantly increases the plan sponsor’s regulatory and operating risks.  One facet of the heightened regulatory risk is the risk of sustaining indemnified fiduciary losses, especially due to excessive fees.  A considerable history has developed implementing this strategy.  It turns out that participants, when they own the investment risk, chafe at paying unnecessary fees as much as defined benefit plan sponsors did when the expense-laden Group Deferred Annuity contract was losing favor. While participants lack the means to directly change this, they have shown little hesitation to bring what pressure they can to bear in the forms of fiduciary breach lawsuits and complaints to government regulators.

THE ADUSTABLE PENSION PLAN

A hybrid defined benefit/defined contribution plan, called the Adjustable Pension Plan (the “APP”), is gaining some traction and could change the calculus of a 401(k) plan replacement strategy.  The APP was first developed by the actuarial consulting firm, Cheiron Inc. The idea is to merge some of the best features of a traditional defined benefit plan with features of a noncontributory defined contribution plan to get a hybrid that provides employees with a minimum or “floor” guaranteed lifetime monthly pension.   In an APP the employer and the employees share the investment risk so neither side shoulders all of it.

A participant in an APP receives the greater of: (1) the Floor Benefit or (2) the Adjustable Benefit.  All employer contributions are pooled and managed professionally so there are no individual accounts.  The Adjustable Benefit depends on actual investment performance.  The employer bears the risk that actual investment performance is below the assumed “Floor Rate.”  If the actual rate of return is below the “Floor Rate,” the Adjustable Benefit reduces.  Conversely, if the actual rate of return is above the “Floor Rate,” the benefit increases.   But, if the Adjustable Benefit falls below the Floor Benefit, the participant would be entitled to receive the Floor Benefit.

Those employers able to forecast a predictable flow of discretionary profit sharing or matching contributions to its 401(k) plan, would do well to reconsider its pension risk posture and determine if an APP, with at least some semblance of a “replacement ratio” objective, is in better alignment with its global risk management than its current 401(k) plan.

CONCLUSION

It is important to stress that there is no “right” or “wrong” pension risk posture.  Employers appear to be as interested as ever in helping employees address their need for post-retirement income.  Their principal constraints are financial ability and risk tolerance.  For many companies, particularly thinly capitalized entities, early stage ventures and start-ups, if any retirement program is affordable, it’s going to be a 401(k) Plan.  For those companies, risk assessment is a straightforward affair.  Yet, for a large swath of mature companies who dumped their defined benefit plans years ago and replaced them with 401(k) plans, they would do well to review whether, in retrospect, the pension risks they accepted align with its appetite and tolerance for risk on an enterprise level.  Gaming out the allocation of pension risks is a healthy “settlor” function of risk assessment.  While this is inevitably an exercise in squeezing the risk balloon, it’s better that management use a firm hand to align the balloon’s proportions with its global risk portfolio, than allow them to fall prey to agendas arising within a retirement plan information silo.