Solving the pensions puzzle

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A host of market and structural problems are plaguing US corporate pension plans. Derivatives dealers are pitching a number of potential solutions.

The private pensions industry in the US is under tremendous strain. Record low interest rates and depressed equity values have undermined defined benefit (DB) plan surpluses and put many fund managers – and the corporate finance directors who have to make up plan shortfalls – in a bind.

Meanwhile, the so-called non-qualified pension schemes (those not guaranteed by the government), which proliferated during the bull market, now seem precarious in light of the subsequent decline in corporate credit quality. A company’s bankruptcy can wipe out its non-qualified pension scheme.

Analysts expect pension problems will cause significant dents in corporate profits in the next couple of years, and companies’ desire to avoid this is creating an opportunity for derivatives dealers peddling solutions.

Major dealers such as JP Morgan Chase, Citigroup, Deutsche Bank and Bank of America (BofA) believe they can use their extensive derivatives, risk management and asset/liability expertise, combined in some cases with their balance sheets, to provide holistic solutions to these problems. But many dealers have yet to pull all the complex strands – derivatives expertise and knowledge of pension regulations and accounting – together, let alone convince pension funds that such services will actually work.

Most investment banks are offering relatively basic derivatives strategies such as equity collars and interest rate swap overlays to protect DB fund surpluses that are now coming under pressure. If pensions begin to go from over- to under-funded, it will place a significant strain on corporate earnings soon. The accounting and taxation research team at US investment bank Bear Stearns believes many corporations will need to start adding money to cover pensions liabilities within a year. A report by the firm released late last year says DB pension assets declined in 2000 for 175 of the 350 companies in the S&P 500 that disclose pension data. In 1999, only 34 companies experienced a decline. The true impact of these falls has yet to be reflected in earnings statements, because a US accounting standard, FAS 87, creates ‘smoothing’ mechanisms that soften the effects of volatile stock markets on pension funding positions.

Soaring costs
Bear Stearns estimates – assuming an average pension portfolio being split 60:40 between equities and bonds – that DuPont’s DB plan, which booked $469 million in pension income in 2000, or 10% of the company’s operating profit, will cost it $136 million in 2003. General Motors’ pension costs could soar from $346 million in 2000 to $2 billion in 2003, while the corresponding figures for Ford would be $177 million and $1.15 billion. The situation is exacerbated at some companies that managed to strip out the over-funded part of their plans during the long 1990s bull run, typically selling it into a special-purpose vehicle (SPV) that was then sold to companies with under-funded positions.

Dealers’ solutions to hedge against surplus declines include the usual array of equity and interest rate overlays. JP Morgan Chase, for example, offers equity puts, which limit downside risk while retaining upside potential but have a high upfront premium; collars, which limit the return on these underlying within a price band but can be more cost-effective than a put and are the most common option strategy used by plans; put spreads, which allow limited corrections with a lower up-front premium than a put; put-spread collars, which provide pensions with protection against limited corrections with no upfront premium; and call overwriting, aimed at enhancing returns in down or stagnant markets – usually through the sale of an out-of-the-money call. “More challenging equity markets are compelling pension plans to place more attention on risk management where basic derivatives applications are useful,” says Nick Kello, a managing director in the bank’s equities group.

Deutsche, meanwhile, is offering plan protection on the liability side, according to Maarten Nederlof, managing director and global head of pension strategies at Deutsche Asset Management. With the recent interest rate declines, pension liabilities have grown at the same time as a fall in asset values due to poor equity market performance. This has resulted in the risk of further contributions to plans by their sponsors. Plans can use interest rate swaps and swaptions in overlay strategies to adjust the interest rate risk of their liability structure to alleviate this problem. “The primary benefit is to close the duration mismatch between assets and liabilities,” says Nederlof.

But as with some of the asset-side equity hedging solutions, such as collars, Nederlof cautions that the timing of such activity is crucial. Otherwise the companies fail to benefit from any upswing in either interest rates or equity values.

Executive benefit plans
Bank of America, meanwhile, is attempting to fix some asset/liability issues in the burgeoning non-qualified executive benefit plan area – typically pay-as-you-go schemes that do not qualify under the Employee Retirement Income Security Act of 1974 (Erisa), a federal law that sets minimum standards for pension plans in private industry. Such non-qualified plans had accrued liabilities of $12.6 billion at 140 major US corporates last year, according to a survey due for release next month by actuarial firm Watson Wyatt.

BofA has teamed up with another actuarial firm, Winklevoss – based in Greenwich, Connecticut – and an unspecified benefit plan consultant, to help corporates convert unqualified plans to qualified DB plans through arbitraging techniques. This approach makes both the corporation and employee better off from a risk, taxation and return perspective. “Our solutions draw on credit derivatives technology, investment/commercial banking relationships, funding ability and pulling all these things into one place,” says Dik Blewitt, a managing director for structured credit products at BofA in New York.

Most Fortune 500 companies have non-qualified executive benefit plans for high-income employees that want to set aside more retirement money than permitted under general qualified pension rules. Many mid-ranking executives have also joined such schemes, now geared towards employees that earn more than $200,000 a year.

Corporates view these programmes as essential for retaining key talent, with some – probably incorrectly – viewing them as a cheap source of funding (they receive money today that they can use to invest in plants and equipment, then pay back at a future date). Employees like the schemes, as they can typically defer tax on income until they retire. Such schemes must remain pay-as-you-go, or ‘unfunded’, to meet the goal of employee tax deferral, says Robin Credico, head of Watson Wyatt’s defined contribution practice in Washington. This means all the assets used to fund the non-qualified benefits must remain assets of the employer, and are subject to claims by the employer’s general creditors.

So, there is a possibility that an employee would never receive amounts deferred under a non-qualified plan due to changes in corporate control or corporate bankruptcy, as happened with Enron. This is unlike qualified DB plans, where funds are secured in trusts protected from both a corporate or employee’s creditors and protected through the federally chartered Pension Benefit Guaranty Corporation in the event of corporate failure.

“As more and more money gets deferred, employees may get worried that the corporation might not be around in the longer term – especially in light of a number of high-profile corporate bankruptcies. So securitising and segregating assets, funding those liabilities, and insuring them against bankruptcy are becoming much more of an issue for corporations,” says Blewitt. Heidi Toppel, senior consultant for excess compensation and benefits consulting at Watson Wyatt, agrees: “The reason it is such a hot topic right now is that executives are beginning to be concerned about unfunded executive benefits. A lot of organisations are looking at it.”

Traditionally, some of this risk can be hedged out using credit default swaps protection on the sponsoring company with SPVs set up to shield payouts to other creditors. Straight protection over 10 years for an AAA to A-rated corporation would be Libor plus 40–250 basis points, rolled over the duration of the scheme. Since the ability to pay could be linked to falling equity markets, some firms might opt for exotic equity-linked options based on a certain percentage fall in stock price. There are many permutations of such arrangements based on corporate risk/return preferences.

But derivatives protection does not eradicate tax issues that may make a non-qualified plan more expensive than a company realised. The Internal Revenue Service (IRS) takes 35 cents from a corporation for every dollar an employee puts into a non-qualified plan. When the employee retires, the company receives a tax rebate on the amount it paid, but no interest. “This timing horizon differential costs it at least 200bp running over 10 years on the notional of that position, using the 10-year swap rate as a discount,” claims Blewitt. The situation is compounded if the crediting rate to employees is higher than the rate a company can borrow at, which is typically the case. Blewitt estimates this can add hundreds of additional basis points. Crucially, BofA believes it can convert between 30% and 60% of non-qualified pensions into qualified DB plans, which eliminate tax and corporate default concerns. “This figure is driven by the nature of the employees: how long they have been working at the employer, how old they are, and actuarial assumptions on how long they will live, driven by how much they already have in their DB plan. It also hinges on rules regarding discrimination testing for participants in a qualified plan,” says Blewitt.

Under DB plans, discriminatory cross-testing is required by the IRS to ensure all employees are setting aside similar amounts. The trick is to take advantage of recent changes in tax legislation, namely the increase in applicable salary caps from $170,000 to $200,000 in January, and the acceptance of a broader view on how much an employee will receive from a variety of sources in retirement. These include defined contribution, DB and life insurance schemes.

While Blewitt declines to provide more specific details on the conversion process, he adds: “What it comes down to is that corporations historically have not utilised anywhere near the legal capacity that is allowed to them under a DB plan.” Watson Wyatt says the BofA scheme sounds very similar to products called QSerps, already in existence for a number of years. But senior actuarial consultant Alan Glickstein challenges BofA’s 30%–60% conversion figure: “It’s relatively unlikely that you will have a clear shot at moving a very large percentage of most organisations’ non-qualified liabilities into the qualified plan.” He adds, however, that this does not diminish the value of conversion “as part of a quiver of tools for a plan redesign and funding”.

So far, only about 20 law firms have implemented such procedures, according to Blewitt. “Law firms are eager to find some way to currently fund executives’ pensions. I think it is culturally somewhat of a sour taste for them to pay out a pension to a retired attorney who is no longer actively bringing work into the firm,” comments Wyatt’s Toppel.

BofA, along with a number of financial institutions, also offers corporate-owned life insurance (Coli) or bank-owned life insurance (Boli) solutions, apparently developed by JP Morgan. This allows a corporate to fund a non-qualified plan, but from an accounting perspective it is not funded. By purchasing a life policy, the company sees the life insurance grow in value, but this growth does not produce a tax liability. But there are risks for both the employee and the corporation, as there is no guarantee that the insurance company will still be in existence in 20 years.

“The key advantage of DB is that the company puts money away in a trust that is completely invulnerable from its creditors and the employee’s creditor. And the company gets a tax deduction for that. From the employee’s perspective it is real, tangible funding,” says Wyatt’s Toppel.

BofA’s holistic approach should bring in more business from pensions looking to refine the assets that could be purchased with the newly qualified money. “Pension plan managers are still looking to earn ‘equity-esque’ returns via alternative investments. CDO equity and debt-based structured credit products provide an attractive alternative to private equity. Based on the current point in the economic cycle, and innovations in managing credit risk, I firmly believe structured credit plays are poised to outperform for the next three to five years, minimum,” says Blewitt. Alternative asset investment is an area most of the other major investment banks are also seeking to exploit. But Jon Lukomnik, a senior consultant at Capital Market Risk Advisors – and former deputy comptroller of the $90 billion City of New York pension plan – says pensions are more interested in investing in real estate, private equity and hedge funds, rather than structured credit products. “There is still a feeling that derivatives can blow you up,” says Lukomnik. Deutsche’s Nederlof echoes this sentiment, saying: “A lot of education is still needed in this area.”

Although Blewitt claims conversion to qualified plans is possible at most institutions, he describes the process as a “home run” when corporates have overfunded qualified DB plans. However, finding such over-funded pensions is likely to prove a hard task during the next few years.

Types of non-qualified deferred compensation plans in the US
  • Defined benefit excess benefit plan. Restores the annual pension benefit to what the formula in the qualified defined benefit plan provides – without regard to the limit (which is $160,000 in 2002).
  • Supplemental executive retirement plan (SERP). Restores the annual pension benefit from all employer-paid sources to what the formula in the qualified defined benefit plan provides – without regard to the annual benefit limit and the maximum compensation permitted for use in the formula (which was raised to $200,000 in 2002 from $170,000 in 2001).
  • Target benefit SERP. Targets a particular level of total retirement income, expressed as a percentage of pre-retirement pay, from all employer-paid sources (including the SERP) at a particular retirement age.
  • Other SERP with alternative benefit formula. Produces a level of retirement income from all employer-paid sources, based on the factors in a new defined benefit formula, such as age, service, credit for prior service in the industry and compensation (as defined specifically for this plan), which is more generous than the formula in the qualified defined benefit plan.
  • Other SERP with alternative accrual pattern. Produces a level of retirement income from all employer-paid sources, based on a more generous annual accrual rate, say 2.5% or more per year of service, than the accrual rate used in the qualified defined benefit plan.
  • Other SERP with some alternative feature. SERP with a twist on something, for example, different early retirement features from those in the qualified defined benefit plan.
  • Voluntary deferral plan. An election by the participant not to receive base salary or bonuses that will be earned in the future. Election defers the date of receipt to some time in the future, such as a specified date or termination of employment. During that time, the deferral is credited with interest based on some predetermined rate or index.
Source: Watson Wyatt 

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