Can the U.S. Supreme Court Save the American Dream?
A pending Supreme Court case shines a light on the rush by U.S. companies to transfer their pension obligations to insurers, leaving workers’ security hanging in the balance.
Jack Cohen, chairman of a group representing 230,000 retirees who once worked for companies that emerged from the 1984 breakup of Ma Bell, doesn’t want to be de-risked.
In a recent interview Cohen quoted a line from an Institutional Investor story on the post-2008 transformation of Wall Street and how new regulations had succeeded only in pushing risky lending out of banks and into the hands of asset managers. “Risk taking cannot be destroyed, it can only be transferred from one spot to another,” Cohen said with a gravelly laugh. He frames much of the conversation about the Association of BellTel Retirees’ lawsuit to stop corporations from transferring their pension responsibilities around this point: Companies such as his former employer Verizon Communications like to talk about eliminating their pension liabilities and may be able to financially engineer deals — known in industry parlance as pension risk transfers — to remove some of the threats that their promises to retirees pose to their current earnings, but the “de” in “de-risking” is a lie. Instead, he says, Verizon, Ford Motor Co., General Motors Co., J.C. Penney Co. and all the other companies that have done these transactions have just shifted the risk to pensioners themselves. “Pensions are a vanishing breed,” bemoans Cohen, 73, who began his 26-year career with Verizon in 1968 with a sales job at what was then called New York Telephone Co.
Pension risk transfers allow corporations to either move their defined benefit liabilities to an insurance company — along with sufficient assets to back those promises — or directly provide employees with a lump sum of cash that represents what they earned during their tenure. If corporations and insurance companies have come up with dry jargon to describe their efforts to get out from under pensions, it is Cohen who puts the process in more-colorful terms. “Corporations want to get rid of their legacy costs,” he says. “They call them an albatross on their neck, but I call them earned benefits.”
Cohen’s group, the Association of BellTel Retirees, is behind a petition for a writ of certiorari, better known as a cert petition, that urges the U.S. Supreme Court to review its case against Verizon alleging that the company violated the Employee Retirement Income Security Act. The case grew out of a deal that Verizon struck in 2012 to buy a group annuity from Prudential Financial and spin off the liabilities of 41,000 retirees to the insurer. In Pundt v. Verizon Communications Inc., the plaintiffs — pensioners who were left behind in Verizon’s plan after the annuity purchase — claim that a series of conflicting decisions by lower circuit courts on companies’ responsibilities under federal pension law undermine ERISA as a national standard. The plaintiffs want the Supreme Court to give the Verizon retirees “standing” — the right to sue — even though their benefits have not yet been hurt. Waiting for proof of harm, which a lower court said it needed to do, will be too late, they argue. Cohen hopes to stop companies from cutting their ties to retirees in the future.
The case is an important one as U.S. companies increasingly look to get rid of some or all of the risks associated with the expensive retirement promises they’ve made to employees since World War II. Although under ERISA employers have always been able to buy annuities from insurers to cover their retirees’ benefits or to offer lump sums, regulatory changes and longer life spans have pushed companies in recent years to think hard about pension risk. More than 500 companies did risk transfer deals between 2007 and 2013. The market is rewarding the transactions by boosting the share prices of companies that do them, and big insurance companies, including Prudential Insurance Co. of America, owned by Prudential Financial, and MetLife, are eager to take on these obligations, which offer both a rich source of new business and a hedge to the mortality risk embedded in their life insurance policies.
Now retirees and their advocates are raising questions about the potential risk to their benefits in these deals and about the expanded financial services role that insurance companies are taking as populations in both rich countries and the developing world reach retirement age at an unprecedented rate.
The corporate pension has been pronounced dead multiple times during the past few decades, but everybody is still picking at the carcass. The asset management industry, whose growth was initially fueled by the trillions of dollars held in defined benefit pension funds, sees opportunity in helping companies build portfolios that may ultimately appeal to insurance companies. Insurers view the business as fertile ground that requires their core expertise of hedging liabilities, and reinsurers are innovating in areas like longevity risk — the possibility that pensioners will essentially live too long.
The U.S. government also has a stake in the outcome. Although risk transfer deals reduce the Pension Benefit Guaranty Corp.’s potential exposure, they could weaken the agency — which was established more than 40 years ago to insure corporate pensions — because the healthiest plans are moved out and it loses premiums. Nonetheless, the government is cautious, not wanting to weaken pensions and increase older Americans’ dependence on Social Security and other safety nets. Already, federal, state and local pensions face a $7 trillion shortfall, about 40 percent of U.S. GDP last year.
Pension risk transfer deals change the landscape for everyone: corporations, insurance companies, asset managers, the government and retirees. They distribute pension risks from specific companies to insurers and reinsurers. Advocates for pensioners contend that individuals are also taking on some of these risks. When pensions are replaced by annuities, they are removed from federal oversight and guarantees under the PBGC. Instead, pensioners are subject to insurance regulations and the strength of guaranty associations that vary from state to state; in some states retirement income is vulnerable for the first time to creditors. Others argue that retirees are wasting valuable energy worrying about annuities when lump-sum distributions — also a pension risk transfer strategy — are the bigger threat. In fact, because of quirks in regulations, companies are encouraged to offer one-time lump sums, which require employees to manage the risks of outliving their savings.
W. Thomas Reeder Jr. agrees that pension risk transfers reorder the defined benefit world. As director of the PBGC, he worries that companies may be transferring lower-risk liabilities to insurers while higher risks are kept in plans that continue to be covered by the agency. The PBGC has started analyzing the transactions, but it doesn’t yet have enough data to draw any firm conclusions. “Companies are trying to shrink the size of their liabilities,” says Reeder, who worked as benefits tax counsel in the Office of Tax Policy at the U.S. Treasury Department before joining the PBGC last October. “We’re concerned about the effect on our rate base and on retirement security.”
Although the PBGC’s soundness has been questioned over the years — the agency relies on fees, its investments and assets from pension plans that it takes over as trustee, and it is not backed by the full faith of the U.S. government — pensioners worry more about the health of insurance companies. They aren’t alone: Last year the International Monetary Fund said in a report that the transfer of pension risks to the insurance industry could itself pose a risk as financial institutions become more interconnected. The IMF contended that “too big to fail” insurance companies are imperiling workers’ pensions and may need to be better regulated.
In April — the same month that the Communications Workers of America union went on strike against Verizon — the IMF again warned about the systemic risks posed by large insurers. The most recent caution came just days after MetLife, one of the largest insurance companies active in pension transactions, successfully fought its designation by the U.S. government as a systemically important financial institution, which would have required it to hold more capital and submit to more oversight.
Clearly, insurance companies are playing a much larger role in financial services in the U.S. than ever before. Since the 1970s asset managers have profited from investing baby boomers’ retirement savings, but now this generation of 60-somethings is turning away from fund managers who know how to invest assets and to insurers for retirement income — either directly through defined contribution plans and annuities or indirectly through defined benefit plans.
Still, a strong case can be made that the deals help companies reduce the risk of their pension obligations. A company like Ford is probably better at manufacturing cars than managing longevity risk. Risk transfers can position companies to compete with younger businesses (like Tesla Motors, in this case) whose workers are covered by defined contribution plans in which employees shoulder the risk of creating nest eggs. Arguably, retirees also want healthier corporations that are better positioned to make good on obligations to pensioners that remain even after annuity and lump-sum deals.
When corporate vice president and treasurer Robert O’Keef was leading an effort to evaluate the viability of a pension risk transfer for Motorola Solutions, the Schaumburg, Illinois–based company had $11 billion in global retirement liabilities for 95,000 participants. Created in January 2011 after Motorola spun off its mobile phone business to focus solely on public safety and government communications, Motorola Solutions has just $6 billion in annual revenue and 15,000 employees. Relative to the size of the company, “we had one of the largest pension obligations of any company in the U.S., whatever yardstick you used — revenue, market cap or employee base,” O’Keef says. In 2014, Motorola transferred $3.1 billion in U.S. liabilities for 31,000 retirees.
The Pension Protection Act of 2006 pushed companies like Motorola and Verizon to come clean about their obligations and spurred the current risk transfer movement. Though some retirement advocates call it the Pension Destruction Act, the PPA was designed to safeguard beneficiaries by requiring companies to report shortfalls on their balance sheets. “The risk that companies have always had on their balance sheets has become more real as the result of regulations,” explains Scott Hawkins, who heads insurance research and consulting at Conning & Co., a $103 billion, Hartford, Connecticut–based insurance asset manager.
Like most legislation, the PPA had unintended consequences. Companies started redesigning their portfolios to mitigate risk and prevent volatility in their earnings, freezing existing plans to new participants and starting discussions about transferring liabilities to insurers — organizations whose raison d’être is to handle risks that could occur far in the future. The PBGC’s Reeder emphasizes that these transactions are designed to shore up company finances. “If everybody has smaller plans on their books, we hope they can manage them better,” he says.
Pension risk transfer deals are a function of both record-low interest rates and people living longer. Given these two trends, companies have had to face painfully high liabilities. By keeping rates low since the financial crisis, global central banks have punished anyone trying to save for the future. Not surprisingly, pension consulting firm Milliman says the funded status of the 100 largest corporate defined benefit plans dropped by $83 billion during the first quarter of 2016. Companies have just 78 percent of the amount of money they need to make good on their commitments. “Low interest rates have been challenging for the most experienced CIOs,” says Michael Moran, pension strategist at Goldman Sachs Asset Management (GSAM). “Companies have pension fatigue.”
Gary Veerman, a BlackRock Solutions managing director who oversees investments such as liability-driven investment strategies for corporate pension clients, says, “If companies don’t buy annuities or offer lump sums, they are, in essence, self-insuring — locking down the risks of their own plans.”
Pension risk transfer is fairly new to the U.S., even though Prudential did its first such buyout in 1928 with the Cleveland Public Library. The recent trend started in the U.K. after government pension reforms there. Between 2007 and June 2015, U.K. companies transferred $180 billion to insurance companies, according to Prudential. The U.S. saw only $67 billion in transactions during the same time period.
Retirees who earned benefits by working for decades for the same employer, like BellTel’s Cohen, are lamenting their pensions being off-loaded to third-party insurance companies. The moves are part of a larger conversation in the U.S. and around the world about the role of government, taxpayers, the private sector and individuals in retirement planning — and who takes on the long-dated risk. Longer lives and an aging population have combined to make pension math almost impossible. No matter the politics, some think insurance companies may be able to take on some of the risk that the PBGC and other federal agencies cannot.
The current system of pension protection has its roots in the 1963 bankruptcy of Studebaker. The carmaker fired 4,000 workers at its manufacturing plant in South Bend, Indiana, and terminated its pension plan. With no national safety net or pension law in place, workers found they had little recourse. Concerned about the new threat to pensions, then–New York senator Jacob Javits championed legislation in 1967 to safeguard retirement benefits and establish a federal insurance program for workers who fell victim to their employers’ troubles. In 1974, Congress passed ERISA to prevent funds from being mismanaged; the law sets minimum standards for pension plans and gives participants the right to sue if their benefits are compromised or plans breach their fiduciary duty.
As part of ERISA, Congress established the PBGC as the pension provider of last resort. In the four decades since the agency’s creation, the U.S. economy has undergone profound changes that have decimated companies once thought impervious. The PBGC now pays 800,000 retirees each month, and 585,000 more will receive benefits from the agency when they stop working.
In 2006, Congress passed the PPA, which was designed to strengthen plans and protect the PBGC, then facing a shortfall. The combination of PPA and new accounting standards required companies to make contributions to troubled plans and to recognize funding gaps, a move that alerted investors to pension plan risk. Two years later companies’ defined benefit portfolios were hit by the financial crisis and plummeting markets. Funding levels at the 100 largest plans dropped by 30 percent, setting the stage for big changes.
Risk transfers have always been allowed under ERISA. Although Prudential this year celebrates the 88th anniversary of its deal with the Cleveland Public Library — with four pensioners still receiving checks from the insurance company — pension risk transfers went largely unnoticed in the U.S. until some megadeals in 2012.
Two of the deals were in the long-troubled auto industry. Both GM and Ford struggled in the years leading up to the financial crisis, in part because of expensive pensions. GM went into bankruptcy in March 2009 and emerged a few months later after a government-backed company hived off the most-profitable assets. Though Ford made it through the downturn without government help, both car companies needed to reduce the risk of their pensions.
Ford offered a lump sum to 90,000 former salaried employees in the U.S. Although it had been common for companies to offer lump sums to vested employees who no longer worked for the company, Ford’s offer was the first made to retirees. After Ford contributed $3.4 billion to the plan, the lump-sum offer settled about $18 billion of the company’s $49 billion in U.S. pension liabilities. That same year GM transferred $25.1 billion in liabilities to Prudential by buying a group annuity for 110,000 former salaried employees — the biggest deal of its kind in U.S. history. The company also offered 44,000 of its 118,000 white-collar employees lump sums. Those who declined were added to the group annuity. GM paid Prudential a premium of about $3 billion for the transaction. It’s easy to see the value of the deal to GM, which at the time had $134 billion in global pension obligations.
To cap off 2012, Verizon announced that October that it was buying a group annuity from Prudential representing $7.5 billion for more than 40,000 employees and would make a $2.5 billion contribution to its pension plan. The $7.5 billion equaled roughly a quarter of the company’s then-$30.6 billion in pension liabilities. Verizon’s deal signaled to the market that pension risk transfer deals were attractive even to healthy companies: Unlike GM, Verizon had an A– credit rating.
The 2012 transactions dealt with an all-but-obsolete form of retirement obligation, the defined benefit plan. In recent decades defined contribution plans, which put the onus on employees to save and invest for retirement, have become increasingly popular among workers who change jobs more frequently than the previous generation. Employees have had mixed success with their defined contribution plans, but the plans have been a boon for companies and don’t appear on their balance sheets.
Verizon retirees first rang alarm bells shortly before the company’s pension risk transfer deal was finalized. In November 2012 two retirees filed a lawsuit to block the transaction on the grounds that as annuitants they would be protected by insurance regulations, which they said were inferior to the ERISA safety net for their pension. Verizon said in a statement at the time that insurance protections were on par with ERISA and that Prudential was irrevocably committed to make all payments. Verizon retirees also said the move was not in compliance with ERISA’s standard termination procedures and that the company “intends to de-risk or abandon” its pension responsibilities to enhance its credit rating. A district court in Texas allowed the annuity transaction to go forward.
The retirees followed up with a class action. One group, Verizon retirees who were included in the annuity, claimed that they didn’t get adequate notice and that the fiduciaries should have obtained their consent before the annuity was purchased. The other group in the suit — retirees who were left in Verizon’s plan and whose benefits were not transferred to Prudential — claimed, among other things, that the company breached its fiduciary duty when it paid a $1 billion fee to Prudential out of plan assets rather than Verizon’s revenue.
Though the Verizon suit put lawyers on notice, companies were increasingly accumulating evidence for why they should do risk transfers. In the U.S. budget for fiscal year 2017, there is a proposal to raise PBGC premiums. Designed to shore up the agency’s financial health, the proposed fee hikes appear to be encouraging more deals, which in turn may require more fee increases as company plans leave the system. At $42 a participant, the 2012 Prudential deal saved Verizon $1.7 million a year in PBGC fees. Agency chief Reeder thinks companies are blowing fee hikes out of proportion, but he says the uncertainty around them is a factor in companies’ deciding to do a risk transfer.
Companies have had to deal honestly with longer life expectancies, especially for those typically covered by pensions: unionized workers with access to good health care services. Recently updated mortality tables — actuarial expectations buried deep in the paperwork of most pensions — shocked companies with the amount of money needed to fulfill their vows to provide retirement paychecks until death. As it turned out, companies had been underestimating that number by 5 to 8 percentage points.
Many of the largest risk transfer deals have involved companies that were once stalwarts of American business. Last year department store chain J.C. Penney — hard-hit by the rise of online shopping and a falloff in mall traffic — reduced its liabilities by 25 to 30 percent after it offered lump-sum payments to retirees and purchased a group annuity from Prudential for another part of its retired workforce. Penney’s stock jumped 7 percent the day it announced the deal. After the restructuring the pension plan that remained with the company was overfunded.
Last year an appellate court affirmed the dismissal of the Verizon class action by a lower court. For the group that represented retirees transferred to Prudential, the court determined that, among other things, ERISA does not require consent for annuity purchases and that Verizon did not violate its duty to make sure fees were reasonable. The other plaintiffs in the suit — retirees who were left in Verizon’s plan — were dismissed because they had no proof of harm to their pensions and therefore no standing to sue under ERISA. The PBGC says 1.1 million retirees have been de-risked in the past few years.
No one seems to like pensions except pensioners. Admitting a bit of paranoia, BellTel’s Cohen thinks Congress felt so lucky that the PBGC survived 2008 and the financial crisis that it is now deliberately trying to kill the last corporate defined benefit plans. “If GM weren’t bailed out, there would have been no way PBGC could have covered all those pensions,” he says.
Corporate CEOs and capitalism may be the bad guys in this year’s chaotic presidential election, but many companies — even very profitable ones — are legitimately weighed down by pension obligations. GM was a victim of rich retirement benefits it offered decades before the American car industry found itself competing with foreign automakers.
Like many companies contemplating risk transfers, Motorola grew into a U.S. heavyweight over the course of the 20th century. Founded as Galvin Manufacturing Corp. in 1928, the company later adopted the name of its popular car radio and expanded into two-way radios that became icons in World War II. Motorola, whose radio technology relayed the first words from the moon, reached a peak of 150,000 employees in 2000, after multiple acquisitions. By the middle of that decade, the company was having trouble competing in the mobile phone business and activist investor Carl Icahn had started pressing it to split its complex business in half. Motorola Solutions emerged in January 2011 as one of those two companies.
As Motorola spun off divisions, it retained pension obligations to its former employees — a surprisingly common practice in divestitures. When the company started thinking about a risk transfer, in 2013, its pension plan was about 70 percent funded. “Running a DB plan is essentially about providing annuities to people,” says treasurer O’Keef. “It’s risky and fundamentally a noncore function to everybody but an insurance company.”
The pension liability was a legacy issue: The participants were almost all retirees and terminated employees — people who had vested benefits but were neither retired nor working for the company. “Most of them were part of businesses that had been sold years ago, and didn’t fully identify with the company,” O’Keef says.
Motorola Solutions worked with creditors, rating agencies, financial and legal advisers, and GSAM to make the risk transfer happen. As in many of these transactions, the company employed advisers to ensure it wasn’t making conflicted decisions, such as choosing the cheapest rather than the best annuity. Motorola Solutions issued $1.4 billion in bonds in August 2014 to make a $1 billion pension contribution. It offered a lump sum to terminated vested employees — 20,000 took it — spun off retirees into their own plan and held an auction for the annuity, which Prudential won. The retirees’ plan was then transferred to the insurer.
That left Motorola Solutions with a $4.5 billion U.S. pension liability. “In the old world, retirees were participants in a plan that was 70 percent funded and guaranteed by a sponsor with a triple-B rating,” says O’Keef. “Once it was spun off, these retirees were in a fully funded plan with backing by Prudential, which has a double-A-minus rating.”
As O’Keef describes it, turning a pension into an annuity is a huge change. “It’s an extraordinary act in the pension landscape,” he says.
George (Phil) Waldeck, head of the pension and structured solutions business at Prudential Retirement, doesn’t think it’s so extraordinary. “These are mainstream obligations for us,” he says. “In the life insurance business, people die unexpectedly early; insurance companies pool the risk and provide a solution. In the pension annuity business, we make long-dated obligation payments to people. We take the risk of people living longer than expected, but remember, large groups of retirees — we pool the risk from different companies — are very predictable when it comes to longevity.”
Waldeck built out the pension risk transfer team at Prudential in 2006, when the PPA was passed. A pension geek who watched on C-SPAN as Congress voted on the bill, Waldeck anticipated that the new law would accelerate moves away from defined benefit pensions and that companies would start reducing the risks of their plans by using liability-driven investment strategies, closing and freezing plans, and doing risk transfers. He thought Prudential could help them meet their obligations in a cost-effective way. “How do companies keep the promises they’ve made to people who used to work for them?” he says.
Waldeck points to the experience of U.K. companies, which confronted similar reforms a few years ago, as proof that pension risk transfers are working and that nothing has gone wrong. “The key is that pension liabilities are getting funded up — companies are plugging deficits — and conservatively matched on insurers’ balance sheets,” he says.
Pension risk transfers will have a mixed effect on the health of the PBGC. Theoretically, the agency is laying off part of its risk every time a company transfers a liability to an insurance company. The PBGC is exposed to plan sponsors with an average of 80 cents for every dollar of liability and a portfolio that is about half in equities, with some alternative investments and corporate bonds. Although the risk transfer deals could reduce the agency’s exposure to corporate America’s pension liabilities, that potential benefit is offset by lost revenue when companies no longer pay premiums.
Even with the PBGC’s limitations, including a $60,136 annual cap for a 65-year-old retiree, one of the biggest complaints about annuity deals by pensioners like BellTel’s Cohen is the loss of the agency’s protection.
To assuage retirees’ fears, the National Organization of Life & Health Insurance Guaranty Associations, an insurance group representing all 50 states, published in April the first study to compare ERISA with state protections. In its report NOLHGA, which hired Willis Towers Watson to conduct the review, points out that in contrast to pension plans and their sponsors, insurers are required to hold capital in excess of liabilities; when they do risk transfer deals, they are obligated to take in assets that represent more than the liabilities they are assuming. ERISA does not require pension plans to be fully funded. NOLHGA also found that no annuity provider went bankrupt during or after the financial crisis, but 931 single-employer pension plans failed between 2007 and 2015. Pension risk transfer critics, however, point to the 1991 failure of Executive Life Insurance Co. and the 2008 American International Group debacle as evidence that the industry needs more regulation.
Former PBGC director Joshua Gotbaum, who is now a guest scholar in the economic studies program at the Brookings Institution, believes annuities are a safe option. To him lump-sum payments are the real risk to retirement security. Corporations are offering them in record numbers because annuities are expensive when interest rates are as low as they are now. Companies can provide lump sums at a big discount to the value of the liability, and they don’t have to disclose the discount. In a 2015 PBGC study, almost 400 of the 500-plus risk transfer deals between 2007 and 2013 were lump sums. “It’s not a great time to buy annuities, but thanks to badly done tax and ERISA regulations, it is a great time for a company to do a lump sum,” says Gotbaum.
Robert Rehm, a co-founder of the BellTel association who retired in 1991 after 30 years at NYNEX Corp. and its predecessor companies, says there are many issues he would like to see resolved if the Supreme Court grants the plaintiffs the right to sue Verizon. Among them is the $1 billion fee Verizon paid Prudential for the annuity. Rehm calls it an enticement for the insurer to take the obligations and says it was wrong for Verizon to take it out of the pension plan itself; he thinks it should have come out of corporate operating expenses. “Don’t charge me a billion dollars because you want to shed your pension,” says the Jericho, New York, resident.
Rehm misses Verizon’s published reports on the health of the pension plan, including how much was paid to retirees and spent on administrative costs, and the ability to call someone in Verizon’s human resources department when he has a question. The annuity doesn’t come with any pension increases. Though Verizon hadn’t made any increases for quite some time, the annuity ends any possibility for raises in the future.
For now, the Supreme Court has done nothing with the BellTel retirees’ cert petition. “It hasn’t denied it, hasn’t granted it, hasn’t rescheduled it and hasn’t asked the government’s views,” says Karen Hansdorf, counsel for the petitioner. She says the court may be waiting for a decision on another case — Spokeo Inc. v. Robins, which also involves plaintiffs that haven’t suffered concrete harm.
As corporate pensions continue their slow death, pension risk transfers are the tombstones. Although the current generation of retirees is likely to get its benefits, everyone else is on their own. “De-risking — it’s a confusing word, a convenient word for corporations,” says Rehm. “Companies are stripping away the pension from their own responsibility. It’s good-bye retiree.” •