Look to Annuities to Salve Pension Fears.

It isn't a strategy for every company, but purchasing annuities for the retired portion of a defined-benefit plan's liabilities can help minimize risk and generate additional income.

In this busy world, a well-funded retirement plan may seem to be the least of a company's worries, but the world is not stagnant. Markets turn -- as they have in recent months -- and one day a company may find itself with a retirement plan with large liabilities, a bad balance sheet and substantial funding requirements at the exact time when it least wants to have to turn its attention to the retirement plan.

Consider recent events. Partly due to the run-up in the equity markets in the past few years, the stampede toward terminating defined-benefit plans has significantly lessened. Because of improved funding levels, these plans often no longer require contributions. In the meantime, CFOs are busy managing their companies to respond to the New Economy. However, liabilities in the defined-benefit plans continue to grow, and this growth is creating potentially hidden risks for the company's financial stability.

With proper planning and follow-through, however, a company's defined-benefit plan may provide a substantial opportunity to improve its bottom line. This opportunity arises by taking advantage of an old game -- purchasing annuities for the retired portion of the plan's liability. The settlement of liabilities under FASB Statement No. 88 can generate income by accelerating the recognition of accumulated gains that have built up on the balance sheet. At the same time, the plan's liabilities and assets decrease, lowering the risk to the plan from decreasing settlement rates and weaker investment returns. As an added benefit, when annuities are purchased, the insurer assumes responsibility for keeping tabs on the company's retirees, eliminating a substantial administrative headache for a benefits department.

The bull market of the 1990s was unprecedented. Year after year, well-invested pension plans earned double-digit returns, outstripping even the most aggressive actuarial assumptions. Through the '90s, the average annual return on a typical asset allocation (60 percent equity and 40 percent fixed-income) was about 15 percent. Offsetting these excess asset returns was the fact that through the middle or latter part of the '90s, liabilities continued to increase as interest rates dropped. Until very recently, however, interest rates had moved back up, helping many plans reach unprecedented funding levels

Still, many companies have seen accrued pension liabilities grow on their financial statements. Because of the differences between the recognition of liabilities under FASB statement No. 87 and the limitations on contributions under the Employee Retirement Income Security Act (ERISA), companies have been booking annual expenses for their pension plan, but have not been required to make cash contributions. So even though plans' funded positions have been improving, the bottom-line liability on the corporate balance sheet has been growing. Some companies have been booking pension income in recent years, but even for these companies the asset shown on the corporate balance sheet is likely to be less than the true reflection of the plan's funded status.

As a result of these events:

1. Balance sheets are misleading. Accrued pension liabilities on the books affect the company's net worth. The accrued liability has grown because the Financial Accounting Standards Board (FASB) requires companies to annually book expenses for their pension plans that exceed the amount that the IRS permits as a contribution to the pension trust. These liabilities represent an obligation for future contributions that are presumed to be necessary. However, this liability is often mythical, since many plans' funding levels are at a point where contributions will not be made for the foreseeable future.

2. Pension Benefit Obligations Continue to Increase. Pension obligations grew, often substantially, during the 1990s as a natural result of the maturing of the population. The average age, service and pay of plan participants continues to increase as the baby boomers mature. Additionally, the retired and vested population has not decreased as once expected, due to improvements in mortality.

3. Old-Line Companies Have Higher Risks. Companies that have defined-benefit plans often are not the same companies who have benefited from the New Economy. Older, mainstream manufacturing companies, which more typically have defined-benefit plans, often have grown more slowly than the liabilities in their defined-benefit plans. In fact, it isn't rare for the pension liabilities to represent a substantial percentage of a company's net worth -- sometimes exceeding it.

A downturn in the economy could quickly turn a well-funded plan into a poorly funded one -- a substantial risk for these old economy companies. An interest rate decline of 150 basis points in the same year as a negative 20 percent investment return, not an impossible scenario, could transform a plan that is over-funded by 25 percent into one that is under-funded by 25 percent -- all in 12 months, If this happens at the wrong time for a particular company, the plan's resulting unfunded liability could exceed the net worth of the company, which could trigger bankruptcy.

What's the good news?

Until the Federal Reserve's surprise rate cut in early January, interest rates had risen subtly over the previous two years, and annuity purchase rates have become substantially more attractive than they had been a few years ago. Back in the '80s, when discount rates were frequently well over 10 percent, companies often sold their retired liabilities to insurance companies to take them off their books. This practice has become less common, but there is renewed interest, for a number of reasons.

1. Lowering Your Risk. Mature plans are likely to have significant retired or inactive liabilities. By settling these liabilities, plan sponsors lock in current interest rates and essentially cash in part of their investment run-up. Also, any remaining excess assets are now spread across a smaller liability. The result is an improved funding level and a better ability to absorb downside risks. This is illustrated by the following example:

Pre-Settlement Funding Status:
Active Liability               $ 60,000,000
Inactive Liability               40,000,000
Total Liabilities               100,000,000
Assets                          120,000,000
Funding Level                   120 percent
Post-Settlement Funding
Status:
Active Liability               $ 60,000,000
Inactive Liability                        0
Assets                           78,000,000
Funded Position                 130 percent

In the above example, we have assumed that the inactive liability was settled at $42 million, resulting in a small loss. We have actually found recently that we are able to settle liabilities at close to a breakeven position, but typically there is a small loss. Even with a small loss in the example above, the funded position improves from 120 percent to 130 percent, substantially lowering the risks associated with any future poor investment performance and mitigating the risk of a drop in interest rates.

2. Pension Income. For the reason cited above, many companies have substantial accrued pension liabilities on their books even though their plans are well-funded, The balance sheet typically has a large unamortized gain due to the run-up of assets over the last decade. Under FAS 88, these gains are recognized immediately as income upon the settlement of liabilities in proportion to the amount settled.

For instance, if a company annuitized one-third of a plan's liabilities (by annuitizing its retirees), then one-third of the deferred gain is immediately recognized as income under FAS 88.

For our company above, here is how the FAS 88 impact might work:

                                   Before Settlement Impact of Settlement
Projected Benefit Obligation         $ (100,000,000)         $ 40,000,000
Assets                                   120,000,000         (42,000,000)
Funded Difference                         20,000,000          (2,000,000)
Transition Obligation                      5,000,000                    0
Prior Service Cost                                 0                    0
Unrecognized Gain                       (35,000,000)           15,588,000
(Accrued)/ Prepaid Pension Expense    $ (10,000,000)          $13,588,000
                                   After Settlement
Projected Benefit Obligation         $ (60,000,000)
Assets                                   78,000,000
Funded Difference                        18,000,000
Transition Obligation                     5,000,000
Prior Service Cost                                0
Unrecognized Gain                      (19,412,000)
(Accrued)/ Prepaid Pension Expense      $ 3,588,000

The company in this example generates $13,588,000 in pre-tax income in the year of settlement and entirely eliminates the accrued expense on its books.

Of course, there are some tradeoffs for reducing the downside risk. In particular, if interest rates remain constant and investment returns stay high, the plan will show higher pension expense in future years if it settles retiree obligations now. This is because the portion of the unrecognized gains that is recognized under settlement accounting would otherwise be amortized as a credit against pension expense in future years. In addition, settling liabilities transfers the financing of the liabilities from a portfolio set by the sponsor over to an insurer, Thus, the sponsor gives up the potential for future equity investment premiums in exchange for eliminating risks.

3. Ancillary Benefits. Settling liabilities can improve your current balance sheet, lower your risks and generate income this year. It can also provide additional ancillary benefits:

1.) Administration for retirees is eliminated, as that responsibility is shifted to the insurance company assuming the liabilities.

2.) Fixed Pension Benefit Guaranty Corp. (PBGC) premiums decline. The fixed premium of $19 a head for every participant is eliminated for those participants for whom an annuity is purchased.

3.) Variable PBGC premiums could decline. Due to the low interest rate used to calculate variable premiums, liabilities are likely to be settled at a favorable rate. The liability for PBGC variable-rate purposes then will decline more than the amount of assets required to settle the liability. Therefore, if you are paying a variable premium, the premium paid on the remaining liability will be lowered as a result of a better funding position.

The Annuity Purchase Process

Fiduciary responsibility -- as well as common sense -- requires that the insurer selected have superior financial quality. In a more innocent age -- before the collapse of companies like Executive Life and Mutual Benefit Life -- some thought that top-tier ratings from rating agencies such as Best's, Standard & Poor's, Duff & Phelps, or Moody's might be sufficient to establish an insurer's soundness. The U.S. Department of Labor, in its Interpretive Bulletin 95-1 (DOL 95-1), torpedoed this position. The DOL's goal is to assure that "fiduciaries choosing an annuity provider for the purpose of making a benefit distribution take steps calculated to obtain the safest annuity available." It requires that a plan fiduciary evaluate several factors:

(1) the quality and diversification of the annuity provider's investment portfolio;

(2) the size of the insurer relative to the proposed contract;

(3) the level of the insurer's capital and surplus;

(4) the lines of business of the annuity provider and other indications of an insurer's exposure to liability;

(5) the structure of the annuity contract and guarantees supporting the annuities, such as the use of separate accounts;

(6) the availability of additional protection through state guaranty associations and the extent of their guarantees."

The DOL continues: "Unless they possess the necessary expertise to evaluate such factors, fiduciaries would need to obtain the advice of a qualified, independent expert." This argues strongly against plan sponsors taking the "do-it-yourself" approach or allowing a broker or consultant without demonstrable expertise to "market" the liability. Rather, the plan sponsor needs to have a well-documented process describing how it complied with the DOL's "guidance." Once that task has been completed, soliciting of bids can begin.

Annuity Insurance Market and Process. An extremely limited number of insurers are active in the annuity market and can be realistically considered among the "safest available." The annuity market varies over time, based on the characteristics of the liability being settled, but a sponsor should expect to receive fewer than 10 bids, or approximately one-third as many as would have been received a decade ago. Thus, it is important to have a bid process that assures that all potential bidders have a thorough understanding of all of the facets of the liability. Specifications for even a modest liability are complex, and the services of an experienced consultant or broker should be sought.

The typical process involves:

* Initial Bid: Solicited after the carriers have had sufficient time to analyze the liability, the initial bid has several purposes:

(1) Serves as a "reality check" for the plan actuary's estimate of the liability;

(2) Provides time to discuss with client and carriers if estimate is "off";

(3) Assures sufficient time to answer questions;

(4) Allows time for thorough review of carriers' bid packages.

* Final Bid: Typically held at least one week after preliminary bids. By this step, the sponsor should have complete confidence that the bidders can meet the "safest available" standard. As bids will be subject to change, the sponsor should be prepared to act on the day that bids are solicited, and actively negotiate for the best price.

In undertaking an annuity placement, you need to ensure that your data records for the portion of the plan you want to settle are credible. This means having dates of birth, accurate information on benefits, optional forms of benefits, etc., for every participant. You will want to discuss with your auditors the timing of the treatment under FAS 88, whether it is recognized when the money actually moves to the insurance company or at the time contracts are signed.

There will be an interim period between when the decision to annuitize is made and when assets are actually transferred. Interest rate swings during this period can substantially affect the plan's funded position. Therefore, you will want to work with your investment advisor to hedge this liability and these investments during this period.

For many companies, now is a good time to look at the balance sheet and the opportunities hidden for generating income within that plan, and the risks that can be averted by taking action now.

Charles Cahill is a senior vice president and Thomas Toale is a vice president at Aon Consulting (www.aon.com), a firm specializing in insurance brokerage and employee benefit consulting.