A New Dawn Nick Davies Area President Andrew Irving Area Senior Vice President and Area Counsel
It is a well known premise that sequels are rarely as good as the original when it comes to blockbuster feature films. Some Godfather and Star Wars aficionados might disagree, but generally, any redux is a bit of a disappointment. This brings us to the world of pensions, where returns rocketed in 2013. Strong equity markets, some movement in interest rates suddenly market value funding levels are above 90% and when taking funding relief (from recent MAP-21 legislation) into account, the perception is everything is rosy again, just like it was in 2007. The second time around is better than the first, right? Background In the 2000s, we saw market crashes which wiped billions of dollars from the collective funding levels of pension plans across the country. At the end of 2007, the average pension plan was in surplus, but the credit crisis again left plan sponsors concerned with the challenges of running a defined benefit (DB) pension plan. Funding levels plunged, with the average plan funded percentage in the low 70s at the end of 2012. Decisions have been made to close and freeze many pension plans across the United States, which has led to DB plans transforming from vital components of employees benefit packages to burdensome legacy financial issues for plan sponsors, CFOs and Treasurers. This creates two challenges for organizations the first is the structure of benefits that companies will provide to their employees going forward. As DB plan benefit accruals (which are used as an attractive employee retention tool) come to an end, reconfiguring total rewards across health, retirement and other benefits becomes a critical discussion for employers to attract and retain top tier employees, as well as assisting workforce planning and management through their employees careers. The second challenge what to do with those outstanding DB plans? Liability Driven Investing Plan sponsors have been struggling to deal with various levels of underfunding through the credit crisis. Sinking equity markets coupled with declining interest rates created a familiar story of pension underfunding. These setbacks have led to a slowing economy, creating downward pressure on corporate earnings just when free cash would be needed to meet legislated pension funding contributions. It has been a tough few years, with the focus shifted for many plan sponsors from equity assets intended to minimize pension contributions in good years, towards incorporating liability hedging strategies, looking to provide protection relative to movements in liabilities. Liability Driven Investing (LDI) is the concept of measuring the performance of the assets relative to the liabilities and for many plan sponsors, moving a portion of their assets to long bonds helps reduce the INSTITUTIONAL INVESTMENT & FIDUCIARY SERVICES ARTHUR J. GALLAGHER & CO. MAY 2014 :: 2
volatility between the two while also maintaining a similar level or slightly higher expected return a win-win. LDI v1.0 considered shifting bond assets already held (mainly core aggregate bonds) to long duration bonds (potentially a mixture of long Treasury STRIPS, other long government bonds, long corporate bonds and possibly Treasury futures or swaps). However, many plan sponsors weren t ready to close their funding gap through additional contributions, instead putting in place an asset derisking roadmap helping to lock in funded status improvements by shifting asset allocations as certain funded status (or interest rate) triggers were hit. With the more recent run up in equity markets (as well as interest rate rises), this so called dynamic derisking has resulted in asset allocations with declining allocations to equities (and other growth assets), with a higher proportion in liability-matching, long duration bonds. Of course, the ultimate question for the plan sponsor is what is their target end-game objective? And what are the tools available to get there as effectively as possible? Increased Opportunity and Complexity This journey plan (conceivably LDI v2.0) considers the range of possible tools and resources available to assist plan sponsors with managing their pension plans. Ultimately, each situation is unique but there will be a target end-game or risk profile that is appropriate and makes sense given the plan s goals and objectives. For some, maintaining an open pension plan will be an HR attraction tool, imposing a comparatively small liability relative to the market capitalization of the company, with a predictable, manageable company contribution rate. For those increasingly numerous others, their frozen defined benefit plan is a legacy issue that provides little value from an HR perspective for current employees or new hires, which nonetheless still needs appropriate fiduciary management. It is an ongoing distraction for finance staff and creates unwelcome volatility to the company balance sheet. Solutions to the last of these features can be achieved through asset allocation derisking. A reduction in administrative burden can also create value for employers both from a cost and time perspective. This evolution has led to significant increased interest in risk transfer opportunities, which are distinct from investment risk reduction strategies. Risk transfer considers the future pension liabilities and explores whether there may be appropriate ways to relieve the sponsoring employer of the risks associated with funding those obligations. One example of this is offering terminated vested employees a lump-sum, cash-out option. Many ex-employees are looking to consolidate their pension benefits and by transferring the benefit as a lump sum, the plan sponsor is also relieved of the duty to maintain funding for the future payment of those benefits a solution for both parties. INSTITUTIONAL INVESTMENT & FIDUCIARY SERVICES ARTHUR J. GALLAGHER & CO. MAY 2014 :: 3
Another step plan sponsors consider is using assets other than cash, such as employer stock, real property or interests in subsidiaries to fund their DB plans. Sometimes these in-kind contributions are used to satisfy minimum funding requirements. Other sponsors use them as voluntary additional contributions to accelerate progress to full funding or to avoid the benefit limitations that result when funding levels dip below certain legislated standards. These transactions must be carefully structured to meet ERISA standards and typically an independent fiduciary represents the plan in deciding whether and on what terms to accept the asset and then to manage it once it becomes a plan asset. Also, of increased note, over the last couple of years has been the bulk annuity purchase a pension buy-out that results in an insurer taking over the payment responsibilities for a portion of the pension plan population. This transaction occurs among the plan sponsor, the plan and a third-party insurance carrier. The critical consideration here is that an additional party is being brought into the equation not solely as an ongoing service provider for the pension plan, but as a party taking over responsibility for the payment of pension benefits to the beneficiaries. The DOL s Interpretive Bulletin No. 95-1 provides direction and guidance for plan sponsors regarding the selection of annuities. Firstly, the selection of the insurance carrier is a fiduciary decision under ERISA. Accordingly, the transaction must be undertaken for the sole benefit of participants and beneficiaries. Secondly, the selected insurance carrier must be the safest available annuity provider taking into account several factors relating to creditworthiness, lines of business, protection for participants, etc. All of these elements create additional layers of due diligence and analysis that should be undertaken and that present fiduciary risk to a plan sponsor, whose corporate interest in minimizing the cost of the annuity purchase creates an inherent conflict with the fiduciary dimensions of the annuity selection process imposed by ERISA. Independent Experience and Advice The important consideration for plan sponsors and fiduciary committees is determination of the appropriate target solution for their specific circumstances. Whether to offer, maintain, freeze or terminate a defined benefit plan is a plan design decision for the plan sponsor and therefore, under ERISA, a so-called settlor decision not subject to ERISA s fiduciary standards. But once the benefit framework has been defined, the process of administering that benefit design and managing the plan assets behind the benefit promises is a matter of fiduciary oversight subject to the mandate that decisions are made prudently and solely in the interests of the plan s participants and beneficiaries. INSTITUTIONAL INVESTMENT & FIDUCIARY SERVICES ARTHUR J. GALLAGHER & CO. MAY 2014 :: 4
Additional complexity should not dissuade committees and boards from making the decisions for the benefit of their plan participants. In particular, a well documented process is critical and taking no action or not investigating options is an implicit decision in and of itself. Investment and benefit committees should work with their staff and prudently selected advisors to investigate options and ensure that they receive, understand and carefully weigh input from those with appropriate expertise. Whether considering asset allocation, manager selection and ongoing monitoring for a current plan (where the plan sponsor retains the pension risk), or lump-sum cash-outs and/or plan termination (where the pension risk is transferred), sound independent advice and guidance will ensure that the broad range of available options are considered and deliberated in a manner consistent with ERISA s demanding standards. In specific circumstances (e.g., an in-kind pension contribution or selection of an annuity provider), an independent fiduciary can help ensure that inherent conflicts of interest are managed. Plan sponsors should work to differentiate between strategic decisions, versus implementation themes. Staff, committees and boards will have limited time and resources and should consider if their efforts are being focused in the right areas. In particular, independent fiduciaries and outsourced CIO (OCIO) arrangements can provide additional resources as an extension of staff to facilitate due diligence and implementation in a timely and robust fashion. Whatever the specific situation, a well-defined process and qualified advice and resources help ensure for both plan sponsors and beneficiaries that there can be a happy ending. INSTITUTIONAL INVESTMENT & FIDUCIARY SERVICES ARTHUR J. GALLAGHER & CO. MAY 2014 :: 5
Nick Davies About the Team Nick Davies, Area President, leads the Institutional Investment & Fiduciary Services team of Arthur J. Gallagher & Co., and Andrew Irving leads its fiduciary decision-making practice, focused on improving the investment program of your benefit plan and other investment pools. Gallagher s Institutional Investment & Fiduciary Services team are a group of established, proven investment professionals who provide objective insights, analysis and oversight on asset allocation, investment managers, and investment risks, along with fiduciary responsibility for investment decisions as an independent fiduciary or outsourced CIO. Nick Davies Area President Institutional Investment & Fiduciary Services nick_davies@ajg.com 202.312.5432 Andrew Irving Area Senior Vice President and Area Counsel Institutional Investment & Fiduciary Services andrew_irving@ajg.com 973.424.6405 www.ajg.com Andrew Irving Investment advisory services and named and independent fiduciary services are offered through Gallagher Fiduciary Advisors, LLC, an SEC Registered Investment Adviser. This document contains proprietary information that belongs to Gallagher Fiduciary Advisors, LLC and is protected by copyright, trade secret and other State and Federal laws. Any copying, redistribution, or retransmission of any of the contents without the written consent of Gallagher Fiduciary Advisors, LLC is expressly prohibited. Gallagher Fiduciary Advisors, LLC is a single-member, limited-liability company, with Gallagher Benefit Services, Inc. as its single member. Neither Arthur J. Gallagher & Co., Gallagher Fiduciary Advisors, LLC nor their affiliates provide accounting, legal or tax advice. 2014 Gallagher Fiduciary Advisors, LLC INSTITUTIONAL INVESTMENT & FIDUCIARY SERVICES ARTHUR J. GALLAGHER & CO. MAY 2014 :: 6 14GBS25520A