Defined benefit plan sponsors have become very focused on ways to control their asset volatility and to remove pension liabilities from their balance sheets. In fact, it would be fair to call “de-risking” a hot global issue which is in the spotlight in Europe, Canada and the United States.

De-risking may take different forms, including: increasing the percentage of assets allocated to fixed income, lengthening bond portfolios, engaging in dynamic allocation strategies, giving retirees lump sum options (removing them from the plan books if they accept the buyout) and purchasing annuities from a third party insurer, who thereafter assumes all payment responsibility. Purchasing annuities results in a complete transfer of longevity and market risk.

Several large U.S. plan sponsors, including General Motors, Ford and Verizon, have gone forward with de-risking transactions intended to shed retiree benefit obligations. Recent legislation having the effect of decreasing the measure of plan underfunding may accelerate this trend. Now there are new U.S. legal developments to report which may reduce plan sponsors’ concerns about the permissibility of de-risking annuitization transactions.

Case in Point

We have been watching for legal developments that would challenge plan sponsors’ efforts to remove investment risk from their pension plans.

Last week, a federal district court in Texas refused to stop Verizon’s annuitization of retiree benefits in response to a lawsuit requesting an emergency injunction brought by two participants, allegedly on behalf of approximately 41,000 Verizon retirees. Verizon is purchasing annuities to partially de-risk its plan, but it is not terminating its defined benefit plan and benefits for about 60,000 plan participants and certain classes of retirees would not be annuitized. Nor was Verizon planning to offer lump sum buyouts to retirees as General Motors did. However, the affected Verizon retirees claimed that annuitization of their benefits was not permitted by their plan document or disclosed in their summary plan descriptions. Even though an independent fiduciary was hired to oversee the transaction, the plaintiffs claimed that transaction violated ERISA by depriving retirees of PBGC insurance protection without going through the standard termination process, and was a breach of fiduciary responsibility. The Texas court did not agree with the retirees.

What Does this Mean for Plan Sponsors Considering De-risking by Annuity Purchase?

This recent decision should allay plan sponsor concerns. Annuitizing retiree benefits is not a new development, and is authorized in regulations issued under ERISA. PBGC did ask for public comments a few years ago about whether annuity purchases prior to plan termination should be restricted, expressing concern about possible issues, but announced in 2010 that it would not pursue any rule-making on these annuity purchases.

Some plan sponsors have regularly distributed individual annuity contracts to participants at retirement to end their PBGC insurance premium obligations and to transfer responsibility to an insurer. Participants whose employers were in less than robust financial condition often welcomed this. And back when defined benefit plans had funding surpluses, group annuity purchases for retirees and even active participants were common in so-called spin off-termination and termination-reestablishment transactions, which were recognized as valid by the IRS and the PBGC.

The only thing really new about the Verizon transaction is its size, but the Verizon decision did not find any special risk associated with large-scale annuitization.

The Verizon decision confirms longstanding U.S. law that the decisions to amend a plan or buy annuities are settlor decisions taken in a non-fiduciary capacity. The selection of a financially sound insurer is subject to fiduciary standards, and the manner of dividing the assets to fund the annuity purchase should be fair to ongoing participants, but Verizon had an independent fiduciary in place to assist it in meeting its fiduciary responsibilities. And the court gave short shrift to the retirees’ arguments that the plan and SPD did not permit annuitization, stating that Verizon had duly amended the plan before the projected closing of the transaction, and SPDs do not need to describe potential future amendments.

Verizon and Prudential have gone ahead with the annuity purchases. This may not be the end of the matter for them because plaintiffs could try to appeal the decision or pursue other litigation challenging the annuitization. However, we believe they are unlikely to prevail unless the courts make new law in this area.

What are the key takeaways for pension sponsors?

The steps taken by Verizon provide important reminders to employers seeking to protect themselves in de-risking situations:

  • Have an independent fiduciary in place to assist with implementation of settlor decisions to buy annuities. The selection of an annuity provider is a fiduciary action.
  • Make sure your operations follow plan documents and consider adding provisions directing the purchase of annuities. A plan amendment may be appropriate or necessary once the decision to annuitize has been made.
  • Disclose the possibility of annuitization in summary plan descriptions.
  • Record the basis for decisions in Minutes that are comprehensive and clear.

We also suggest the following good practices:

  • Consider the funding status of the plan, and the need to have cash available for any annuity purchases or retiree buyouts.
  • Involve a fiduciary investment adviser or investment manager.
  • Consult your accountants about the accounting impact of your program.