For more than a decade, the world of retirement plan design has seen an accelerating trend away from traditional defined benefit pension arrangements to defined contribution plans with all the bells and whistles. On the one hand, defined benefit pension plans, reflecting a long-term outlook designed to provide lifetime income, are subject to largely unpredictable funding volatility and ever-tightening regulatory controls. At the same time, such arrangements are not perceived as valuable by younger, mobile members of the workforce, who are said to not understand or appreciate their value. On the other hand, defined contribution plans are, by their nature, always fully funded, provide each participant with a very tangible individual account and are “portable” as individuals move from one position to another. These considerations have led to pension plan freezes or closures, often coupled with defined contribution enhancements, becoming more the rule than the exception. Although this trend represents a major transfer in retirement plan financial risk from the defined benefit plan sponsor to the individual savings plan participant, untenable levels of risk still remain for sponsors of defined benefit plans.

With steep market declines in 2008 impacting defined benefit plan assets and declining interest rates escalating pension liabilities, coupled with the more stringent funding requirements of the Pension Protection Act of 2006, changes in accounting rules and other legislative tinkering, the plan sponsor’s situation has continued to worsen, accelerating the desire to reduce defined benefit plan exposure. Because plan termination generally requires full funding of all liabilities, those plan sponsors seeking to “get out of the pension business” through plan termination have found their companies further than ever from the desired goal. As a result, driven by concerns focused more on mitigating risk than pure cost savings, derisking techniques have grown in importance and are being implemented at a rapid pace.

Pension derisking involves reducing the level of risk associated with defined benefit plans arising primarily from volatility, whether it be due to underfunding or changes in underlying assumptions used to determine liability. While full plan termination is the ultimate way to eliminate this risk, other strategies are available where this is not possible. Those that have gained some traction, particularly following the publicity surrounding their recent use by Verizon and General Motors, include:

  • Offering lump sum settlements to former employees who have not yet started receiving their pension payments.
  • Annuitizing payments currently being made to retirees through purchase of an annuity contract from an insurance company, which is then fully responsible for future payments.
  • Liability-driven investment strategies (LDI), which match up plan assets with pension liabilities.

A few comments can be made about each of these options that may be helpful in assessing their suitability for a particular company:

  • Lump sum windows. A lump sum settlement offer typically is made to a specified group of deferred vested former employees; the offer is held open for a limited period only. Practical steps, which are of some consequence, include locating such individuals and effectively communicating to each the details of the available lump sum election.

Necessary information includes appropriate disclosures relating to other available options, the relative value of each and the basis on which the lump sum amount is determined. This is perhaps the most common strategy currently in use, having an acceptance rate that is not entirely predictable but often as high as 70 percent. Participants generally may choose a tax-free rollover of a lump sum settlement; in any event, they will no longer be a liability of the plan for PBGC or funding purposes. In considering a lump sum window, consideration must be given to funding requirements and how these can be satisfied. Antiselection risk must be weighed, as well as whether implementation while interest rates are at historic lows makes sense. A further drawback to this approach arises if the lump sum settlement program could trigger settlement accounting (resulting from immediate recognition of a portion of unrealized losses or gains when liabilities are settled), impacting financial statement reporting. This concern may be addressed in designing the scope of the window.

  • Annuitization. Annuitization involves the purchase of annuities from an insurance company. When annuitizing pensions already in pay status, issues relating to locating individuals, benefit calculations and communication are minimized. Moreover, pensioners experience no disruption, and all future administrative activity is necessarily assumed by the insurance company. As in the case of the lump sum strategy, because liabilities are removed from the plan, PBGC insurance ends and these benefits will no longer be a liability of the plan for PBGC premium or any other purpose. All of this comes at a cost, of course, as annuity purchase rates may well be higher than permitted cash-out rates. Also introduced is an element of fiduciary risk associated with the selection of the annuity provider and structuring of the contract, requiring careful attention to ERISA fiduciary risk management.
  •  LDI. Liability-driven investment strategies do not settle liabilities, but serve to reduce volatility. This alternative avoids settlement accounting issues and the need for immediate funding of settlements. However, PBGC, administrative and regulatory burdens continue.


Implementation of a derisking program, particularly one involving a lump sum window or annuitization, requires careful analysis by plan actuarial and legal advisers. Legal issues are presented on both the corporate and plan compliance sides. It is critical that any lump sum window or annuitization be structured as a “settlor” function, reflected in appropriate corporate actions and formal plan amendments. This limits ERISA fiduciary risk to implementation activities, including selection of any annuity provider. In this regard, of course, appropriate independent experts or fiduciaries can be engaged to assist. Legal review of the overall communication program, including details of disclosure material and election forms, is also critical in assuring satisfactory results. No less important is the role of the plan’s investment managers to generate necessary liquidity. Except in the case of LDI, each strategy involves appropriate plan amendments, which under current law cannot be made unless the plan is adequately funded or the plan sponsor is prepared to provide such additional funding as is required in connection with implementation. With today’s access to inexpensive capital, this represents an option to be considered for corporate financing. A plan sponsor may well prefer to reflect long-term debt on its books than to face the continued volatility associated with defined benefit obligations.