Managing Global Pension Risk

Now is the time to consider opportunities to manage global pension cost and risk. Many employers have already frozen their defined benefit plans and implemented defined contribution plans.  Of course, such cost-reduction strategies may raise employment law issues in non-US jurisdictions because of the Acquired Rights Directive in EU jurisdictions and similar legislation elsewhere.  In considering any such change, an employer has to consider how such change will be communicated to employees and employee representatives, including works councils and unions.  Further, the immediate impact on the pension plan’s financial statements must be considered.

Employers outside the US have focused on funding and pension asset opportunities that may not be available to US employers due to ERISA rules.  Employers in Germany may establish contractual trust agreements (CTAs) to allow them to net pension assets and pension provisions under certain conditions for US GAAP and German GAAP purposes resulting in a reduced balance sheet total and improved financial indicators.  UK employers may use asset-backed funding to essentially replace cash deficit contributions over a defined period with access to a group income-producing asset that is designed to pay off the pension deficit over a longer period.  Asset-backed funding is typically implemented through a Scottish limited partnership, which for technical reasons does not breach the UK rule against investing in the employer.  The strategy aims to: alleviate the risk of trapped surplus in a pension plan; reduce or spread out the cash contributions required to pay off any pension deficit; and improve the funding and security of member benefits and the “employer covenant” in a tax efficient way.

Global employers may also utilize risk transfer strategies like annuity buy-outs and longevity hedges.  In an annuity buy-out, the employer pays a premium to an insurer who assumes the liability risk with respect to a fixed group of pension liabilities for terminated vested participants, retirees or, in some cases, active participants.  The cost of the annuity-buyout approach may be a drawback.  The longer the liability duration (that is, the younger the covered participants and the longer their then life expectancies), the higher the annuity premium.  The benefit of the annuity-buyout approach, however, is that it will result in an immediate reduction in the projected benefit obligation and may have the most significant market reaction.  Alternatively, pension investment in a longevity hedge may be a possibility.  The pension plan pays a fixed periodic amount to the counterparty until an agreed date and, in return, the counterparty pays the actual amount required to meet pension benefit obligations to retirees.  If the retirees live longer than expected, the counterparty will pay more than it receives in the swap, and if mortality exceeds expectations, the pension plan loses on the trade.  Note that the counterparty risk remains with the plan, and the funding risk remains with the employer.  Although the longevity swap has advantages (e.g., a certain cash flow to meet specific, potentially large liabilities; no upfront premium nor bulk annuity purchase; pension plan retention of the assets), the transaction is complex and can require months to implement.

Maura Ann McBreen is a partner in the Firm’s Chicago office and has over 30 years' experience in executive compensation and employee benefits. Maura Ann focuses on executive compensation and employee benefits, especially with regard to single employer, multi-employer, and multinational benefits. She addresses operational and fiduciary issues as they arise under tax-qualified retirement plans, including employee stock ownership plans, and leads our global pensions practice. She designs deferred compensation and equity-based incentive compensation plans, advises on issues under Code Sections 162(m), 280G, 409A and 457A and negotiates executive employment agreements.