There was a time when the journey toward a financially secure retirement ran straight and smooth, both for employers and employees. Companies offered generous pensions to nearly all workers, and most workers logged many years of experience with a single company, confident that when it was time to exit the workforce, they would be well provided for.
That road developed some potholes in the 1980s, when companies began a marked shift toward defined contribution plans. Before long, the Pension Benefit Guaranty Corp. was sounding the alarm over a few companies’ underfunded defined benefit plans. The loudest sirens were heard at automakers like Chrysler and airlines like United; the latter’s declaration of bankruptcy and subsequent $8.3 billion pension-fund failure ranks as the biggest defined benefit collapse since the PBGC began guaranteeing pensions in 1974.
Nonetheless, accounting regulations gave companies plenty of latitude in how they managed their pension plans. Those that didn’t have enough in the till to meet their obligations could smooth the value of plan assets (averaging them out over five years from 80 percent to 120 percent of the assets’ fair market value). Those with overfunded plans enjoyed the perception of superior operating performance, with that pension cash hoard often masking a range of weaknesses.
But even favorable accounting treatment couldn’t stem the move away from defined benefit plans. While 38 percent of Americans had a defined benefit pension as their primary retirement plan in 1980, by 1997 this percentage had dipped to 21 percent, according to the Pension Benefits Council.
That percentage is likely to drop even faster, thanks to the near-simultaneous advent of the Pension Protection Act of 2006 (PPA) and the Financial Accounting Standards Board’s FAS 158. Together, the new federal law and accounting guidance have created conditions under which companies must deploy greater resources and expertise to efficiently manage pension assets. The PPA cut the number of years companies can smooth, limiting pensions as a strategic accounting tool; FAS 158 requires them to put their funded status on the balance sheet, which makes the costs more transparent to investors and thus harder to manipulate. In short, the new regulations have made pensions more complex to manage and increased the penalties for mismanagement.
That shift, say some experts, has fundamentally changed the way in which companies should regard defined benefit plans. “Pensions have gone from being an HR issue to a finance issue,” says Stephen Bozeman, a principal at Barclays Global Investors (BGI) in San Francisco. “Your pension plan is now a potential liability, something that can actually bring the company down.”
The specter of increased risk brought about by stricter funding and reporting requirements is leading some companies to look more closely at integrated pension management, which takes traditional pension outsourcing one notable step further: instead of outsourcing just the management of their defined benefit plans, companies outsource a portion of the underlying liability as well. As co-fiduciary, the vendor assumes a degree of liability in the event of a lawsuit. While this doesn’t get the employer completely off the hook, in the event of litigation it provides the presence of an independent third party that has reviewed the transactions and investment strategies. And if the case is lost, there would theoretically be another party to split the settlement.
A growing number of firms, including Fidelity Investments, Frank Russell, Northern Trust, SEI Investments, UBS Global Asset Management, and Barclays Global Investors, are pitching more-sophisticated pension-management services. Providers say the number of queries from CFOs has skyrocketed since FAS 158 and the PPA. Nevertheless, the question remains: Is outsourcing something as sensitive as employees’ retirement benefits in companies’ best interest?
Some think not. “The downside to any form of outsourcing is the loss of control, which could have cost ramifications,” says attorney John Martini, practice group leader for the Tax, Benefits, and Wealth Planning Group in the Philadelphia office of Reed Smith LLP. “As the fiduciary, you have an obligation to monitor the activities of the outsourcing provider. In a period in which stocks are losing value, even what appear to be the most prudent, reasonable actions — like outsourcing — will get scrutinized if the stock tanks and the sharks come out to play.”
No surprise, then, that some companies are holding firm to their current strategies, at least for now. “We froze our defined benefit plan and continue to manage it in-house,” says David Devonshire, recently retired CFO of Motorola Inc. (He retains the title of executive vice president.) “We’ve looked at outsourcing and are obviously well aware of it as a burgeoning trend, but we didn’t feel a compelling need to do it. Of course, that can always change.”
Other companies have been quicker to jump. “Managing pension plans is not a core competency for us,” says Bill Dordelman, vice president of finance at Comcast Corp. The Philadelphia-based cable provider inherited a defined benefit plan following its 2002 acquisition of AT&T Broadband — but not, regrettably, the plan’s in-house pension staff. “For us to create an in-house investment staff would be costly and inefficient,” Dordelman says. “Outsourcing management of the plan to a firm that makes asset-allocation decisions on a day-to-day basis, and is willing to put its money where its mouth is in terms of being a fiduciary, made complete sense.”
Mark Halverson, managing director of the global wealth management services division of Accenture’s Capital Markets practice, sums up the essential argument made by the new crop of service providers this way: “Most employers are not experts on managing money on behalf of employees, and don’t necessarily view retirement management as a strategic capability. Rather, providing these benefits is an obligation they have to fulfill to their employees.”
And some of them do a bad job of it. “We’ve seen too many examples of companies that have loaded their retirement plans with their own stock, without allowing for appropriate asset allocation and diversification, to the detriment of their individual employees,” says Halverson.
For acquisition-minded companies that suddenly find themselves burdened with multiple pension plans, the outsourcing option can be particularly compelling. “We’ve got some U.S. defined benefit plans and some Canadian ones; some that are underfunded and some that are overfunded,” says Bill Ferko, CFO and vice president at Genlyte Group Inc., a Louisville-based manufacturer of lighting fixtures. “Meanwhile, we’re moving most of the organization into defined contribution plans.”
Ferko estimates that Genlyte’s aggregate defined benefit plan assets totaled $105 million last year, while its obligations were $120 million. In Canada, the assets and obligations reached $13 million and $18 million, respectively. “Obviously, we’re slightly underfunded, but for a company with $1.6 billion in sales this is not a big issue,” he says. “Nevertheless, we’re outsourcing almost everything. We’ve weighed the cost of this approach versus building an internal staff, and it makes sense for us.”
Time to Reevaluate?
The combined weight of FAS 158 and the PPA has accelerated the push to freeze or terminate pension plans. McKinsey & Co. projects that by 2012, 50 to 80 percent of all private-sector defined benefit assets will be frozen or terminated, as compared with 25 percent today. A recent survey by the Employee Benefit Research Institute pegs the current percentage of frozen or terminated plans at one-third, with another third expected to follow suit within the next two years.
The trend seems clear, and regardless of which approach a company takes, most will need to reevaluate their approach to pension management. “Companies are freezing their defined benefit plans because they can’t tolerate the volatility, but as soon as they do that, [the plan] is no longer a strategic resource in the company,” explains Aaron Meder, head of Asset Liability Investment Solutions in the Americas at UBS Global Asset Management.
A key part of deciding to outsource, BGI’s Bozeman maintains, is weighing a potential service provider’s expertise. “With defined benefit plans now a liability on the balance sheet each year, you’ve suddenly got to deal with an entity that’s as big as a large operating division in some companies, and yet you have little or no expertise in managing it,” he says. Jim Morris, senior vice president, Retirement Solutions, at SEI Investments in Oaks, Pennsylvania, has a similar take. “While some large organizations have dedicated teams to do this, that’s an anomaly,” he says. “In most organizations, pension investment management is a part-time job. Due to the impact of market volatility on cash requirements, financial reports, and debt covenants, a single person cannot do the job, much less an internal staff.”
Despite the changed landscape, not everyone is sanguine about handing over management of pension assets and liabilities. Amtrak, for example, examined the strategy two years ago and found it wanting. “It wasn’t like the fiduciary responsibility was coming completely off our shoulders,” says Amtrak treasurer Dale Stein. “To meet those responsibilities, we’d still need to approve the asset allocation, investment managers, and fee schedules, and oversee the performance. We didn’t see the cost-benefit.”
But Accenture’s Halverson argues that any discussion of the benefits of outsourcing should focus on whether and to what degree employees benefit. “Many Americans may find that their savings or retirement plans are not sufficiently funded to sustain their retirements,” he explains.
And, while integrated pension management isn’t free and isn’t likely to be offset cost-wise by labor reduction, having another firm — especially a financial institution — as a co-fiduciary gives employees the peace of mind “of another deep pocket,” says Reed Smith’s Martini.
At the very least, companies now have a wider range of choices as they confront the demands of the PPA and FAS 158. Some may welcome a little navigational assistance as they travel that road to retirement.
Russ Banham is a contributing editor of CFO.
Tough Rules, Tough Times
The Pension Protection Act of 2006 and Financial Accounting Standard 158 represent two critical examples of the push for more transparency and disclosure that began with the Sarbanes-Oxley Act of 2002. The PPA requires companies to make the contributions necessary to plans to amortize their unfunded benefit liabilities within the next seven years, in addition to tightening smoothing methods and shortening amortization periods. The law essentially forces sponsors of underfunded plans to contribute substantially more to their plans on an annual basis — the case, for example, with Amtrak. “Based on the new rules, our actuaries told us we needed to increase our payment into the defined benefit plan by 75 percent this fiscal year, and must make additional payment increases over the next few years,” says William Campbell, CFO of the Washington, D.C.-based railroad.
FAS 158 (Employers’ Accounting for Defined Benefit Pension and Other Postretirement Plans), issued in September 2006, further ups the ante. The rule requires companies to recognize the funded status of their benefit plans, measured as the difference between plan assets at fair value and the benefit obligation, in their annual statements of financial position. “The requirements to account for funding shortfalls caused huge volatility in many companies’ income statements,” says Jamie Cornell, senior vice president of employer marketing at Fidelity Employer Services Co. “For publicly traded companies, there was the possibility of falling share prices.” — R.B.