Navigating Corporate Pension Plans: Regulatory Funding Obligations, De-risking Transactions, and the Influence of Interest Rates
The interplay between regulatory frameworks, third-party de-risking activities, and interest rates shapes companies’ financial strategies for corporate pension plans, thus impacting the retirement security of workers. Pension Risk Transfer (PRT) activities have been on the rise due to the current challenging economic landscape, with defined benefit pension plan sponsors increasingly conducting annuity buyouts and pension de-risking transfers. Whilst the market volatility caused by COVID-19 had the biggest impact on defined benefit pension plans’ funding, current geopolitical conflicts in Ukraine and the Middle East, combined with high interest and inflation rates, are also impacting pension plan funding and PRT activities. Defined benefit pension plans are facing increasing challenges which are exacerbated by economic volatility, thus making it imperative to examine the effectiveness of existing regulations and the implications of PRT activities in light of evolving market dynamics.
US Regulatory Framework for Corporate Pension Plans
US corporate pension plans are governed by the Employee Retirement Income Security Act of 1974 (ERISA), which regulates rates of funding, vesting, and pay-out for pension plans. Under this federal law, pension plans which are in deficit have a seven-year catch-up period (Section 303(c)(2) ERISA) and only need to achieve a minimum of 95% funding (Section 303(h)(2)(C)(iv)(II) ERISA). This has resulted in chronic underfunding, leading the current private-sector deficit to about $1 trillion.
In 1974, ERISA created The Pension Benefit Guaranty Corporation (PBGC), a government agency whose main purpose is to protect the retirement incomes and pension benefits of American workers participating in private-sector defined benefit pension plans. In the occurrence of underfunded pension plans, the PBGC steps in to pay part of the underfunded pension, acting as federal pension insurance.
Both of these elements create a moral hazard problem as companies rely on such provisions and agencies to let their pension plans go underfunded for long periods, therefore increasing their pension plan liabilities and impacting their balance sheet. The leniency of existing regulations creates opportunities for companies to engage in risky financial practices and potentially jeopardize the retirement security of workers, especially as they rely on the PBGC to bail them out. This inherent inefficiency in the regulatory framework raises critical questions about the potential for regulatory reform to strengthen accountability and mitigate systemic risks.
Why Are Pension Plans Underfunded?
The corporate pension plan regulatory framework’s leniency allows for many firms to have underfunded pensions for years at a time. Companies prefer to underfund their plans rather than pay the full liability, as an underfunded pension plan creates an incentive to take risks and catch up. Companies such as Verizon and Honeywell have taken advantage of the lenient regulation and underfunded their pension plans to use it as a cheap source of debt. This can lead to irrational behaviour, and in the case of low interest rates, it could lead to a pension crisis. Indeed, AT&T saw its pension deficits more than double to $343 billion in early 2015, following the company’s drop of its discount rate from 5% to 4.2% and its use of updated mortality tables to calculate liability.
In addition, underfunding a plan can be a tactic used in union negotiations as a company can leverage this seeming financial constraint to get concessions from unions. One of the noted shortcomings of the 2006 Pension Protection Act (PPA) is that “the PPA benefit restrictions could induce some plan sponsors to intentionally underfund their plans to avoid paying benefits negotiated in good faith through a collective bargaining process.” However, this risk is mitigated by the new 2023 Bill C-228 Pension Protection Act under which defined benefit pension plan deficits will have to be paid in priority to most other creditors.
Further, pension insurances provide free put options for corporations, which may increase the attractiveness of bankruptcy as the company knows that if it fails to fund its pension plan, the PBGC will provide federal pension insurance and take over the pension plan to pay parts of the underfunded pension. Indeed, this is illustrated by the General Motors bailout of 2008, when the General Motors pension fund – then one of the largest US corporate pension plans – was underfunded by 14 percent with pension assets worth $85 billion by the end of 2008 against $98 billion in pension liabilities.
Interest Rates’ Impact on De-risking Transactions
De-risking is the process by which companies offload pension liabilities to a third-party insurer who will take over the company’s pension plan liabilities. These transactions are referred to as net zero as they often involve the simultaneous transfer of pension plan liabilities and assets to a third-party insurer. Indeed, General Motors agreed to provide Prudential Financial with $25.1 billion in assets in exchange for the guaranteed payment of 110,000 participants’ pension benefits in its 2012 pension risk transfer. Such de-risking transactions allow companies to reduce the size of their balance sheet, thus allowing them to focus on the core activity of their business. Whilst pension risk transfers to retirement plan participants and insurance companies are an efficient way to reduce pension plans’ “impact on the balance sheet, income statement and contributions required with funded status volatility, along with reducing PBGC premiums,” such strategies are highly dependent on interest rates.
In order to benefit from de-risking, companies must have fully funded pension plans to transfer them to a third-party insurer. The main driver of pension funding is interest rates because funding pension plans becomes easier as interest rates increase. This is because the liability shrinks and cash contributions to pensions decrease, thus increasing funding levels. Therefore, companies with large pension plans benefit from high interest rates as it allows them to keep their pension debt liability under control and decreases their pension underfunded liability. Conversely, a low interest rate makes such liability larger for the company which can lead to a fall in the funded status. Thus, when interest rates drop, pension plans become underfunded almost mechanically because the liabilities become bigger. The inverse relationship between interest rates and pension liabilities highlights how sensitive pension plans are to market fluctuations. Companies seeking to optimize funding levels and manage pension funding obligations must take into account interest rates’ volatility as a critical component of their funding strategies and de-risking decisions to manage risk.
Between March 2022 and July 2023, the US Central Bank has raised interest rates 11 times in an effort to combat inflation. This hike in interest rates, combined with strong investment returns throughout 2023 as stocks rallied 25 percent, has led to many pension funds nearing or reaching their fully funded status. Corporate pension funding has hit its highest level since the financial crisis as liabilities stabilized, leading to an overall increase of 6.1 percent in the WTW Pension Index from the previous year, ending December 2023 at 107.5 percent funded status. The maintenance of this status remains to be seen, as Goldman Sachs expects five interest rate cuts this year starting in March, potentially impacting pension plan funding further.
The convergence of regulatory considerations, de-risking activities, and interest rate dynamics emphasize the complexity of corporate pension management. Whilst ERISA provides a framework for oversight, the evolving landscape needs constant evaluation and highlights the need for constant adjustments to the regulatory framework to address emerging challenges and mitigate systemic risks. Pension governance must take into account the interplay between regulatory frameworks, market volatility, and stakeholder interests to ensure sustainable pension practices and maintain the integrity of private retirement systems. Successfully navigating corporate pension plans requires a multifaceted approach that balances regulatory oversight, risk management strategies, and market dynamics.
Nastassia Merlino is a Corporation LL.M. candidate at NYU and serves as a Graduate Editor for the NYU Journal of Law & Business and as a Graduate Research Fellow at the NYU Pollack Center for Law & Business. She graduated from the University of Geneva in Switzerland with an LL.B. in General Law, a Certificate in Transnational Law (summa cum laude), and a Master’s in Business Law (magna cum laude). She then graduated from NYU Steinhardt with a Master of Arts in Music Business.