Pensions is an area which requires deep knowledge of many things. It is a hugely fascinating sub-area in finance on which there is little research.
HBSWK discusses this interesting case study on how GM has tried to pass its management of pension liabilities to a different company. Importantly, it says that despite defined benefit plans becoming history, they are still not dead as those liabilities still have to be paid. With interest rates at record low levels, they have to pump more funds in these funds.
companies are still on the hook for paying benefits to those employees who have already been promised them. As their workers age, employers face the difficult question, How are we going to make good on those promises?
The question is particularly urgent now, says Viceira, who teaches in the area of investment management and capital markets. For starters, the financial crisis depleted many pension plans by dramatically reducing the value of investments, even while companies were still responsible for paying predetermined benefits.
Increasing the pressure are two other factors. Life expectancy has increased, adding to the length of time corporations are required to pay. And interest rates have fallen to historic lows, increasing the funding that companies must set apart to make up for the lower yield on the assets already in place.
“Companies have had to increase their contributions exponentially as interest rates declined,” says Viceira. That strain was a major factor in bankruptcies in the steel, airline, and car industries. More and more, companies are looking for a way out of pension plans, while still making good on their obligations.
They have three choices, says Viceira. The first is to do nothing and continue to invest in equities, hoping the numbers will work out. The second is to work a deal with employees for a lump-sum payment covering the value of their pension, walking away without further obligations. That number can be large, however, and few companies can afford to pay out all that money at once.
Third is to give the pension management to a professional firm:
The final option is for companies to “de-risk” their pension plan by putting assets into more predictable investments that generate enough income while still reducing the risk due to market or interest rate volatility. To do that, some companies are turning to the experts in evaluating risk: insurance companies.
In the HBS case study Prudential Financial-General Motors Pension Risk Transfer: Back to the Future?, Viceira, with Emily A. Chien, wrote about the historic de-risking of GM’s pension plan for salaried employees, a $25 billion deal negotiated last year. GM transferred its assets to Prudential, which then promised to make good on the benefit payouts in the form of guaranteed annuities.