From the May 2009 issue of Treasury & Risk magazine

No Rest on Retirement

There is nothing like a global economic crisis to take the fun out of retirement. Pressured by stagnating sales, underwater investments and severe capital and credit constraints, employers are suspending company 401(k) matches in record numbers, freezing traditional pension plans and wondering how they're going to fund suddenly underfunded plans or otherwise get the liabilities off the balance sheet--not to mention figure out viable ways to recruit and retain talent.

Employees, on the other hand, are tucking away their unopened 401(k) statements in a drawer and planning to work well past their once hoped-for retirement dates, while keeping their fingers crossed that they can hold onto their jobs in the interim. Baby Boomers are in the worst shape; their bountiful investments of two years ago now resemble their skimpy portfolios in the early 1990s, when they thought they would live forever and retire in still-youthful shape. Now, 58% of retirement plan participants surveyed by Barclays Global Investors in April say they plan to work until they die, while 63% say their former certainty about reaching their retirement goals has declined in the past year.

There are few easy solutions to the unprecedented crisis in employee confidence and even fewer examples of companies easing widespread retirement anxieties. Some employers, like cosmetics company Clarins USA, caught some luck for employees by sponsoring innovative annuities that help plan participants lock into a regular income stream from their 401(k) assets for life, thus making a defined-contribution plan more like a traditional, reliable pension. Others took sizable portions of defined-benefit obligations off the balance sheet, like Tecumseh Products, maker of hermetically sealed compressors used in refrigeration applications, which transferred $160 million of pension obligations to an insurance company in 2007. In both these cases, however, timing was the key factor. While both options remain viable, the economic crisis has dulled their glint.

Most employers are like American Electric Power, a Columbus, Ohio-based utility that provides electricity to customers in 11 states. AEP's defined-benefit plan was fully funded going into the economic crisis, with assets of about $4 billion and a liability of about $4 billion. This balanced equation derailed in the last year; the liabilities remain the same but the assets are now "just north of $3 billion," says CFO Holly Koeppel. To get its funding back on track, AEP went out in April and did a public offering of 60 million common shares that raised about $1.69 billion. "We factored in the need to fund a substantial amount of this cash into our pension plan," Koeppel adds.

AEP is far from alone in its pension underfunding. An analysis in March by Watson Wyatt indicates that the aggregate funding of the 100 largest pension sponsors in the United States fell by $303 billion in 2008, a 30% decline from the prior year. The benefits consultancy notes that aggregate funding levels decreased from 109% at the end of 2007 to 79% at the end of last year. A similar analysis by Hewitt Associates puts the funded status of plans even lower. "For every dollar of pension liabilities, companies on average have 65 cents of pension assets," says Joe McDonald, a principal in the benefits consulting firm's Bridgewater, N.J., office.

The consequence? Employers will be required to make "staggering pension contributions over the next couple years, at a time when they can least afford it," says David Speier, senior retirement consultant at Watson Wyatt. In contemplation of these contributions, many employers are cutting back on retirement expenses. Watson Wyatt notes that 12% of employers have either reduced or eliminated their matching contributions for employee 401(k) plans, with another 12% planning to do the same this year. Among them is J.P. Morgan Chase & Co., which announced in April that it had stopped matching 401(k) contributions for its 200,000 employees, "based on the current economic environment."

While suspending the match is an enticing way to save money, it has its unintended consequences. Hewitt Associates estimates that companies will save an average $1,500 per employee. "This means the average large company can save $25 million a year by cutting their match, the average mid-sized company can save more than $10 million, and the average small company nearly $2 million," says McDonald.

Nice money if you can get it, but Hewitt and other benefits consultants warn that eliminating the match can backfire. "It's a disincentive to participate in the plan," says Tom Clark, vice president of Lockton Financial Advisors, which estimates that 20% of its clients have suspended or reduced the corporate match in the last year. "How do you communicate to employees that the 401(k) plan is still a good deal if you have decided it isn't worth it to match their contributions?"

"We're concerned about the suspension of matches," Robert Walter, a principal at Buck Consultants, chimes in. "To the extent these are eliminated, it will cause people to lower their savings rates and not have enough to live on when it comes time to retire. This is a time when savings should increase, particularly in 401(k) plans that are tax-favored."

McDonald shares these views. "We caution employers to cut their match only as a last resort," he says. "When the match is cut, workers are more likely to reduce their own 401(k) contributions or even stop contributing." Even a short break in savings can reduce retirement balances by hundreds of thousands of dollars, he explains. "A younger worker earning $50,000 a year who stops contributing 6% of his or her salary for five years will have $150,000 less in retirement," McDonald adds.

Small wonder that many employers have closed down or frozen their defined-benefit plans. McKinsey & Co. estimates that by 2012, 50% to 75% of private sector defined-benefit plans will be frozen. With such traditional pensions going the way of the buggy whip, underfunded plans requiring steep infusions of cash, and company matches of 401(k) investments falling by the wayside, is Corporate America about to retire retirement?

If so, productivity will suffer--not exactly the antidote to the global economic crisis. "We're in a serious situation in which employees who feel they can't retire will stick around longer than their employers would like," says Bill McClain, a principal at human resources consulting firm Mercer in New York. "Concerned about their retirements, they will be distracted in their jobs and feel less commitment to a company that doesn't take care of them."

Taking care of its U.S.-based employees is a strategic priority at Clarins, which latched onto a novel way to relieve their retirement anxieties in late 2007. Prudential Financial, Clarins' pension plan recordkeeper and trustee, met with the company's CFO, Marc Rosenblum, to introduce him to IncomeFlex. The annuity product guarantees a minimum withdrawal benefit from the plan assets of individual 401(k) participants--even if the account balance declines or becomes depleted because of a market downturn. The annuity essentially guarantees employees a regular income stream for life. "We have both a defined-benefit plan that is currently fully funded and a 401(k) plan, believing firmly that if you want and expect loyalty from employees you have to take care of them," says Rosenblum.

The annuity guarantees a steady lifetime annual withdrawal, based on the highest of three values--the market value of the assets, the highest value of the assets based on the plan participant's previous birthday, or a 5% income growth value. In return, Prudential will guarantee a 5% minimum withdrawal, starting at age 65, for the rest of the retiree's life. If employees change their minds, they can move out of the option at any time free of withdrawal fees. "The concept of a guaranteed return for plan participants had great appeal," Rosenblum says. "It's a good product for a person who knows he or she will retire in a certain number of years and wants to count on a definite income stream to receive--no matter what."

Clarins' employees above the age of 50 years--the product's threshold--were offered five funds from Prudential in which to invest their savings, ranging from conservative to more aggressive. Rosenblum estimates that one-quarter of these plan participants opted for IncomeFlex. "Those who did it back in 2007 gained the greatest benefit, given the current market turmoil," the CFO says. "Obviously, our timing was good when we made it available."

Approximately 130 companies have offered IncomeFlex to their plan participants since the annuity became available in 2007, says Mark J. Foley, a vice president on the retirement income team at Prudential. "No company wants a situation where retirees run out of money and they blame it on their employer," Foley comments. "The product also addresses people's fear about annuities--handing over a check to the insurer and you can't get it back. That's not the case here. You can walk away any time you want. Everything is completely transparent."

There is risk, however. If the insurance company providing the annuity fails, state guaranty funds would pick up some of the company's outstanding debts, though not 100 cents on the dollar. Benefits consultants, for the most part, like the concept. "People distrust financial institutions right now, given the spate of federal bailouts," says Mercer's McClain. "But, for some people uncomfortable about managing a lump sum of money at retirement or faced with the risk of outliving their assets, an annuity can be a way to pool that risk with others and have the assets managed by someone arguably more adept at investing."

The same risk of insolvency arises in the transfer of a pension plan's assets and liabilities to an insurer. Tecumseh Products, with $1 billion in revenues last year, did just that in 2007. At the time, one of the company's defined-benefit plans was "grossly overfunded," explains Tecumseh's assistant treasurer, Jim Zawacki, "and we needed cash, in part because of currency exchange issues dampening our profitability in Brazil, where we have a large presence.... It just didn't make sense to leave untapped cash on the balance sheet."

Tecumseh decided to terminate the plan, extract the overfunding as cash, and commence a new defined-benefit plan for its salaried employees. "Ultimately, we yielded $100 million in cash before taxes, while transferring about $160 million in liabilities to the insurer, MetLife," says Zawacki. "They now hold these assets on their balance sheet, and have to make payments to retirees regardless of the value of these assets."

Tecumseh would not comment on what it paid MetLife to assume the plan and its $160 million in liabilities, but again, timing played a critical role. MetLife would likely charge Tecumseh quite a bit more today were it to absorb its plan assets and liabilities. Benefits consultants explain that annuities are cost-effective in good times and less so in bad. "Transferring pension liabilities in the days of double-digit inflation was inexpensive, which is why many companies took this route in the 1970s and early 1980s," McClain says. "Today, a company with $100 million in liabilities is looking at paying an insurer $110 million to $115 million to get it off the balance sheet."

Walter at Buck Consultants gauges the cost even higher, at 20% for fully funded plans, depending on a wide mix of variables like the demographics of plan participants and the asset allocation mix. For some companies the cost may be worth it. "It depends on the needs of the business, how investors will look at its balance sheet and whether or not it is a good way of using cash," he says.

MetLife does not publicize its fees for the pension risk transfer product or the number of companies that have engaged it. But, Cynthia Mallett, vice president of its corporate benefit funding group, says employers don't have to buy into the concept whole hog. "We're finding tremendous interest right now in partial risk transfer solutions, using the product to manage financial effects on the balance sheet," she says. "For example, if you have acquired several companies in recent years and inherited their defined-benefit plans, you may want to pick a core plan and move the others off the balance sheet."

Hewitt's McDonald says the concept is a "viable strategy, but one that is not happening very much at the moment." He notes that in a recent survey, only 5% of the company's Fortune 500 clients responded affirmatively to a question asking whether they had transferred pension assets and liabilities off their balance sheet or were considering it. "It's dormant but still practical," he says. "Two years ago would have been the opportune time."

As with everything these days, two years ago is a time we shall all remember fondly.

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