Investment Banks and Pension Liabilities

Every once in a while I am forced to modify a strongly held belief in the face of the withering fire of facts and events. The collapse of financial institutions such as Lehman, Bear Sterns, Merrill and AIG has caused me to reconsider my general faith in the investment banking community's ability to manage risk. More particularly, from the perspective of the employee benefits world, I have reconsidered my view that these financial institutions could provide a solution to help corporate america get defined benefit pension plans off of their financial statements.

It was not too long ago, that I believed that folks who ran ran Investment Banks were better than the rest of us. They were smarter, more creative and they dressed a bit better. They certainly got paid more and they seemed innovative enough to come up with a solution to one of the most pressing issues facing Companies with defined benefit pension plans: how to get rid of them (i.e., get them off of the balance sheet) in a financially efficient way.

For those not into defined benefit pension plans some brief background might help. Defined benefit pension plans provide guaranteed income at retirement as opposed to defined contribution 401(k)-type plans which only guarantee a contribution or match. The long-term liabilities inherent in defined benefit plans are backed by a federal insurance company - the Pension Benefit Guaranty Corporation. The trend away from defined benefit plans has become very pronounced over the past five years for a number of reasons but the balance sheet and income statement volatility caused by these Plans has been a major factor.

However, while many companies have "frozen" their plans by stopping future benefit accruals past the freeze date, they have not been able to get the liabilities accrued prior to the freeze date off of their financial statements. This is because, under the extensive regulatory scheme surrounding defined benefit plans, there are only recognized methods, barring bankruptcy, that companies can terminate them and both approaches have significant financial drawbacks: purchase annuities from an established AAA-type insurance company for all accrued benefits, or convince employees to take a lump sum buy-out.

Buying annuities from insurance companies is very expensive because insurance companies must, by law, invest the proceeds from such a purchase very conservatively, they need to earn a profit and they are culturally risk averse. Paying out lump sums to employees is just as expensive because of laws requiring the use of conservative actuarial assumptions in calculating such lump sums.

Enter the investment banks. Why not hand off the pension plans to these guys. They can manage the investments much more aggressively than an insurance company and with their risk management skills can do so without putting pension benefits in jeopardy. Even after building in their profit, they can take over a pension plan at a much more attractive price than an insurance company or by paying participant lump sums.

This was a win-win for corporate sponsors of defined benefit plans looking to get rid of them and for investment banks looking to get their hands on huge pools of additional assets with which to practice their financial engineering skills.

Amazingly enough, I could have written the last paragraph with a straight face six months ago. In fact, this was a business investment banks wanted to get into and were lobbying the government to allow this third avenue for transferring pension risk.

In September, the IRS formally closed the door on this approach with Revenue Ruling 2008-45 saying that pension buyouts as described above would violate the IRC's "exclusive benefit" rule. Without going through the technical aspects of this ruling suffice it to say that the IRS believed that divorcing pension assets/liabilities from any link with employees would not lead to the ideal management of these plans. And given that the federal government, through the pension benefit guaranty corporation, would assume all unfunded liabilities of plans unable to pay benefits, they have a large stake in insuring that pension plans are managed prudently.

The Administration has followed up with proposed guidelines for future legislation that would allow these types of transactions. In order to protect their insurance liability, the guidelines include a heavy dose of regulation around the companies doing the buying and the underlying fundamentals of the transaction.

Several months of watching investment banks get crushed have made the Revenue Ruling and the Administration's guidelines moot if not downright amusing. No one believes that investment banks are particularly clever at managing investment risks anymore. No doubt about it but purchasing annuities from insurance companies is a very expensive proposition. After all, you are basically investing your money into long-term corporate bonds. But handing off a plan to a place like Lehman, Morgan or Goldman? No way. As they have demonstrated, they are great at taking long-term risks to maximize short-term revenue. What do they care about benefit payments 40 years down the road when their are bonuses to be paid six months from now.

Nothing against these companies or large bonuses but it is now clear that the incentives at these firms are completely misaligned for managing a long-term liability like pensions.

If the Federal Government is on the hook for pension promises not kept by the original plan sponsors or the third-parties who might take them over, they are absolutely right to require a great deal of regulation of these "deposits" including segregated accounts and restrictions on investments. But with that type of regulation, the investment houses will be acting more like insurance companies and providing insurance company returns on investments. Which leads back to insurance company prices. Which leads back to what's the point of making any changes to the whole structure anyway. The regulatory structure is already in place for managing long-term liabilities through established insurance companies. Why more-or-less duplicate the structure by regulating investment banks in the area of pension liabilities?

I have come around. If companies want to get the pension liabilities off of their books, they need to pay the appropriate (read: risk asverse) price. Either go the lump sum route or purchase annuities via the already highly-regulated insurance companies.