Pension risk transfer strategy

I went kayaking today.  When I am on the river my cell phone is in a dead zone and it gobbles up battery life.

That plays into Pension risk transfer strategy because I was having a conversation with Jeff, a former co-worker who is receiving conflicting signals about retirement.  He was driving down from "Up North" and we were chatting away when my cell phone battery went Tango Uniform.

This post is a continuation of our conversation.

The single most informative reading of the tea leaves is in a white paper published by Prudential.  The intended audience is Chief Financial Officers and Pension Fund Managers.  Keep in the intended audience in mind;  when they say risk reduction they don't mean risk reduction for you and me. Full text can be found here:

Key passages:

In 2006, the Pension Protection Act (PPA) was enacted to bring forth broad changes to the U.S. pension system. While most of these changes were intended to secure pension funding levels, thereby protecting benefits for millions of American workers, one key but often overlooked change of the PPA was the favorable restructuring of rules for paying out pension benefits in the form of a lump sum.  (bolding by EatonRapidsJoe)

From a strategic perspective, the new lump sum rules under PPA provide most plan sponsors with a cost–effective benefit risk transfer strategy for both active and frozen plan

By allowing full lump sums, a plan sponsor essentially transfers legacy plan costs to terminating and retiring participants.

The possibility of future interest rate increases might also cause plan sponsors to study the potential advantages and risks of delaying the implementation of a lump sum option beyond 2012. However, it is important to note that the lump sum and ERISA funding rates will generally move in the same direction. Therefore, as rising interest rates will tend to improve the funded status of the plan they will also result in lower lump sum payouts.

By allowing full lump sums, a plan sponsor essentially transfers legacy plan costs following employee terminations and retirements to the plan participants.

For sponsors of frozen pension plans looking for a cost–effective exit strategy to guide them to and through the plan termination process, the lump sum option should be viewed as a primary cost containment lever within that strategy, thus paving the way for a cost–effective terminal annuity at plan termination

As I read this white paper I am struck that there are now legal provisions that allow companies to unilaterally divest themselves of their pension obligations with a lump sum.  One reason this has not happened in a wholesale way is that the out-of-pocket cost drops dramatically as interest rates rise.  Look at the chart to the right of this post.  Many pension plans are under-funded because of the historically low interest rates.  Those same pension plans will be over-funded at +6 percent interest rates.  At that point, it makes a lot of sense for companies and governmental units to liquidate their pension funds by writing a check and sending you on your way.

It appears that there is very soft language that allow companies and governmental units to dismantle their plans when they determine that the administrate costs are "arduous".  That leaves Joe Lunchbucket with a windfall and the responsibility to manage it.  The investment industry vultures will feed well.  Many Joe Lunchbuckets will fall afoul of IRS rules and lose a chunk to a big tax bite.  Inflation and rising interest rates are Siamese twins and the circumstances that trigger the liquidation (higher interest rates) means that inflation will be simultaneously sapping the buying power of the distribution.

I know that I am blessed to have a pension.  I am resigned to the possibility that I might not have one in 12 months after interest rates dance across the point of no-return on the slippery slope of inflation.

I pray a lot.