Private equity firms acquiring portfolio companies with defined benefit pension schemes often overlook the financial risks associated with these funds. ((See JP MORGAN: ‘DERISKING’ TO CONTINUE, LED BY BUYOUTS, MORE FIXED INCOME, 20 No. 7 Pension Plan Fix-It Handbook Newsl. 6 (2013) [hereinafter ‘DERISKING’].)) For private equity firms, the opportunity to realize additional value through efficient risk management of the pension fund by de-risking is an important consideration facilitated by the passage of the Pension Protection Act of 2006 (PPA). ((29 CFR 2509.95-1.))
What is Pension De-Risking?
Since the passage of the Pension Protection Act (PPA) in 2006, pensions are increasingly treated as long-term liabilities that need to be tightly funded and accounted for on a short-term basis. With the passage of the PPA, Congress substantially increased the interest rate assumption that employers use to calculate lump sum pension payments. ((See Jack VanDerhei, Retirement Income Adequacy After PPA and FAS 158: Part One – Plan Sponsors’ Reactions, 307 Emp. Benefit Res. Inst. (2007).)) Thus, corporations were able to decrease costs through employees’ acceptance of lump sum payouts. ((See id.))
In 2012, the effects of the PPA were fully phased in. This, combined with the increasing volatility of the market has led to predictions that pension de-risking transactions will continue to become more prevalent. ((See National Retiree Legislative Network, Pension Plan ‘De-Risking’: Strengthening Fiduciary Duties to Protect Retirees 9 (2013).)) Most recently, de-risking through transferring assets to third party insurance companies has been receiving the most attention. ((See ‘DERISKING.’)) These transactions, called group annuity contracts, can be enormously beneficial, but the complex legal and governance issues can represent severe barriers to the benefits of these transactions. ((See id.)) For example, a thorough evaluation of the financial and legal strength of the annuity provider is necessary to avoid lawsuits from plan holders alleging that the company mismanaged pension obligations. ((See id.)) Likewise, governance issues, such as the information dispensed to plan participants and shareholders along with the consideration of any third party contracts that may need to be unwound in the event of a transfer, are important considerations necessary to avoid liability.
Two recent deals have led companies and private equity funds to realize the potential in pension de-risking through group annuity contracts. In June 2012, General Motors Company announced a deal that it had struck with The Prudential Insurance Company of America (Prudential) for the purchase of over $26 billion worth of annuity contracts to satisfy its pension obligations to approximately 42,000 salaried retirees. ((See Nancy G. Ross & Sam Myler, The Risks of De-Risking to Eliminate Company Pension Liability, Corporate Counsel (Jan. 30, 2013), http://www.law.com/corporatecounsel/PubArticleCC.jsp?id=1202586180856&The_Risks_of_DeRisking_to_Eliminate_Company_Pension_Liability&slreturn=20130530151602 [hereinafter Risks of De-Risking].)) In October, Verizon Communications Inc. announced its own buyout deal with Prudential, this one involving the purchase of $7.5 billion in obligations. ((See Risks of De-Risking.)) The size of these transactions and prominence of the parties has led to speculation that these deals may be the beginning of a significant trend toward de-risking through massive plan-wide buyouts.
Guidelines and Duties Requiring Consideration for Pension De-risking Transactions
Given the high cost and participant involvement of these complex transactions, attention must be paid to compliance issues. These issues are particularly salient for private equity funds, where ability to exit quickly and avoid costly litigation is of utmost importance. The selection of an annuity provider is considered the most important decision a private equity fund will make in these transactions. ((See Noam Noked, Court Rejects ERISA Challenge to Pension De-Risking Transaction, HLS Forum on Corp. Governance (Jan. 12, 2013, 9:24am), http://blogs.law.harvard.edu/corpgov.)) To further assist with this decision, the Department of Labor issued the Interpretative Bulletin 95-1 (the IB) in 1995. The IB makes it clear that fiduciaries must make all efforts to select the “safest annuity available.” ((29 CFR 2509.95-1.)) The private equity fund must abide by three duties established by ERISA. ((See Candace L. Quinn et al., Squire Sanders, Hot Topics for Plan Fiduciaries in Today’s Litigious Environment: How to Mitigate Risks of Liability (2013).))
First, the duty of loyalty to plan participants must be observed. ((See Sarah A.W. Fitts et al., Pension Derisking: The Critical Role of the Independent Fiduciary, 7 Debevoise & Plimpton Financial Institutions Report 11 (2013).)) It requires that plan fiduciaries make decisions concerning the disposition of plan assets with a single eye to the interests of participants. ((See id.)) This duty applies when making the selection of an annuity provider. A plan sponsor would undoubtedly risk claims by participants that the sponsor breached its duty of loyalty to the participants if evidence was uncovered that the fund chose an annuity provider based on business relationships with the provider or the cost of the annuities to the company
Second, the duty of prudence implemented by ERISA requires that fiduciary decisions be made with the appropriate degree of skill, prudence, and diligence necessitated by the circumstances. ((See Risks of De-Risking.)) The duty of prudence demands that the plan sponsor thoroughly considers the insurer’s solvency, the diversification of its investments, the size of the buyout relative to the size of the insurer and any other considerations that may bear on the security of the participant’s annuity under the contract to ensure that the pension obligations are satisfied. ((See id.))
Finally, fiduciaries have a duty to pay participants the benefits they are owed under the plan. ((See Risks of De-Risking.)) Issues can arise when participants believe that they are not getting the entire benefit owed under the plan. When selecting an annuity, the plan sponsor must ensure that the annuity is able to fulfill the promised benefits under the plan. If the plan sponsor selects an annuity that provides payments inconsistent with what the participant is owed, participants will likely bring claims that the plan sponsor breached its obligation under the plan and violated fiduciary duties owed to the participants.
Most private equity funds seek to exit the portfolio company in a tight time frame, so it is essential that private equity investors have a strategy for tackling the defined benefit pension plan before taking on risk exposure to the pension fund. Any de-risking objectives must begin with risk quantification, especially considering the potential solutions to minimize risk and the associated costs. The success of de-risking through group annuity contracts will likely lead private equity funds to find de-risking solutions through massive plan wide buyouts while ensuring compliance with fiduciary duties to reap the maximum benefit of these transactions.
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