Defined Benefit Plans: Proposed Plan Buyouts by Financial Firms Pose Potential Risks and Benefits
Published: 2009-03-16T00:00:00

Fast Facts:

Highlights:
section_title: Why GAO Did This Study
paragraphs: Some U.S. financial and pension consulting firms have recently proposed alternatives to terminating a defined benefit (DB) pension plan and contracting with insurance companies to pay promised benefits. In their proposals, a plan sponsor would typically transfer the assets and liabilities of a hard-frozen DB plan--one in which all participant benefit accruals have ceased--along with additional money, to a financial entity, which would become the new sponsor. Such buyouts would have implications for participants, plan sponsors, and the Pension Benefit Guaranty Corporation (PBGC), the federal agency that insures private DB plans. This report addresses the following questions: (1) What is the basic model of proposed sales of frozen DB plans to third-party financial firms and how does it compare with a standard plan termination? (2) What are the potential risks and benefits of plan buyouts for participants, PBGC, plan sponsors, and other stakeholders? To address these questions, GAO reviewed proposed models for plan buyouts and analyzed regulatory and statutory issues associated with terminations and buyouts. GAO also interviewed labor and pension advocacy groups, pension regulatory agencies, and pension experts.
section_title: What GAO Found
paragraphs: In proposed DB plan buyouts, a third-party financial company would take over sponsorship of a hard-frozen plan from the original sponsor, in exchange for money to compensate for plan underfunding, expenses, and risk. As with a standard plan termination, the objective of a buyout would be to allow the original sponsor to shed its obligations to the plan, but potentially at lower cost and possibly with greater flexibility. In buyout proposals, the new sponsor would assume all plan responsibilities and PBGC guarantees would continue to apply to plan benefits. In comparison, a standard termination ends the plan, and an insurance company contracts to pay accrued benefits to participants (to the extent participants' benefits are not paid out by the plan as part of the termination); PBGC guarantees no longer apply, but state guarantees do. Insurance companies generally must comply with state-based risk-based capital requirements, which may provide safeguards against insurer insolvency and protections for pension benefits paid this way. In some cases, plan buyouts could increase the security of DB pensions by allowing weak sponsors to transfer plan sponsorship to firms with stronger financial backing and improved plan management. However, buyouts would sever the employment relationship between sponsors and participants, possibly eroding incentives to manage the plan in the interests of participants. Buyouts could increase the risk of a large claim against PBGC by increasing the concentration of assets and liabilities held by a single sponsor or sector. They could also lead to conflicts between agencies regulating financial companies and those regulating pensions. In August 2008, the Internal Revenue Service issued a ruling declaring that a DB plan that was bought out by a nonemploying entity would not qualify for tax preferences under current law.

section_title: Letter
paragraphs: In recent years, a number of prominent U.S. employers have terminated  their defined benefit (DB) plans. Other pension plan sponsors have frozen  their plans, either by closing them to new participants or by slowing down  or ceasing the accrual of additional benefits to existing participants.  Provisions of the Pension Protection Act of 2006 (PPA), which established  more stringent plan funding requirements, and recent Financial  Accounting Standards Board (FASB) standards, which require additional  financial reporting for DB plan sponsors, place more requirements on DB  plan sponsors and could possibly lead to more freezes and terminations in  upcoming years.
A sponsor generally may terminate a DB plan and shed all plan  responsibilities either by hiring an insurance company to pay all accrued  benefits to participants through a group annuity contract or, if the plan  permits, by paying the benefits owed in a different form (such as a lump- sum distribution). In recent years, some U.S. financial institutions and at  least one pension consulting firm have proposed an alternative to this  “standard” termination model in which a plan sponsor would engage a  financial entity to take ownership of the assets and liabilities of a hard- frozen DB plan, or one in which all participant benefit accruals have  ceased, with the financial entity becoming the new sponsor. Such  transactions carry potential risks and benefits for participants, plan  sponsors, and the Pension Benefit Guaranty Corporation (PBGC), the  federal agency that insures private pension benefits. Government officials,  pension advocates, and some academics have expressed concerns that  these new arrangements would place the responsibility for managing DB  plans on firms that have no employment relationship with the participants,  and potentially increase the risk of losses to participants and PBGC;  proponents argue that such arrangements will improve the security of  benefits and provide better overall plan management. In August 2008, the  Internal Revenue Service (IRS) ruled that such DB plan buyouts by a  nonemploying entity would not qualify for tax preferences under current  law, effectively prohibiting this new type of arrangement. At the same  time, the Department of the Treasury (Treasury) issued guidelines,  developed with the Departments of Labor (Labor) and Commerce  (Commerce) and PBGC, that could be used to shape legislation that would  allow tax preferences for such nonemployer plans, should Congress  choose to do so.
In light of these issues, you requested that we examine these proposed  transactions in greater detail. Specifically, this report addresses the  following questions:  1.  What is the basic model of proposed sales of frozen DB plans to third- party financial firms and how does it compare with a standard plan  termination? 2.  What are the potential risks and benefits of plan buyouts for  participants, PBGC, plan sponsors, and other stakeholders?
To learn about proposed plan buyouts by third-party sponsors in the  United States, we interviewed individuals from several financial  institutions and from a pension consulting firm that have publicly  expressed an interest in engaging in such transactions. We also reviewed  and assessed literature from these companies describing their proposed  business models for plan buyouts. We spoke with pension practitioners  and government representatives in the United Kingdom (UK) to identify  and analyze plan buyouts that have taken place there, as well as to discuss  the British pension regulatory structure and pension plan governance. To  compare proposed buyouts with plan terminations, we spoke with officials  from IRS and pension and bank regulatory agencies, from insurance  companies and organizations, and from companies proposing buyout  models.
To analyze key regulatory and statutory issues associated with DB plan  buyouts and identify the potential impact of buyouts on participants,  PBGC, plan sponsors, and other stakeholders, we interviewed  representatives from labor and pension advocacy groups, pension experts,  pension regulatory agencies, and the Federal Reserve Board (FRB) and the  Office of the Comptroller of the Currency (OCC). We also discussed the  nature of current government oversight of insurance companies that issue  group annuities for terminated plans with insurance industry experts and  regulators, and we reviewed rules describing the regulatory safeguards  and benefit guarantees for group annuities issued by insurers. Finally, we  reviewed laws governing the sponsorship of pension plans and relevant  government statements regarding plan buyouts.  We did not assess  Treasury’s suggested guidelines for buyouts issued concurrently with the  August 2008 IRS revenue ruling.
subsections: section_title: Background
paragraphs: By many measures, PBGC-insured private sector DB plans have been in  decline since the 1980s. As of 2007, companies sponsored around 30,000  DB plans, down from over 114,000 in 1985. The total number of  participants in these plans rose from 38 million to 44 million over this time  period, but according to the most recent data available, the percentage of  the active workforce covered by a DB plan fell from 31 percent in 1985 to  17 percent, as of 2005. Also, the percentage of DB participants who are  retirees has grown steadily, to where they made up over one-quarter of all  DB participants in 2005. PBGC has seen its net financial condition hurt by  losses from the termination of large underfunded plans this decade. After  reporting a surplus as recently as 2001, PBGC’s insurance programs  reported a combined net accumulated deficit as high as $23.5 billion in  2004 before improving to over $11 billion as of the end of fiscal year 2008.
Under the U.S. voluntary, tax-preferenced pension system, employers can  choose to form, terminate, or freeze plans. Both plan terminations and  freezes can reduce potential retirement income from DB plans for future  retirees. A termination occurs when a sponsor ceases to operate a plan  and agrees to disburse all accrued benefits to participants, whereas a  freeze limits or halts some or all future pension accruals for some or all  participants. Under the Employee Retirement Income Security Act of 1974  (ERISA), the primary federal law governing DB plans, plan sponsors may  terminate a fully funded plan (called a standard termination) by  purchasing a group annuity contract from an insurance company, under  which the insurance company agrees to pay all accrued benefits, or, if the  plan permits, by paying participants the benefits owed in a different form,  such a lump-sum distribution. If the plan does not have sufficient assets  to pay all vested benefits owed to participants, and a company is in  financial distress, the sponsor may file for a “distress” termination with  PBGC. Under these circumstances, PBGC pays benefits to participants up  to specified limits, using its own assets and any remaining assets in the  plan. PBGC may also initiate termination of a plan if a plan cannot pay  benefits when due or if the loss to PBGC is expected to grow unreasonably  without termination. From 1990 to 2006, sponsors voluntarily terminated  over 61,000 sufficiently funded single-employer plans.
A plan freeze limits some or all future pension accruals for some or all  participants, but does not terminate the plan. Freezes can take various  forms: a soft freeze, which closes the plan to new entrants and may limit  benefit accruals based on a component of the benefit accrual formula; a  partial freeze, which changes the plan’s benefit formula to reduce future  accruals for a subset of active participants; and a hard freeze, which  ceases all future accruals, with no additional benefits granted for future  years of service or salary gains for any workers. A recent GAO survey  found that 21 percent of all active participants in single-employer DB plans  are affected by a freeze, with hard freezes accounting for about half of all  freezes (although larger sponsors are significantly less likely to have a  hard-frozen plan than smaller ones). A separate PBGC study found that  14 percent of plans were hard-frozen as of 2005, with a nearly 50 percent  increase in frozen plans since 2003.
Some pension experts expect plan freezes and terminations to persist or  increase in the near future, partly because of recent changes in pension  requirements. The PPA tightened certain funding rules for DB plans,  which may discourage some sponsors from continuing to operate a plan or  offer ongoing benefits accruals. The PPA reduced the period allowed for  filling in funding shortfalls from up to 30 years to 7 years. Previous funding  requirements had allowed sponsors to smooth DB plan asset values over 5  years, and use a 4-year average of interest rates to measure plan liabilities,  rather than reporting assets and liabilities based on current market  measures; this helped dampen plan funding volatility from year-to-year  swings in market conditions. The PPA reduced the smoothing period for  reported assets to 2 years, and reduced the period for averaging interest  rates used to measure liabilities to 2 years, changes that could increase the  volatility of reported plan funding. In addition, new accounting standards  will require DB sponsors to report their pension liabilities and assets on  their balance sheets in more transparent ways than in the past. In a recent  GAO survey, the primary reasons cited for freezing plans were the cost of  plan contributions and the volatility of plan funding. About a third of  sponsors of frozen plans in the survey said they will ultimately terminate  the plan, and over 60 percent were unsure of their future course. Outside  experts are also not optimistic about DB plans in the near future: One  study by McKinsey & Company predicts that 50 to 75 percent of all private  sector DB assets will be in frozen or terminated status by 2012. Another,  by Watson Wyatt, stated that plan freezes and terminations may have  declined in 2007 after a peak in 2006; however, turmoil in the financial  markets in 2008, with plummeting values in stocks, could severely  negatively affect the funding of many DB plans, and could lead to  increased plan freezes or terminations if required contributions rise  significantly. The recently enacted Worker, Retiree, and Employer  Recovery Act of 2008 provides DB sponsors with some temporary relief  from some of these new requirements in response to the current financial  crisis.
On August 6, 2008, IRS issued a revenue ruling declaring that the transfer  of a pension plan to “an unrelated taxpayer,” without the concurrent  transfer of significant business assets, operations, or employees, such as in  a merger or business acquisition, would violate the “exclusive benefit” rule  of the Internal Revenue Code (IRC). This rule provides that any pension  plan must be operated for the exclusive benefit of a sponsor’s employees  and their beneficiaries. This means that under current law, generally any  plans transferred to a nonemployer sponsor would not receive the same  tax benefits an employer-sponsored plan would, including but not limited  to the tax deferral on sponsor contributions and the return on plan assets.  According to the Treasury Department, as a result of this ruling,  companies will be unable to take over any pension plans, frozen or active,  except as part of a business merger or acquisition.
section_title: Proposed Plan Buyouts Would Offer Sponsors an Alternative to Standard Plan Terminations, with Significant Differences
paragraphs: Under proposed models for DB plan buyouts, a plan sponsor would  transfer plan assets, along with funds to cover any plan underfunding, plus  additional money to compensate for risk and administrative costs, to a  financial company. The financial company would become the new plan  sponsor, taking over all obligations of the original sponsor. These types of  buyouts would typically, but not necessarily, target hard-frozen plans, or  portions of plans, in which participants are no longer accruing benefits,  limiting some of the incentive problems of having a plan sponsor who is  not the participants’ employer. The new sponsor would be able to keep  money above the minimum funding levels required by ERISA outside the  plan and eventually keep whatever money in the transaction was not  needed to pay for plan funding and expenses. A plan buyout, like a  standard plan termination via an insurance company, is intended to allow  the sponsor to transfer all plan responsibilities to another company, but  possibly at lower cost than a termination. In addition, the sponsor taking  over the plan would face different regulatory requirements than an  insurance company contracting to pay benefits from a terminated plan,  including different oversight, financial requirements, and benefit  guarantees.
subsections: section_title: Proposed Plan Buyouts Seek to Offer Alternative to Termination, with Possible Flexibility and Cost Advantages to Plan Sponsors
paragraphs: While there are different models for DB plan buyouts, the basic  transaction would involve the transfer of the assets and liabilities of a  pension plan from a plan sponsor to a financial entity. The original  sponsor would set up a corporate subsidiary, into which it would put the  pension plan (see fig. 1). The original sponsor would arrange for the  pension assets to be held by or transferred to a trust designated by the  subsidiary; in addition, it would transfer to the subsidiary enough cash or  other assets to cover any plan underfunding. It would also provide  additional money to cover the new sponsor’s administrative costs and to  compensate for the risk associated with plan sponsorship, which could be  kept outside the plan. Risks include factors that could affect the future  value of plan assets and liabilities, such as investment performance,  interest rates, or mortality rates. The subsidiary could also include a  relatively small number of employees from the original sponsor, such as  those administering the plan. The financial company would then take over  ownership of the subsidiary and become the new plan sponsor. The  objective of the original sponsor, the employer, would be to shed all of its  sponsorship responsibilities and liabilities.
Available for future  required plan contributions  or for the new plan  sponsor to keep as profit.
The distinction between assets in the plan versus those outside represents  a key detail of any plan buyout. In general, if a sponsor withdraws excess  assets from an overfunded DB plan, this action would trigger a 50 percent  excise tax as a “reversion,” in addition to corporate income tax. Money  outside the plan would be available for future contributions to the plan if  additional funding is needed; however, should the new sponsor be  successful at growing plan assets up to a level sufficient to pay accrued  benefits and administrative expenses, the company may be able to keep  this money as profit without this money being subject to the reversion tax.  Thus the new sponsor, similar to any sponsor, has an incentive to keep as  much money as possible outside the plan itself while meeting ERISA  minimum funding requirements.
Representatives of firms that have expressed an interest in taking over  plans said that their firms would most likely target slightly underfunded  plans. It would, most likely, be difficult for the sponsor to include enough  cash to convince a financial entity to take over a plan that was below 80  percent funded in a buyout, considering the funding gap and the premium  the new sponsor would charge to take over the plan. They also said that  hard-frozen plans would be the simplest types of plans to buy out. In a  hard-frozen plan, the absence of future benefit accruals for salary  increases and time of service limits potential sources of funding  uncertainty. However, even in a hard-frozen plan, changes in interest rates  or mortality assumptions could increase or decrease the valuation of plan  liabilities, and investment performance can affect plan asset levels,  possibly triggering additional contributions to maintain plan funding at  legally required levels. Buyouts would not necessarily be limited to hard- frozen plans; however, transferring sponsorship of an active or soft-frozen  plan would be more complicated, since participants would continue to  accrue benefits in these plans. This would create a problematic incentive  for the new sponsor to freeze the plan and cease all accruals in order to  avoid paying ongoing benefits to participants that work for another firm. If  buyouts were allowed to include soft-frozen or active plans, explicit  regulation or contractual language would likely be required to assure  ongoing benefits and applicable ERISA protections to participants.
From the point of view of the plan sponsor, a buyout would serve a  function similar to plan termination, since in both cases an objective of the  sponsor is to shed responsibilities associated with the plan. Buyouts seem  to offer two potential advantages to the sponsor: flexibility and cost. A  plan buyout could offer flexibility if sponsors were allowed to shed only a  portion of a plan, rather than terminating the entire plan. For example, a  sponsor could segregate the benefits for retirees or former employees and  sell this “legacy” portion of a plan to a new sponsor, with assets moving to  the new sponsor to cover only the benefit liability for these participants; a  buyout of this kind would resemble that of a hard-frozen plan in that  benefits for retirees and separated employees have ceased accruing. If this  arrangement were allowed, the employer could then keep its current  workers, or active participants, in the original plan that it continues to  sponsor.
Buyouts may also cost the sponsor less than a termination of the same  plan. This cost difference may reflect the differences in assumptions  appropriate for an ongoing plan, which would be the case for a buyout, as  opposed to a terminating plan whose benefits an insurance company  would contract to pay. The financial entity taking over sponsorship of an  ongoing plan would be taking on liabilities recorded at “current liability”— that is, using the assumptions for discount rates, smoothing, mortality, and  other factors as prescribed by ERISA funding requirements for ongoing  plans. ERISA funding rules allow sponsors to report measurements of plan  assets based on an average over a designated period of time and of  liabilities using an average of recent interest rates. Using such smoothed  values dampens the year-to-year volatility in funding levels and required  contributions compared with using current market values. In contrast, an  insurance company prices a plan’s liabilities based on assumptions  appropriate for a terminating plan, or “termination liability.” An insurance  company may also consider in its price the risk of future improvements in  mortality beyond those currently projected and the risk of taking on the  obligation to pay benefits without the possibility of collecting future  premiums. Other differences between insurance company prices and  current liability could include (1) a more conservative rate-of-return  assumption reflecting the investments used to support annuities, (2) an  underlying interest rate used to value liabilities based on current market  values rather than smoothed values, and (3) an assumption that  participants in a terminated plan will retire somewhat earlier than those in  an ongoing plan. It is unclear to what degree the assumptions a firm  taking over an ongoing plan would reflect current liability or termination  liability, but prospective financial sponsors said they expected to be able  to compete with plan termination prices.
From the acquiring sponsor’s point of view, a plan buyout could offer  access to new investment capital, although with the restrictions facing all  DB plans regarding ERISA funding requirements and the tax on the  reversion of plan assets. Buyouts could also provide a strategy for funding  multiple plans by merging the assets and liabilities of an underfunded plan  with the excess assets of a similarly overfunded one. While any sponsor  can merge plans, buyouts might facilitate such a strategy. On net, the  change in risk of underfunded benefits might be balanced across the  participants in underfunded and overfunded plans, but workers whose  previous sponsor had funded a plan to ensure that benefits would be paid  might not favor their plan’s surplus funding other workers’ benefits at their  expense.
section_title: Plan Buyouts Would Differ in Key Ways from Plan Terminations
paragraphs: While proposed plan buyouts are intended to provide a similar function to  plan sponsors as plan terminations, they differ in many important ways,  including the treatment of the plan, applicable regulatory requirements,  protection of plan benefits, and fiduciary responsibilities (see table 1).  Fundamentally, a plan buyout differs from a termination because the  buyout treats the plan as an ongoing concern, while a termination ends the  plan. In a buyout, the new sponsor would presumably have to fund the  plan according to ERISA minimum funding requirements and make all  plan disclosures. The sponsor would pay PBGC premiums, and PBGC  guarantees would continue to apply to plan benefits. Oversight of the  plan would remain within the jurisdiction of federal pension regulatory  agencies: PBGC, Labor, and Treasury.
In contrast, a standard plan termination ends the plan itself. If the sponsor  purchases an insurance company annuity contract, payment of plan  benefits that are covered by the contract becomes the obligation of the  insurance company, which is regulated by state insurance bodies. State  regulation of insurance companies is grounded in statutory valuations of  an insurer’s assets and liabilities and risk-based capital requirements, as  laid out by the National Association of Insurance Commissioners (NAIC),  the organization of state insurance regulators. Risk-based capital refers to  the amount of assets an insurer holds in order to ensure that it can pay its  obligations, which in this case would mean the accrued benefits in the  plan. Regulators set the amount of risk-based capital a firm must hold  depending on different categories of risk, including asset risk, insurance  risk, interest rate risk, and business risk, with firms deemed to hold riskier  obligations or operations forced to hold more assets against those risks.  Because asset risk is one of the risk categories considered by regulators,  insurance companies have an incentive to invest conservatively. NAIC  guidelines suggest that an insurer hold total capital levels of at least 200  percent of the minimum risk-based capital requirements to avoid any  corrective action. If the insurance company has total capital levels below  this percentage, regulators could take a variety of corrective actions,  ranging from requiring the company to report how it intends to raise its  capital levels to a state takeover of the insurer.
In a buyout, depending on the institutional nature of the purchasing entity,  the new sponsor may also face capital requirements. For example,  regulators for banks and other regulated financial institutions, including  OCC, FRB, the Federal Deposit Insurance Corporation (FDIC), and the  Office of Thrift Supervision (OTS), look at capital and leverage ratios to  assess whether banks are holding enough capital based on those identified  risks to ensure the safety and soundness of the banks and bank deposits.
Government guarantees backing up plan benefits would also differ under  buyouts and terminations. With plan buyouts, PBGC would continue to  guarantee benefits for participants of bought-out plans in the event the  new sponsor could not pay because of financial distress. In contrast, for  benefits paid by insurance companies following plan terminations, state  insurance commissions maintain guaranty funds, funded by insurance  companies (on a post insolvency basis), which can be used to pay  policyholders in the event of insurer insolvency. Guarantee limits vary by  state, but all states provide coverage of up to at least $100,000 per  beneficiary for annuities, according to the National Organization of Life  and Health Insurance Guaranty Associations (NOLHGA). This limit would  not be as high as PBGC guarantees for distress-terminated plans for some  beneficiaries, but NOLHGA claims that guarantees have allowed over 90  percent of policyholder benefits to be paid in full during past insolvencies,  similar to PBGC’s success to date in covering pension benefits in distress  terminations. Partly, this is due to assessments the state guaranty  associations can levy on other insurance companies to collect additional  money to pay policyholders.
In addition, sponsor fiduciary requirements could differ between buyouts  and terminations. Pension plan sponsors have a fiduciary duty to manage  plans solely in the interest of plan participants and beneficiaries. While  the decision whether or not to terminate a plan is generally viewed as  outside the management of a plan and not covered by this duty, should a  decision be made to terminate a plan, the selection of an annuity provider  is a covered fiduciary duty. Labor has interpreted this duty as generally  requiring DB plan sponsors to choose “the safest available annuity” and  has published explicit factors for sponsors to consider when making such  a selection. According to insurance representatives with whom we spoke,  this has typically meant that AA-rated companies or stronger have  dominated the DB plan termination market. Further, a purchase of an  annuity by a sponsor of a terminating plan establishes an “irrevocable  commitment,” as required by ERISA, that all plan benefits will be paid.  While it is possible that similar fiduciary standards could apply in the case  of DB plan buyouts by financial entities, the law, having not contemplated  such transactions, does not specify explicit standards.
section_title: Some Plan Buyouts Could Benefit Participants and PBGC, but in General Pose New Risks
paragraphs: DB plan buyouts by financial companies could, in some cases, improve the  security of benefits. Those buyouts in which weak sponsors of  underfunded plans, who otherwise would choose not to terminate,  transferred their plans to companies with stronger financial backing and  superior pension financial management could improve plan funding and  decrease the risk of distress termination. PBGC would, in addition, benefit  from the continued premiums new sponsors would pay for insurance on  their plan benefits, as opposed to premiums ceasing when a plan is  terminated. However, these advantages would seem to apply in only a  small subset of potential buyouts, and would likely provide limited upside  for participants and PBGC. Further, plan buyouts could create risks for  various pension stakeholders. For example, the new sponsor assuming  responsibility for paying plan benefits would not have an employment  relationship with participants, raising concerns about its incentives to  manage the plan for the exclusive benefit of participants. Buyouts may  also raise risks to PBGC, depending on the structure of the transaction, in  that a financial sponsor taking on several plans may become weak, and  PBGC may have limited authority to intervene to prevent risky buyouts.  Further, the recent financial crisis has highlighted the emergence of  serious and previously unforeseen risks with financial companies, even  among firms that had been considered strong. Buyouts by financial  sponsors may also create regulatory ambiguities and conflicts between the  goals of agencies regulating financial sponsors and those regulating  pensions. (See table 2 for potential risks and benefits of plan buyouts.)
subsections: section_title: Some Plan Buyouts by Financially Strong Sponsors Could Increase Benefit Security for Participants and PBGC
paragraphs: Advocates of allowing pension plan buyouts point to a potential “win-win- win”: more options and lower cost for sponsors who wish to shed their  pension plans, more security for participants than a weak sponsor can  provide, and reduced risk of large claims from distress terminations for  PBGC. Plan sponsors could benefit from buyouts if they provide a cheaper  means for shedding a pension plan than terminating the plan through an  insurance company. Buyouts could also allow sponsors to shed just a  portion of the plan while maintaining sponsorship for a smaller plan. To  the extent that the lower cost of plan buyouts reflects a competitive  advantage over a plan termination without increasing pension risk,  buyouts can be viewed as a beneficial financial innovation.
Buyouts could add security for plan participants if the new sponsor can  manage plan assets and liabilities better than the original sponsor, if the  original sponsor could not terminate the plan. The financial backing of the  assets of a large, diversified, and well-capitalized parent company or of  large amounts of investment capital could better ensure that assets will be  available to pay promised benefits. It could also lower the likelihood that  PBGC would face a future claim from distress termination, since a  stronger sponsor would be in a better position to keep the plan funded and  be less likely to face financial distress than a weaker one.
section_title: Pension Buyouts by Financial Entities May Pose New Risks and Regulatory Challenges
paragraphs: While buyouts could provide more security for plan benefits in some  cases, they may also create new risks that could adversely affect benefit  security. These include the severing of the plan from a direct employment  arrangement between employer and employee, the ability of PBGC to  monitor and intervene in buyouts that could have adverse implications for  participants and PBGC, and potential conflicts and issues between the  regulatory missions of PBGC and various financial regulators.
Buyouts would affect the relationship between sponsor and participant by  separating it from an employment arrangement, possibly raising concerns  about the management of participants’ pension benefits and the long-term  effect on the DB system. With an employer-sponsored plan, the financial  fate of the plan depends to a large degree on the financial fate of the  company, since a healthier company is better able to fund its DB plan and  the plan will not endure a distress termination as long as the company  thrives. Opponents to buyouts contend that even in the case of a frozen  plan, an employer sponsor, as opposed to a third-party sponsor, has a  greater incentive to manage the plan in the interests of its employees  because it has an incentive to maintain a good working relationship with  them. In addition, a frozen plan that remains within the firm has at least  the chance of being “thawed,” especially within a collective bargaining  agreement. Workers may also have a relationship with plan  administrators within their own company, and may worry about  addressing concerns when dealing with administrators of a new sponsor  outside their company. Further, the option of plan buyouts for frozen  plans as a less expensive alternative to plan termination may provide an  incentive for existing sponsors to freeze their plans, an act that could  reduce future retirement income for participants.
Buyout proponents argue that the employment relationship plays a  diminished role in hard-frozen plans, which would be the primary target of  buyouts. Because these plans offer no future accruals, they serve a very  limited ongoing function of providing benefits to employees, and therefore  likely do not play a strong role in attracting or retaining workers. As one  advocate also pointed out, DB plans can change sponsorship as a result of  company mergers or acquisitions, which could result in a situation where  the new sponsor becomes responsible for managing the benefits of a  participant it has never employed (such as a worker who has left the firm  prior to the merger and change of sponsor). However, the IRS ruling  suggests that the underlying employment relationship between plan  sponsor and participant is fundamental to the rationale for the tax-favored  status of qualified plans.
The buyout of plans by a nonemployer may also create some perverse  incentives or ambiguities in applying rules that guide how the sponsor may  interpret participant benefits or rights. One key issue concerns whether a  participant who had not yet reached the minimum service time with his  employer would continue to accrue service time after the plan changes  sponsors. For example, a plan may require a minimum of 5 years of service  to be able to qualify for benefits upon retirement. A worker may have 4  years working for an employer when the company sells its pension to a  financial entity, which would become the new sponsor. If the participant  continues to work for another year, he would have 5 years of service with  the employer, but not with the sponsor, and therefore it is possible the  sponsor would claim that the participant has not vested. Similarly, should  an active or soft-frozen plan be bought out by a nonemployer, there would  be a potential question of whether a participant would continue to accrue  service time after the transfer of sponsorship.  Other benefits, such as  shutdown benefits—significant early retirement benefits triggered by  layoffs or plant closings—may be affected by decisions by the employer,  who would no longer be responsible for paying the benefits, creating an  incentive mismatch between employer and sponsor unless the plan was  amended explicitly to address this.
Arranging a DB plan buyout in situations where participants and  beneficiaries are covered by a collective bargaining agreement may  involve overcoming additional challenges. Under federal law, “wages,  hours, and other terms and conditions of employment” are mandatory  subjects of collective bargaining. Case law has established that employee  pension benefits are generally subject to mandatory collective bargaining.  On the other hand, courts have recognized that terms and conditions of  employment do not encompass every employer decision or management  function that may have an indirect impact upon or be of interest to  employees. One expert with whom we spoke was unsure whether the  sale of a pension plan from an employer to a third-party sponsor would be  considered negotiable under a collective bargaining agreement. The  outcome in individual cases may depend on the specific facts and  circumstances involved, including the terms of any applicable union  contracts.
Buyouts would have an ambiguous impact on PBGC’s financial position  and risk. PBGC would benefit if a plan buyout moved a plan from a  financially weak sponsor to a stronger one with a better ability to fund the  plan sufficiently because PBGC would take a loss if it had to take  responsibility for paying benefits of an underfunded plan that closed in a  distress termination. In addition, PBGC would benefit from continued  premium payments by the new sponsor, compared with the original  sponsor terminating the plan. However, buyouts would be unlikely to  involve the weakest and riskiest plans —proponents of buyouts with  whom we spoke said that the plans financial companies would most likely  target would be only slightly underfunded. Large, more severely  underfunded plans held by weak sponsors, which present the biggest risk  of a large claim on PBGC’s assets, would seem to be an unlikely target for  buyout because of the amount of cash a prospective financial sponsor  would require to agree to take over the plan. It therefore seems unlikely  that the buyouts would help rescue the riskiest plans or reduce PBGC’s  overall risk significantly, unless a buyout prevented the future erosion of  plan funding in large plans.
More important for PBGC, seemingly strong companies buying out plans  may not remain financially strong. The current turmoil in the financial  markets, which has led to the failure of financial institutions and direct  federal financial assistance to others, provides clear evidence that the  financial strength of a firm or industry can quickly deteriorate. Even if the  financial sponsor appeared to be stronger than employers from whom it  purchased DB plans, plan buyouts could move multiple plans from several  firms in different industries to the control of one firm or industry. This  could increase the magnitude of future losses to PBGC and participants  should that sponsor or industry find itself in financial distress.
For PBGC, the potential risk associated with any particular DB plan  buyout depends in part on the structure of the new sponsorship. A large  financial company, such as a bank or an investment bank, might choose to  set up a subsidiary explicitly to sponsor bought-out plans. If the parent  financial company owns at least 80 percent of the subsidiary containing  the plan, then the subsidiary would generally be within the financial  company’s “controlled group.” This would mean that the parent company  could be liable for supporting the pension plan should the plan terminate  with insufficient assets to pay accrued benefits. However, a firm  conducting a buyout could transfer plan assets and liabilities to a separate  subsidiary or investment vehicle outside the parent company’s controlled  group. In this case, the larger parent may not be legally liable to the  pension plan if the plan became underfunded or the sponsor suffered  financial distress, possibly increasing the risk of lost participant benefits  or losses to PBGC in the event of a plan termination. Therefore, the  structure of the sponsorship of any plan may affect the potential risk to  PBGC.
According to PBGC officials, the agency’s ability to prevent buyouts that  increase risk to itself and the DB system relies on statutory provisions  permitting PBGC to involuntarily terminate a plan and to seek recovery  from plan fiduciaries who engage in transactions to evade plan liability.  PBGC officials indicated, however, that those provisions could be of  limited value when applied to buyouts. The first provision authorizes  PBGC to institute proceedings to involuntarily terminate plans in certain  specific circumstances involving a sponsor failure to comply with funding  laws or anticipation of such failure. The second permits PBGC to recover  from persons entering into transactions for the purpose of evading liability  in connection with a plan termination. This provision was intended to  deter attempts by plan sponsors to shift pension obligations to weak  companies. Because it could result in original plan sponsors being liable  for plan obligations as if a plan buyout had never occurred, it may  discourage plan sponsors from selling plans to a new sponsor that is  obviously not financially sound. However, PBGC officials stated it would  still be very difficult and costly to prevent risky buyouts because PBGC  faces a heavy burden of proving that one of the triggering criteria has been  met, and could involve protracted litigation. Further, under the first  provision a forced plan termination would still likely lead to losses, and  under the second provision PBGC has only a 5-year window to prove that  a transaction was conducted to evade liability. Other former PBGC  officials with whom we spoke thought that PBGC probably had the ability  under its current authorities to craft rules to prevent buyouts that would  increase the risk of losses to the agency.
Regulated financial firms face capital requirements designed to try to  ensure the safety of bank deposits and assets. While these requirements  could provide additional security for plan benefits if they improve the  likelihood of ongoing solvency for the sponsor, the oversight goals of  banking regulatory agencies may conflict with those of the pension  regulatory agencies. Bank regulatory agencies, such as OCC or FRB, seek  to ensure that the activities of a banking institution do not create undue  risk for the safety of the depositors and the soundness of the banks.  Therefore, if a banking institution wanted to take over the sponsorship of  a pension plan, financial regulatory agencies may need to ensure that plan  sponsorship does not unduly increase the risk to the bank, and especially  to bank depositors. This might take the form of shielding bank assets from  liability for pension plan underfunding. This would seemingly conflict  directly with the interests of PBGC, which would want assets of the  sponsor beyond the plan itself available to cover pension obligations  before allowing a distress termination. This regulatory conflict would have  implications for the security of plan benefits under a new sponsor  following a plan buyout if some of the assets of a large financial sponsor  were shielded from potential pension liability. Such a conflict may lead to  the perverse result that regulated, well-capitalized banking entities might  be barred from participating in DB plan buyouts while financial entities  that may be exempt from some securities laws and regulations, such as  hedge funds, would not. On the other hand, it is possible that OCC or FRB  might conclude that the financial company has sufficient assets outside of  its banking activities to provide financial support for plan funding, or that  the structure of the buyout provides sufficient protections for banking  assets, and allow the banking entity to take over a plan.
Plan buyouts might place additional demands on pension regulators to  enforce current rules. Financial entities taking over plans in buyouts may  offer investment services or asset-liability management geared toward DB  plans. As plan sponsors themselves, they could theoretically hire a related  subsidiary to provide these services, but doing so could present a conflict  of interest between their role as sponsor and as investment manager.  ERISA generally prohibits a range of transactions that could trigger  conflicts of interest but there are a number of specific exceptions. It is  unclear if plan buyouts will make it more difficult to monitor such  transactions. A second source of potential oversight difficulty concerns  the excise tax on plan reversions. A sponsor of an overfunded plan could  attempt to extract excess plan assets, which would typically be subject to  an excise tax, by selling the plan to a financial sponsor in exchange for  cash or assets reflecting the plan surplus (less fees the new sponsor might  collect to take over the plan). IRS officials with whom we spoke  mentioned that buyouts could possibly make enforcing the reversion tax  more complicated, particularly if the transaction included the transfer of  some business assets.
section_title: Concluding Observations
paragraphs: The recent IRS ruling and legislative efforts to address the nation’s  financial difficulties have pushed DB plan buyouts off the immediate  policy agenda. At first glance, buyouts in and of themselves seem to be a  minor issue. With a primary target market of sponsors of slightly  underfunded, hard-frozen plans, both the direct benefits and costs of such  transactions appear comparatively small. To the extent that a buyout  results in a stronger sponsor of the pension plan, the buyout could make  participant benefits more secure and reduce PBGC’s financial exposure  somewhat. Sponsors would certainly benefit from the increased choice  they would have in being able to shed their pension liabilities, presumably  at reduced cost compared with standard termination through insurance  companies. If such buyouts represented new level-playing-field  competition to insurance terminations, with no added risk to participants  or to PBGC, they could be seen as a financial innovation that increased  flexibility and lowered cost to DB sponsors.
The troubling aspects of DB plan buyouts involve risks that may be  difficult to foresee or quantify now or at the time of any particular  transaction. It is unclear to what extent buyouts would cost less than  standard plan terminations simply because of differences in regulations  facing financial institutions and insurance companies providing similar  services to plan sponsors instead of from economic efficiency. Further, the  current economic downturn has laid bare the current weaknesses and  imperfections of financial regulation, with banks and insurance companies  previously considered to be sound and well capitalized suffering  catastrophic losses.
Plan buyouts, as proposed by potential sponsors, would likely provide  very limited upside for participants, since PBGC guarantees have covered  the overwhelming majority of participant benefits in DB plans that PBGC  has taken over. They may offer cost savings and flexibility to sponsors, but  they would appear to offer few advantages for benefit protection over plan  terminations already recognized by ERISA. Although it is possible that the  current financial crisis could uncover weaknesses in the regulation of  annuity providers for terminated plans, the potential advantages appear to  be limited to a very narrow set of scenarios in which a buyout by a strong  sponsor rescues the plan from a distress termination and saves  participants from lost uninsured benefits. Even to the extent they are a  successful model, buyouts could erode worker retirement benefits by  encouraging plan freezes by sponsors wishing to avail themselves of this  option. For PBGC, the gains in security would also likely be small, since  only mildly underfunded plans are likely to be targeted for buyout,  although it is possible that some buyouts could prevent further erosion in  plan funding. Whatever the ultimate effect buyouts would have on benefits  security or plan sponsorship, it seems likely that they would change the  traditional role that DB pensions play as a benefit employers provide  directly to their employees. One’s evaluation of buyouts may depend on  the degree to which DB plans are defined by the employer-employee  relationship, and not just on the monetary value of the benefits.
section_title: Agency Comments
paragraphs: We provided a draft of this report to the Department of Labor, the  Department of the Treasury, IRS, and PBGC, all of whom provided  technical comments that we incorporated as appropriate.
As agreed with your offices, unless you publicly announce its contents  earlier, we plan no further distribution until 30 days after the date of this  letter. At that time, we will send copies of this report to the Secretary of  Labor, the Secretary of the Treasury, the Director of PBGC, appropriate  congressional committees, and other interested parties. We will also make  copies available to others on request. In addition, the report will be  available at no charge on GAO’s Web site at http://www.gao.gov.
If you have any questions concerning this report, please contact Barbara  Bovbjerg at (202) 512-7215 or Joseph Applebaum at (202) 512-6336.
Contact points for our Offices of Congressional Relations and Public  Affairs may be found on the last page of this report. GAO staff who made  contributions are listed in appendix III.
section_title: Appendix I: UK Experience with Noninsured Plan Buyouts Provides Only Limited Regulatory Lessons for the United States
paragraphs: The United Kingdom (UK) has in recent years seen a marked increase in  defined benefit (DB) plan sponsors closing their plans. British plan experts  and policy makers with whom we spoke estimated that terminations are  expected to involve assets of £10 billion in 2008. Most of these closeouts  have been conducted by insurance companies in ways similar to pension  terminations in the United States, with sponsors terminating their plans  and purchasing group annuities from insurers to pay plan benefits.  However, a few have involved noninsurance entities. In 2007, two financial  firms, Citigroup and Pension Corporation, took over control of four  defined benefit plans with a value of £4.5 billion collectively. Citigroup’s  purchase of the plan sponsored by Thompson Regional Newspapers most  clearly resembled the structure of models proposed by U.S. firms:  Thompson created a subsidiary, into which it put its pension plan plus  additional assets, and Citigroup purchased this subsidiary and became the  plan’s new sponsor. Citigroup pointed out some benefits of this buyout for  all parties involved, including the facts that Thompson was a relatively  weak sponsor and the investment strategy proposed by Citigroup was  conservative in nature.
To take over the Thompson pension plan, Citigroup had to obtain approval  from both U.S. and United Kingdom regulatory agencies. The Federal  Reserve Board (FRB) approved the plan buyout while making it clear that  its approval was limited to the specific conditions of this deal, involving a  hard-frozen, fully funded plan in which the plan assets equaled or  exceeded the value of future plan benefit payments. Citigroup proposed  that this deal be done through a nonbank subsidiary, and FRB wanted to  know if this transaction posed any risk to subsidiary groups, Citibank in  particular. We were told that, under UK law, the corporate control group  of a subsidiary would be liable for any losses the pension plan might incur,  meaning that the Pensions Regulator, the main British pension regulatory  agency, could seek recovery from the U.S.-insured depository institution  of Citibank in the event that something went awry with the fund. FRB  officials indicated that they would have serious concerns about allowing a  U.S. banking institution to subject itself to the liabilities of a pension plan  acquired by a subsidiary. In order to secure final approval from FRB,  Citigroup had to receive written assurance from the Pensions Regulator  that Citibank assets would not be pursued in the event of the plan  becoming insolvent. The Pensions Regulator agreed to grant this  exemption for a period of 5 years.
While that buyout contained features similar to those in U.S. proposals,  there are inherent structural differences between the UK and U.S. pension  regulatory systems that appear to limit the lessons from the UK experience  for the United States. Officials told us that, unlike American plans, British  defined benefit plans are managed by separate boards of trustees rather  than plan sponsors. Trustees have the power, for example, to constrain  plan sponsors from employing any investment strategy that may lead to  undue risk for the participants or the British federal pension insurance  fund, the Pension Protection Fund (PPF); in contrast, U.S. plans are not  required to have any such governance body. Furthermore, according to  pension experts, the tax on plan reversions in the UK is significantly lower  than in the United States, and Citigroup made clear its intent to keep any  remaining surplus after either paying all promised benefits or terminating  the plan through an insurance company. This source of profit would not be  available in the United States because of the size of the reversion tax.
Additionally, the Pensions Regulator has powers that allow for flexibility  and give strong protection to plan members.  As the DB plan buyout  landscape continues to evolve, the Pensions Regulator has the power to  intervene when it believes a noninsurer transaction might put plan  members and the PPF in jeopardy. The Pensions Regulator has already  shown its willingness to engage in such intervention during the Pension  Corporation’s buyout of the telecommunication firm Telent. In contrast to  Citigroup, the Pension Corporation acquired pension plans by gaining an  interest in the original employer sponsor. These takeovers more closely  resembled a merger and acquisition transaction than they did a pension  plan buyout. In this case, the trustees of the Telent pension plan claimed  that the interests of the Pension Corporation were not aligned with those  of the trustees and plan members. Some believed that the Pension  Corporation’s sole interest in acquiring Telent was to seek higher returns  from the fund as a means of profit for the corporation, rather than for the  members. The Pensions Regulator agreed with the trustees and exercised  its power by installing three additional independent members as trustees,  thus preventing the Pension Corporation from gaining control of the  board. In addition to showing the powers of the Pensions Regulator, this  instance also illustrates the relative importance of UK trustees. It was the  trustees that first notified the Pensions Regulator about the potential risk  being imposed on members.
section_title: Appendix II: Internal Revenue Service 2008 Revenue Ruling on Defined Benefit Plan Buyouts
paragraphs: On August 6, 2008, the Department of the Treasury and the Internal  Revenue Service (IRS) issued Rev. Rul. 2008-45. This ruling decided  whether DB plans bought out by third-party sponsors complied with or  violated the “exclusive benefit” rule of the Internal Revenue Code (IRC).  This rule provides that in order to constitute a qualified plan, a pension  plan must be operated for the exclusive benefit of a sponsor’s employees  and their beneficiaries.
The ruling declared that the transfer of a pension plan to “an unrelated  taxpayer,” without the concurrent transfer of significant business assets,  operations, or employees, such as in a merger or business acquisition,  would jeopardize a plan’s tax qualification. IRS contrasted the transfer of a  sole pension plan with the transfer of a plan in connection with the  acquisition of business assets or operations, and held that since a plan in  the first instance would no longer be maintained by an employer to  provide retirement benefits for its employees and their beneficiaries, it  would not satisfy the rule. The ruling further held that this would still be  the case if the purchasing company has “some employees…or some  business assets or operations transferred, where substantially all of the  business risks and opportunities” relate solely to the buyout of the plan  itself. This means that under current law any plans transferred to a  nonemployer sponsor would not receive the same tax benefits an  employer-sponsored plan would, such as the tax deferral on sponsor  contributions to the plan and on the return on plan assets. According to  Treasury, as a result of this ruling, companies will be unable to take over  any pension plans, frozen or active, except as part of a business merger or  acquisition.
Advocates of buyouts said that they believed the IRS ruling was broader in  its coverage of all third-party buyouts than it needed to be under the law  and inconsistent with prior rulings on plans that change sponsors. Instead,  they thought the ruling should have left open the possibility of case-by- case IRS approval pending an evaluation of whether a buyout benefited  participants or the Pension Benefit Guaranty Corporation (PBGC).
Concurrent with the ruling, the Department of the Treasury issued a set of  principles, with input from the Department of Labor, Department of  Commerce, and PBGC, that might guide Congress should it decide to write  legislation that would permit pension plan buyouts. These include the  following: (1) companies should give advance notice of plan buyouts to  participants and regulators; (2) only financially strong entities in well- regulated sectors would be permitted to acquire a pension plan in a plan  buyout transaction; (3) the parties to the transaction would be required to  demonstrate that participants’ benefits and the pension insurance system  would be exposed to less risk as a result of the buyout, and that the  buyout would be in the best interests of the participants and beneficiaries;  (4) limitations on buyouts would be imposed to limit undue concentration  of risk; (5) transferees and members of their controlled groups would  assume full responsibility for the liabilities of transferred plans and would  comply with post-transaction reporting and fiduciary requirements; and  (6) subsequent buyout transactions for a plan would be subject to the  same rules as the original buyout.
section_title: Appendix III: GAO Contacts and Staff Acknowledgments
subsections: section_title: Contacts
section_title: Staff Acknowledgments
paragraphs: In addition to the contacts above, Charles A Jeszeck, Mark M. Glickman,  Brian Tremblay, Craig Winslow, Karine McClosky, Jessica Orr, and Mimi  Nguyen made important contributions to this report.