Otherwise attractive businesses with significant defined benefit pension liabilities are often “off limits” for private equity firms understandably concerned about future pension payment obligations and their financial statement impact. However, if there were techniques to reduce or even eliminate future pension payment obligations and their volatile financial statement impact without breaking promises to retirees, private equity buyers might find a number of transactions more viable.
Private equity buyers may be able to adopt some of the approaches used recently by General Motors and Verizon, whose large ongoing pension obligations under legacy defined benefit plans, were adversely affecting their strategic direction. Each of these companies used pension plan assets (in addition to cash) to purchase group annuity contracts from The Prudential Insurance Company of America that covered a portion of their pension obligations.
In representing Prudential in each of these transactions, which were the two largest derisking transactions ever completed, the Debevoise team found a number of implications for private equity firms. As noted above, these transactions could be used to manage the pension plan liabilities of potential acquisition targets with legacy defined benefit plans as well of existing portfolio companies. Second, since defined pension plans have historically been significant investors in private equity funds, such transactions will involve simultaneous transfers of a substantial number of interests in private equity funds owned by the pension plans involved to the counterparty selling the annuity contract.
What Is Derisking?
The term derisking, of course, refers to reducing risks, which in the pension world means finding ways to reduce an employer’s exposure to volatility, whether due to underfunding or changes in key assumptions such as interest rates and longevity. Derisking can be achieved by tightly matching payment obligations to investments, reducing obligations by buying out retirees or by purchasing annuities to cover the payment obligations, effectively shifting payment and longevity risks from the pension plan to the insurance company.
What Did General Motors and Verizon Do?
Both General Motors and Verizon derisked portions of their pension obligations through purchases of group annuity contracts. The group annuity contracts cover all future pension liabilities for qualifying retirees who are already receiving retirement payments from the pension plans, i.e., qualifying retirees who are “in pay status.” Payments required under the pension plans will be made by the insurer directly to the retirees covered by the group annuity contracts. Retirees not covered by the group annuity contracts will, of course, continue to participate in the company plans. The group annuity contracts purchased by GM and Prudential did not cover employees not “in pay status,” and the pension obligations to those employees were, accordingly, not derisked.
What Were the Differences in the Transactions?
General Motors and Verizon took different approaches to derisking. The General Motors plan did a “buy-out” transaction. This involved, first, splitting the salaried employee plan into two: one that will continue more or less unchanged, primarily for active employees, and the other for salaried employees who were already in pay status (the “buy-out plan”). Participants in the buy-out plan who met certain other criteria were offered an opportunity to receive a lump-sum payment in exchange for their pension. For those who either did not qualify for or did not elect a lump-sum, the buy-out plan purchased a group annuity contract. Following the purchase and after completion of various administrative steps, the buy-out plan will be terminated and General Motors will be permanently relieved of responsibility for future payments for participants in the buy-out plan.
Verizon, by contrast, did a “lift-out” transaction. Verizon purchased a group annuity contract for the qualifying retirees who were in pay status in exchange for certain plan assets but without terminating the plan, which will continue with respect to retirees whose pensions were not “lifted out.” As a consequence of the purchase, the obligation to pay the retirees covered by the annuity is shifted to Prudential and Verizon’s plan will continue for the employees not covered by the group annuity contract.
What is the Difference to Retirees?
The retirees whose pensions were annuitized should not notice any difference in the amount of their payments or otherwise. Indeed, the only difference should be that their pension checks should now say “Prudential” on them instead of the name of their former employer.
Pensions that have been derisked through annuitization may not be subject to oversight of the Department of Labor or benefit from the Pension Benefit Guaranty Corporation insurance (which is similar in concept to the FDIC insurance on bank deposits). This may matter in the event of an insurer bankruptcy. However, state insurance laws provide oversight, and the use of a separate account to support the annuity payment obligations is an added level of protection. Although there have been criticisms to the approach used in these transactions and requests for a moratorium on derisking transactions until further study is completed, there has not yet been any regulatory movement on this issue.
Do General Motors and Verizon Still Have Pension Plans?
Yes, both companies still have significant pension obligations that have not been annuitized.
What was Unique about These Transactions?
Although employers have long had the ability to derisk their pensions by purchasing annuities, the scale of these transactions made them unique. GM and Verizon transferred approximately $25 billion and $7.5 billion of pension liabilities, respectively, in connection with their purchases of these guaranteed annuity contracts.
Secondly, GM and Verizon used their plans’ assets, plus cash to make up the underfunding shortfall in the plan, to pay the annuity premium. This is an innovation, as traditionally in a derisking transaction the pension plan would have liquidated its portfolio and purchased the annuity for cash. When using an existing portfolio as currency, the transferred assets must conform to the insurer’s target portfolio allocations and duration as closely as possible, with deviations increasing the dollar value of the premium. Pricing is also determined by the actuarial characteristics of the participants in the plans (e.g., age, gender and similar factors). Obviously, pricing is critically important to the insurance company, because once the insurer has assumed the obligation to pay the pension obligations, it has also assumed the risk for market performance of the assets and actuarial variations in the actual retiree population. Unlike the pension plan, which could require contributions from the employer, the insurer will not have recourse to the company for additional funds if expectations differ from actual results.
Why Are These Transactions of Interest to Private Equity Firms?
Private equity firms may find annuitization transactions attractive as a tool for managing the pension risks of both existing portfolio companies and potential acquisition targets.
Secondly, private equity firms should be conscious of these transactions because pension plan and insurance company limited partners are likely to seek consent from fund general partners to transfers of limited partnership interests in future annuitization transactions. Because of the nature of the transfer, several terms considered “market” in normal transfers of interests in private equity funds may present challenges.
General partners often request, as a condition to granting their consent to a typical transfer, that the transfer close only at the end of a quarter (or month), that the transferor and the transferee be jointly and severally liable for damages arising out of the transfer, and certain assurances relating to the publicly traded partnership rules are made. The parties in the GM and Verizon transactions resisted these and a number of other routine requests from the general partners whose consents to transfer were being sought. While solutions were found to all of these (and other) challenges, we expect that insurers will push harder in the future to avoid taking on additional risks beyond the investment and to have the timing of the transfers more closely align with the closing date of the annuity purchases. Further, we expect that pension funds that are anticipating future annuitizations may start to request, at the time they invest in a fund, side letter provisions intended to facilitate those transactions.
Can Private Equity Fund Managers Use Derisking Techniques?
Private equity owners of businesses may not have the same level of defined pension liabilities that GM and Verizon carried, but they may well be able to use the derisking approach to boost the value of existing portfolio companies and to structure transactions that may not otherwise be compelling. However, derisking transactions raise complex legal questions in a variety of areas, including ERISA’s rules regarding fiduciary duty and prohibited transactions, qualified plan rules and insurance regulation.