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Terminated Vested Cashouts
Overcoming Common
Misconceptions
1
Terminated Vested Cashouts Overcoming Common Misconceptions
Terminated Vested Cashouts
— Overcoming Common Misconceptions
Inthepastfewyears,agrowingnumberofdefinedbenefitpension
planshavebeenoptingtotransferriskfromthebalancesheetthrough
lumpsumcashoutwindowsandannuitypurchasesfrominsurers.
Whileafewhigh-profileretireeannuitypurchasetransactionswere
madein2012,themostcommonformofrisktransfertodatehasbeen
lumpsumcashoutwindows1
forterminatedvested2
participants.
The advantages to the plan sponsor of a lump sum
cashout can be numerous, and the economics
of such an exercise are often very compelling.
Furthermore, increases in interest rate levels and
improvements in funded status during 2013 may
make 2014 an opportune time to capitalize on these
advantages. Benefits to the plan sponsor of offering
a terminated vested cashout window include:
•• Reduced pension liability, leading to lower plan
financial risk and volatility.
•• Eliminated PBGC premiums for participants
electing a lump sum (PBGC per-participant
premiums are scheduled to increase from $35 per
participant in 2012 to $64 by 2016 and continue to
increase thereafter).
•• Eliminated ongoing administrative costs for
participants electing a lump sum.
•• Reduced investment management costs for the
funds used to cashout.
•• Ability to make lump sum payments before updated
statutory mortality tables increase costs (recently
released mortality tables by the Society of Actuaries
could increase terminated vested liabilities by
5%–10% or more).
•• Potential interest rate arbitrage in 2014, depending
on the relationship between lump sum rates and
market-based rates.3
At the same time, these programs tend to be
popular4
with participants. Many participants use
the opportunity to consolidate their retirement
assets into an Individual Retirement Account (IRA) or
other tax-advantaged vehicle, allowing them to take
more control over their retirement planning.
For these reasons, we saw many plan sponsors
embark on cashout projects beginning in 2012,
and this trend seems to be intensifying in 2014.
Keep in mind, however, that the business case
for a project of this nature is driven by the unique
circumstances of the plan sponsor, and a cashout will
not make sense in every situation. That said, some
sponsors for whom a cashout might be appealing
are waiting on the sidelines, hesitant because of
perceived concerns about offering a window. In this
Mercer Point of View we identify some common
concerns and discuss how they might be addressed
to allow for a successful risk transfer project.
2
Terminated Vested Cashouts Overcoming Common Misconceptions
Some sponsors have expressed a concern that by paying out
lump sums to participants, they are losing the opportunity to
generate returns in excess of the liability growth rate, which could
impact their P&L expense. Whether or not this is true depends
upon which assets are used to pay out lump sums. If lump sums
are paid proportionally from all asset classes, then there is an
opportunity cost in the form of lower potential future returns,
which can manifest as an increase in P&L expense. Some sponsors
are comfortable with this because there is a corresponding risk
reduction for the plan.
But plan sponsors who feel that they are already taking the
appropriate level of risk in the plan might instead pay all lump
sums out of fixed income assets of a comparable duration.
This trades out a fixed income asset for a fixed income liability,
leaving the plan roughly neutral on a risk basis and preserving the
same level of growth assets. For example, if you were to consider
the cashout as an asset class, cashing out the obligation from fixed
income assets effectively “immunizes” that portion of the portfolio
from risk — in other words, it acts as an extension of the fixed
income portfolio. The following illustration shows this concept:
In this example, lump sums are paid from fixed income assets.
Therefore, the growth portfolio and risk level remain the same
in dollar terms, even as they become a larger portion of the
investible portfolio.
Impact of risk tr
relative portfoli
LDI portfolio
Growth portfoli
BEFORE AFTER
60%
40%
50%
50%
1. “Interest rates are too low right now” 2. “I will incur an opportunity cost in
my asset portfolio”
Impact of risk transfers
on relative portfolioLDI portfolio Growth portfolio
A lower interest rate leads to a higher lump sum value.
While this is good for participants, some sponsors worry that
they are paying out lump sums at the “top of the market”.
Interest rates have increased by around 75 basis points from
their 2012 lows, but they remain low relative to historical norms.
Some plan sponsors have strong feelings that interest rates
(and corresponding lump sum rates) will increase and therefore
result in a more opportune time to execute in the future.
While reasonable people can have different expectations for
interest rate directions in the short term, waiting for a rise in
interest rates to take action is a bet on the direction of interest
rates. Many plan sponsors already have a significant position
in their plans that would be rewarded with rising rates
(or penalized with lower rates) because their portfolios have
low fixed income holdings and/or short fixed income durations
compared to the plan’s liabilities. In addition, if a plan sponsor
were looking to profit from the expectation of rising rates,
there are generally more efficient ways to do so than carrying
terminated vested liabilities. For example, a sponsor could
express the same view on interest rates by selling bonds or
shortening the duration of its fixed income portfolio at a cost
that may be significantly less than retaining the terminated
vested obligation and the associated holding costs (PBGC
premiums, administration costs, longevity increases, etc).
Furthermore, it is important for plan sponsors to consider
when and how interest rates are set for purposes of a cashout.
Many plans lock in lump sum interest rates for a full year based
on a “lookback.” If the locked-in lookback interest rate is higher
than current market rates, then the lump sum paid is typically
lower than the market value of the liability released, resulting
in an economic gain. For example, for a typical calendar-year
plan, rates have declined by 30–50 basis points since late 2013.
This could translate to lump sum payments being 5%–10%
lower than the employer liability.
This difference could get bigger, smaller, or reverse depending
on interest rates. Even if the actual payout of lump sums takes
several months, plan sponsors can often take steps immediately
through investment policy to preserve the difference.
3
Terminated Vested Cashouts Overcoming Common Misconceptions
3. “My funded status
will deteriorate if I am
already underfunded”
It is true for an underfunded plan that
paying out a dollar of assets and a dollar
of liabilities reduces the funded status on
a percentage basis. There are potential
funding and reporting implications to this
that should be understood by the employer
prior to executing a lump sum cashout.
That said, the unfunded amount in dollar
terms would generally remain about
the same.
In addition, the funded status (as
measured by accounting assumptions)
may understate the true economic cost
of carrying the liability, as it does not
include costs of holding the liability, such
as administrative and PBGC costs. And if
sponsors capture tactical opportunities
(suchasthearbitrageopportunitydiscussed
above), the lump sums paid may be less
than the liability released. The combination
of these two factors can often neutralize any
decline in funded status percentage.
Plans — especially those using a
“glidepath” approach for investments —
will want to revisit the impact of a cashout
on their investment policy to determine
whether some of the funded status
triggers or target allocation percentages
will need to be adjusted following the
payout of lump sums.
4.“Paying lump sums will trigger
a P&L settlement charge and
impact our share price”
If the total lump sum payout exceeds
certain thresholds, settlement accounting
is triggered. Because most plans today
hold a large unrecognized loss on the
balance sheet, settlement accounting for
these plans generally leads to a P&L charge
under US GAAP5
although the net balance
sheet is largely unaffected.
If settlement accounting is truly undesirable,
lump sum windows can be constructed
in “tranches” such that the settlement
accounting threshold is not breached in any
year. Such tranches can be constructed by
lump sum value, business unit/division, or
other reasonable methods6
that produce
the desired result — maximizing the value
of a cashout window while eliminating
settlement recognition.
Keep in mind, however, that a settlement
charge is not always a bad thing. First, the
market has become more savvy about
adjusting earnings for pension expense and
is less likely to penalize an organization for
taking prudent steps to manage risk within
its pension plan just because the one-
time accounting outcome happens to be
negative. When looking at the underlying
economics of the plan, a settlement has no
impact on the true financial condition of
the plan or the company — and a cashout
window is arguably favorable from an
economic standpoint. Second, some
CFOs view a settlement charge as a good
thing, because it “clears out” some of the
unrecognized loss from the balance sheet,
thus reducing the headwind to pension
expense on a go-forward basis. In fact, some
sponsors have moved to a “mark-to-market”
accounting approach that removes these
unrecognized losses entirely.
5. “My contributions will go up”
In the long run, contribution policy is
generally an issue of “pay me now or pay
me later” — the ultimate level of pension
contributions is always equal to the total
benefits paid out, less any investment
earnings net of expenses. To the extent
that lump sums paid out are less than the
economic liability, we would expect long-
term contributions to decrease. But it is
true that the timing of contributions can
accelerate modestly following a cashout
exercise, largely due to the current status of
funding relief (MAP-21). Keep in mind that
under MAP-21 funding relief, the funding
target is calculated using high interest rates
that are currently disconnected from the
true “market value,” and this will reverse
itself over the next few years.In any event,
we typically find that this contribution
acceleration is small relative to the potential
cost savings of removing participants from
the plan, but each plan sponsor should
evaluate their situation individually.
4
Terminated Vested Cashouts Overcoming Common Misconceptions
6. “I don’t want my employees
to squander their pensions”
Some plan sponsors express paternalistic
concerns that participants will lose the
longevity and investment protections of an
annuity benefit if they elect a lump sum. This
is a valid concern, as lifetime annuities are
an effective way to ensure that individuals
won’t outlive their money in retirement.
However, keep in mind that terminated
vested participants, by definition, were not
“career employees” at your organization.
So for many, the deferred vested pension
may make up only a small part of their total
retirement savings.
Participants may find that their retirement
planning may be made easier by combining
their lump sum with their other retirement
savings. In fact, we see evidence that
participants are doing this. Our experience
has been that over 80% of lump sums over
$50,000 are rolled over into an IRA or
other tax-qualified vehicle. Furthermore,
providing participants with the flexibility
to make individualized decisions with their
retirement funds promotes the opportunity
for building wealth based on their individual
financial goals and preferences. Finally,
keep in mind that a lump sum program is
voluntary — participants who prefer the
security of a lifetime annuity can keep it.
7. “We are going to fully
terminate the plan
soon anyway”
Many frozen-plan sponsors intend to
eventually terminate their plans once
funded status improves. A terminated
vested cashout project can align very well
with that goal for several reasons:
•• Plan termination is a lengthy process
that can take 12–24 months or longer.
Paying out lump sums now reduces risk
and carrying costs over this period, and
it ensures that payment occurs before
the new (more expensive) mortality
tables take effect for lump sums.
•• Paying out a lump sum during plan
termination carries an onerous
administrative burden, as the PBGC
requires disclosure of participant-
level data that can be difficult to find,
particularly for participants who
terminated decades ago. Paying lump
sums while the plan is operationally
active can be less complex and less
costly. Sponsors should be cautious not
to implement a cashout window
too close to actual termination to
avoid the appearance that they are
trying to circumvent PBGC plan
termination processes.
Most sponsors looking to terminate are
looking for opportunities to support
or accelerate the process, so a cashout
window could be thought of as a phased
termination step.
8. “My participant data is not
clean enough”
Many plan sponsors struggle to
maintain accurate data for terminated
vested participants, especially those who
terminatedemploymentmanyyearsago.
Theprospectofcleaningdatauptofacilitate
lumpsumpayoutscanfeeldaunting.
However, this is actually a good reason to
execute a lump sum cashout window now,
rather than waiting until these participants
retire and then individually researching
and cleaning up their benefits. Doing
the cleanup as a batch is typically more
efficient and less costly than on an “ad hoc”
basis, and the more time that has passed
since termination of employment, the
harder researching these participants will
become. This data clean-up project will
eventually have to be done regardless of
direction, and if the financial business case
for a cashout window is compelling, it may
suggest no better time than the present.
5
Terminated Vested Cashouts Overcoming Common Misconceptions
9. “I don’t have the bandwidth to
handle this, and it’s too expensive to
hire a third party to do it”
Human Resource functions are constantly being
asked to do more with less, and executing a lump
sum cashout is a major initiative. Beyond just the
calculation of benefits, significant communications
need to occur with former employees, and our
experience has been that plan sponsors receive more
phone calls than participants in the window.
Forthisreason,mostsponsorslookforexternalsupport
toexecutetheseprojects.Whilecostsvarydepending
onthesizeofthegroupandthelevelofsupportneeded,
manyplansponsorsfindthat:(1)thecostofthecashout
isequivalenttoorlessthanthecostofdoing“adhoc”
calculationsasparticipantsretire,and/or(2)thecostof
suchaprojectpaysforitselfquicklyinadministrative,
PBGC,mortalityincreases,andothersavings.Many
sponsorshavefoundtheROIontheseprojectsto
beupwardof50%perannum(onaninternalrateof
returnbasis)afterconsideringtheone-timecostof
implementationandtheexpectedannualsavingsthat
wouldresult.Inotherwords,the“break-even”time
horizonmaybeveryshort.However,everysituationis
different,andplansponsorsshouldevaluatethecosts
andbenefitsapplicabletotheirprogram.
10. “Mortality changes won’t happen
until 2016, so there is no reason to
act now”
In many cases, given declines in interest rates during
the first quarter of 2014, the financial business case
may be compelling at the moment (lump sums may
be lower than the obligation released), and this
opportunity can be captured and executed on in 2014.
However, it is unclear what the relationship will be after
2014, which leaves the possibility that this opportunity
will be missed. Additionally, it seems likely that
auditors may insist on some recognition of improved
mortality tables for 2014 or 2015 financial disclosures.
Even assuming the statutory requirements for cash
funding and lump sum payments will reflect increased
longevity after January 1, 2016, plan sponsors may
need to move soon. While 2016 may seem like a long
way away, executing a successful cashout exercise
takes significant time, planning, and effort. Just the
process of calculating benefits, mailing, and recording
elections typically takes around six months. And prior
to that, many sponsors will need to clean up data to
prepare, as well as build consensus and get buy-in
from key stakeholders in the program. This process can
take many months or even over a year. A delay could
mean paying larger lump sums based on the new
statutory mortality table, although the other potential
savings discussed above would still be available.
6
Terminated Vested Cashouts Overcoming Common Misconceptions
Conclusion
In this Point of View we have addressed many of the misconceptions
around cashouts, so that plan sponsors can better assess the
opportunity to de-risk. We believe that for plan sponsors that can get
past these misconceptions, the benefits of a lump sum window may
be compelling. However, each organization’s specific circumstances
need to be considered when making the “go/no go” decision.
Mercer has a great deal of experience helping plan sponsors
review the formal business case for a lump sum cashout window.
We suggest that a formal review include:
•• Exploring the financial implications through three
lenses — economics, accounting, and cash — and
helping to put the cashout exercise in the context
of broader risk management strategies that the
sponsor may employ.
•• Quantifying the specific level of potential expense
savings (annually and present value).
•• Reviewing the cost of executing a cashout project
and determining the specific implementation steps.
•• Formalizing the business case — is the
ROI compelling?
•• Reviewing any barriers to a successful project
•• Considering the “fit” of a cashout project within
your broader financial strategy.
•• Assisting with asset allocation decisions such as
which assets to pay benefits from and what the asset
allocation should look like after the cashout program.
•• Launching a data clean-up project to make
sure complete and accurate calculations exist
for former employees.
•• Building a formal project plan with clear roles and
responsibilities to promote a successful project.
Mercer consultants are very well versed in all aspects
of cashout and risk management projects, and
we have a great deal of experience helping plan
sponsors explore the business case and ultimately
execute if the opportunity is compelling.
MAKING ACCOUNTABILITY WORK
7
Terminated Vested Cashouts Overcoming Common Misconceptions
Contacts
Jonathan Barry
Partner
+1 617 747 9676
jonathan.barry@mercer.com
Richard McEvoy
Partner
+1 212 345 3194
richard.mcevoy@mercer.com
Scott Jarboe
Partner
+1 202 331 2523
scott.jarboe@mercer.com
Matt McDaniel
Principal
+1 215 982 4171
matt.mcdaniel@mercer.com
Footnotes
1
An offer of lump sums to terminated vested participants could be done either as a permanent plan feature or as a
one-time window. However, amending the plan to allow for permanent lump sums becomes a protected benefit
that cannot be removed, causing potential future administrative and cost concerns. For this reason, most sponsors
elect to pay lump sums as a one-time window opportunity.
2
A terminated vested participant is a former employee who worked long enough to earn a vested benefit but has
not yet begun collecting a monthly pension.
3
Most plans set interest rates once per year using a “lookback” method to a month prior to the beginning of each
plan year. That rate is then locked in for all lump sums paid during the year. If rates fall significantly during the
year, the plan sponsor has an opportunity to pay out lump sums using the older (higher) interest rate, leading to a
potential gain to the plan: where the value of the lump sums paid is less than the value of the liability released. For
calendar-year plans, this was generally true through the first quarter of 2014.
4
A cashout exercise cannot be mandatory — the participant must elect to receive a lump sum. Our experience
indicates that most cashout exercises achieve a takeup rate between 40% and 60%.
5
This discussion applies to plans reporting under US GAAP. Under IAS 19R, settlement accounting is typically not
as large an issue — the charge (or credit) is generally simply the difference (if any) between lump sums paid and
liability settled.
6
Note that plan amendments to allow lump sums have to meet nondiscrimination rules for timing and effect.
ImportaNt notices
References to Mercer shall be construed to include Mercer LLC and/or its associated companies.
© 2014 Mercer LLC. All rights reserved.
This contains confidential and proprietary information of Mercer and is intended for the exclusive use of the
parties to whom it was provided by Mercer. Its content may not be modified, sold, or otherwise provided, in
whole or in part, to any other person or entity, without Mercer’s prior written permission.
The findings, ratings, and/or opinions expressed herein are the intellectual property of Mercer and are subject
to change without notice. They are not intended to convey any guarantees as to the future performance of the
investment products, asset classes, or capital markets discussed. Past performance does not guarantee future
results. Mercer’s ratings do not constitute individualized investment advice.
Information contained herein has been obtained from a range of third-party sources. While the information
is believed to be reliable, Mercer has not sought to verify it independently. As such, Mercer makes no
representations or warranties as to the accuracy of the information presented and takes no responsibility or
liability (including for indirect, consequential, or incidental damages) for any error, omission or inaccuracy in the
data supplied by any third party.
This does not constitute an offer or a solicitation of an offer to buy or sell securities, commodities, and/or any
other financial instruments or products or constitute a solicitation on behalf of any of the investment managers,
their affiliates, products, or strategies that Mercer may evaluate or recommend.
For the most recent approved ratings of an investment strategy, and a fuller explanation of their meanings,
contact your Mercer representative.
For Mercer’s conflict of interest disclosures, contact your Mercer representative or see
www.mercer.com/conflictsofinterest

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Securing Retirement Outcomes - Mercer 2014

  • 2. 1 Terminated Vested Cashouts Overcoming Common Misconceptions Terminated Vested Cashouts — Overcoming Common Misconceptions Inthepastfewyears,agrowingnumberofdefinedbenefitpension planshavebeenoptingtotransferriskfromthebalancesheetthrough lumpsumcashoutwindowsandannuitypurchasesfrominsurers. Whileafewhigh-profileretireeannuitypurchasetransactionswere madein2012,themostcommonformofrisktransfertodatehasbeen lumpsumcashoutwindows1 forterminatedvested2 participants. The advantages to the plan sponsor of a lump sum cashout can be numerous, and the economics of such an exercise are often very compelling. Furthermore, increases in interest rate levels and improvements in funded status during 2013 may make 2014 an opportune time to capitalize on these advantages. Benefits to the plan sponsor of offering a terminated vested cashout window include: •• Reduced pension liability, leading to lower plan financial risk and volatility. •• Eliminated PBGC premiums for participants electing a lump sum (PBGC per-participant premiums are scheduled to increase from $35 per participant in 2012 to $64 by 2016 and continue to increase thereafter). •• Eliminated ongoing administrative costs for participants electing a lump sum. •• Reduced investment management costs for the funds used to cashout. •• Ability to make lump sum payments before updated statutory mortality tables increase costs (recently released mortality tables by the Society of Actuaries could increase terminated vested liabilities by 5%–10% or more). •• Potential interest rate arbitrage in 2014, depending on the relationship between lump sum rates and market-based rates.3 At the same time, these programs tend to be popular4 with participants. Many participants use the opportunity to consolidate their retirement assets into an Individual Retirement Account (IRA) or other tax-advantaged vehicle, allowing them to take more control over their retirement planning. For these reasons, we saw many plan sponsors embark on cashout projects beginning in 2012, and this trend seems to be intensifying in 2014. Keep in mind, however, that the business case for a project of this nature is driven by the unique circumstances of the plan sponsor, and a cashout will not make sense in every situation. That said, some sponsors for whom a cashout might be appealing are waiting on the sidelines, hesitant because of perceived concerns about offering a window. In this Mercer Point of View we identify some common concerns and discuss how they might be addressed to allow for a successful risk transfer project.
  • 3. 2 Terminated Vested Cashouts Overcoming Common Misconceptions Some sponsors have expressed a concern that by paying out lump sums to participants, they are losing the opportunity to generate returns in excess of the liability growth rate, which could impact their P&L expense. Whether or not this is true depends upon which assets are used to pay out lump sums. If lump sums are paid proportionally from all asset classes, then there is an opportunity cost in the form of lower potential future returns, which can manifest as an increase in P&L expense. Some sponsors are comfortable with this because there is a corresponding risk reduction for the plan. But plan sponsors who feel that they are already taking the appropriate level of risk in the plan might instead pay all lump sums out of fixed income assets of a comparable duration. This trades out a fixed income asset for a fixed income liability, leaving the plan roughly neutral on a risk basis and preserving the same level of growth assets. For example, if you were to consider the cashout as an asset class, cashing out the obligation from fixed income assets effectively “immunizes” that portion of the portfolio from risk — in other words, it acts as an extension of the fixed income portfolio. The following illustration shows this concept: In this example, lump sums are paid from fixed income assets. Therefore, the growth portfolio and risk level remain the same in dollar terms, even as they become a larger portion of the investible portfolio. Impact of risk tr relative portfoli LDI portfolio Growth portfoli BEFORE AFTER 60% 40% 50% 50% 1. “Interest rates are too low right now” 2. “I will incur an opportunity cost in my asset portfolio” Impact of risk transfers on relative portfolioLDI portfolio Growth portfolio A lower interest rate leads to a higher lump sum value. While this is good for participants, some sponsors worry that they are paying out lump sums at the “top of the market”. Interest rates have increased by around 75 basis points from their 2012 lows, but they remain low relative to historical norms. Some plan sponsors have strong feelings that interest rates (and corresponding lump sum rates) will increase and therefore result in a more opportune time to execute in the future. While reasonable people can have different expectations for interest rate directions in the short term, waiting for a rise in interest rates to take action is a bet on the direction of interest rates. Many plan sponsors already have a significant position in their plans that would be rewarded with rising rates (or penalized with lower rates) because their portfolios have low fixed income holdings and/or short fixed income durations compared to the plan’s liabilities. In addition, if a plan sponsor were looking to profit from the expectation of rising rates, there are generally more efficient ways to do so than carrying terminated vested liabilities. For example, a sponsor could express the same view on interest rates by selling bonds or shortening the duration of its fixed income portfolio at a cost that may be significantly less than retaining the terminated vested obligation and the associated holding costs (PBGC premiums, administration costs, longevity increases, etc). Furthermore, it is important for plan sponsors to consider when and how interest rates are set for purposes of a cashout. Many plans lock in lump sum interest rates for a full year based on a “lookback.” If the locked-in lookback interest rate is higher than current market rates, then the lump sum paid is typically lower than the market value of the liability released, resulting in an economic gain. For example, for a typical calendar-year plan, rates have declined by 30–50 basis points since late 2013. This could translate to lump sum payments being 5%–10% lower than the employer liability. This difference could get bigger, smaller, or reverse depending on interest rates. Even if the actual payout of lump sums takes several months, plan sponsors can often take steps immediately through investment policy to preserve the difference.
  • 4. 3 Terminated Vested Cashouts Overcoming Common Misconceptions 3. “My funded status will deteriorate if I am already underfunded” It is true for an underfunded plan that paying out a dollar of assets and a dollar of liabilities reduces the funded status on a percentage basis. There are potential funding and reporting implications to this that should be understood by the employer prior to executing a lump sum cashout. That said, the unfunded amount in dollar terms would generally remain about the same. In addition, the funded status (as measured by accounting assumptions) may understate the true economic cost of carrying the liability, as it does not include costs of holding the liability, such as administrative and PBGC costs. And if sponsors capture tactical opportunities (suchasthearbitrageopportunitydiscussed above), the lump sums paid may be less than the liability released. The combination of these two factors can often neutralize any decline in funded status percentage. Plans — especially those using a “glidepath” approach for investments — will want to revisit the impact of a cashout on their investment policy to determine whether some of the funded status triggers or target allocation percentages will need to be adjusted following the payout of lump sums. 4.“Paying lump sums will trigger a P&L settlement charge and impact our share price” If the total lump sum payout exceeds certain thresholds, settlement accounting is triggered. Because most plans today hold a large unrecognized loss on the balance sheet, settlement accounting for these plans generally leads to a P&L charge under US GAAP5 although the net balance sheet is largely unaffected. If settlement accounting is truly undesirable, lump sum windows can be constructed in “tranches” such that the settlement accounting threshold is not breached in any year. Such tranches can be constructed by lump sum value, business unit/division, or other reasonable methods6 that produce the desired result — maximizing the value of a cashout window while eliminating settlement recognition. Keep in mind, however, that a settlement charge is not always a bad thing. First, the market has become more savvy about adjusting earnings for pension expense and is less likely to penalize an organization for taking prudent steps to manage risk within its pension plan just because the one- time accounting outcome happens to be negative. When looking at the underlying economics of the plan, a settlement has no impact on the true financial condition of the plan or the company — and a cashout window is arguably favorable from an economic standpoint. Second, some CFOs view a settlement charge as a good thing, because it “clears out” some of the unrecognized loss from the balance sheet, thus reducing the headwind to pension expense on a go-forward basis. In fact, some sponsors have moved to a “mark-to-market” accounting approach that removes these unrecognized losses entirely. 5. “My contributions will go up” In the long run, contribution policy is generally an issue of “pay me now or pay me later” — the ultimate level of pension contributions is always equal to the total benefits paid out, less any investment earnings net of expenses. To the extent that lump sums paid out are less than the economic liability, we would expect long- term contributions to decrease. But it is true that the timing of contributions can accelerate modestly following a cashout exercise, largely due to the current status of funding relief (MAP-21). Keep in mind that under MAP-21 funding relief, the funding target is calculated using high interest rates that are currently disconnected from the true “market value,” and this will reverse itself over the next few years.In any event, we typically find that this contribution acceleration is small relative to the potential cost savings of removing participants from the plan, but each plan sponsor should evaluate their situation individually.
  • 5. 4 Terminated Vested Cashouts Overcoming Common Misconceptions 6. “I don’t want my employees to squander their pensions” Some plan sponsors express paternalistic concerns that participants will lose the longevity and investment protections of an annuity benefit if they elect a lump sum. This is a valid concern, as lifetime annuities are an effective way to ensure that individuals won’t outlive their money in retirement. However, keep in mind that terminated vested participants, by definition, were not “career employees” at your organization. So for many, the deferred vested pension may make up only a small part of their total retirement savings. Participants may find that their retirement planning may be made easier by combining their lump sum with their other retirement savings. In fact, we see evidence that participants are doing this. Our experience has been that over 80% of lump sums over $50,000 are rolled over into an IRA or other tax-qualified vehicle. Furthermore, providing participants with the flexibility to make individualized decisions with their retirement funds promotes the opportunity for building wealth based on their individual financial goals and preferences. Finally, keep in mind that a lump sum program is voluntary — participants who prefer the security of a lifetime annuity can keep it. 7. “We are going to fully terminate the plan soon anyway” Many frozen-plan sponsors intend to eventually terminate their plans once funded status improves. A terminated vested cashout project can align very well with that goal for several reasons: •• Plan termination is a lengthy process that can take 12–24 months or longer. Paying out lump sums now reduces risk and carrying costs over this period, and it ensures that payment occurs before the new (more expensive) mortality tables take effect for lump sums. •• Paying out a lump sum during plan termination carries an onerous administrative burden, as the PBGC requires disclosure of participant- level data that can be difficult to find, particularly for participants who terminated decades ago. Paying lump sums while the plan is operationally active can be less complex and less costly. Sponsors should be cautious not to implement a cashout window too close to actual termination to avoid the appearance that they are trying to circumvent PBGC plan termination processes. Most sponsors looking to terminate are looking for opportunities to support or accelerate the process, so a cashout window could be thought of as a phased termination step. 8. “My participant data is not clean enough” Many plan sponsors struggle to maintain accurate data for terminated vested participants, especially those who terminatedemploymentmanyyearsago. Theprospectofcleaningdatauptofacilitate lumpsumpayoutscanfeeldaunting. However, this is actually a good reason to execute a lump sum cashout window now, rather than waiting until these participants retire and then individually researching and cleaning up their benefits. Doing the cleanup as a batch is typically more efficient and less costly than on an “ad hoc” basis, and the more time that has passed since termination of employment, the harder researching these participants will become. This data clean-up project will eventually have to be done regardless of direction, and if the financial business case for a cashout window is compelling, it may suggest no better time than the present.
  • 6. 5 Terminated Vested Cashouts Overcoming Common Misconceptions 9. “I don’t have the bandwidth to handle this, and it’s too expensive to hire a third party to do it” Human Resource functions are constantly being asked to do more with less, and executing a lump sum cashout is a major initiative. Beyond just the calculation of benefits, significant communications need to occur with former employees, and our experience has been that plan sponsors receive more phone calls than participants in the window. Forthisreason,mostsponsorslookforexternalsupport toexecutetheseprojects.Whilecostsvarydepending onthesizeofthegroupandthelevelofsupportneeded, manyplansponsorsfindthat:(1)thecostofthecashout isequivalenttoorlessthanthecostofdoing“adhoc” calculationsasparticipantsretire,and/or(2)thecostof suchaprojectpaysforitselfquicklyinadministrative, PBGC,mortalityincreases,andothersavings.Many sponsorshavefoundtheROIontheseprojectsto beupwardof50%perannum(onaninternalrateof returnbasis)afterconsideringtheone-timecostof implementationandtheexpectedannualsavingsthat wouldresult.Inotherwords,the“break-even”time horizonmaybeveryshort.However,everysituationis different,andplansponsorsshouldevaluatethecosts andbenefitsapplicabletotheirprogram. 10. “Mortality changes won’t happen until 2016, so there is no reason to act now” In many cases, given declines in interest rates during the first quarter of 2014, the financial business case may be compelling at the moment (lump sums may be lower than the obligation released), and this opportunity can be captured and executed on in 2014. However, it is unclear what the relationship will be after 2014, which leaves the possibility that this opportunity will be missed. Additionally, it seems likely that auditors may insist on some recognition of improved mortality tables for 2014 or 2015 financial disclosures. Even assuming the statutory requirements for cash funding and lump sum payments will reflect increased longevity after January 1, 2016, plan sponsors may need to move soon. While 2016 may seem like a long way away, executing a successful cashout exercise takes significant time, planning, and effort. Just the process of calculating benefits, mailing, and recording elections typically takes around six months. And prior to that, many sponsors will need to clean up data to prepare, as well as build consensus and get buy-in from key stakeholders in the program. This process can take many months or even over a year. A delay could mean paying larger lump sums based on the new statutory mortality table, although the other potential savings discussed above would still be available.
  • 7. 6 Terminated Vested Cashouts Overcoming Common Misconceptions Conclusion In this Point of View we have addressed many of the misconceptions around cashouts, so that plan sponsors can better assess the opportunity to de-risk. We believe that for plan sponsors that can get past these misconceptions, the benefits of a lump sum window may be compelling. However, each organization’s specific circumstances need to be considered when making the “go/no go” decision. Mercer has a great deal of experience helping plan sponsors review the formal business case for a lump sum cashout window. We suggest that a formal review include: •• Exploring the financial implications through three lenses — economics, accounting, and cash — and helping to put the cashout exercise in the context of broader risk management strategies that the sponsor may employ. •• Quantifying the specific level of potential expense savings (annually and present value). •• Reviewing the cost of executing a cashout project and determining the specific implementation steps. •• Formalizing the business case — is the ROI compelling? •• Reviewing any barriers to a successful project •• Considering the “fit” of a cashout project within your broader financial strategy. •• Assisting with asset allocation decisions such as which assets to pay benefits from and what the asset allocation should look like after the cashout program. •• Launching a data clean-up project to make sure complete and accurate calculations exist for former employees. •• Building a formal project plan with clear roles and responsibilities to promote a successful project. Mercer consultants are very well versed in all aspects of cashout and risk management projects, and we have a great deal of experience helping plan sponsors explore the business case and ultimately execute if the opportunity is compelling. MAKING ACCOUNTABILITY WORK
  • 8. 7 Terminated Vested Cashouts Overcoming Common Misconceptions Contacts Jonathan Barry Partner +1 617 747 9676 jonathan.barry@mercer.com Richard McEvoy Partner +1 212 345 3194 richard.mcevoy@mercer.com Scott Jarboe Partner +1 202 331 2523 scott.jarboe@mercer.com Matt McDaniel Principal +1 215 982 4171 matt.mcdaniel@mercer.com
  • 9. Footnotes 1 An offer of lump sums to terminated vested participants could be done either as a permanent plan feature or as a one-time window. However, amending the plan to allow for permanent lump sums becomes a protected benefit that cannot be removed, causing potential future administrative and cost concerns. For this reason, most sponsors elect to pay lump sums as a one-time window opportunity. 2 A terminated vested participant is a former employee who worked long enough to earn a vested benefit but has not yet begun collecting a monthly pension. 3 Most plans set interest rates once per year using a “lookback” method to a month prior to the beginning of each plan year. That rate is then locked in for all lump sums paid during the year. If rates fall significantly during the year, the plan sponsor has an opportunity to pay out lump sums using the older (higher) interest rate, leading to a potential gain to the plan: where the value of the lump sums paid is less than the value of the liability released. For calendar-year plans, this was generally true through the first quarter of 2014. 4 A cashout exercise cannot be mandatory — the participant must elect to receive a lump sum. Our experience indicates that most cashout exercises achieve a takeup rate between 40% and 60%. 5 This discussion applies to plans reporting under US GAAP. Under IAS 19R, settlement accounting is typically not as large an issue — the charge (or credit) is generally simply the difference (if any) between lump sums paid and liability settled. 6 Note that plan amendments to allow lump sums have to meet nondiscrimination rules for timing and effect. ImportaNt notices References to Mercer shall be construed to include Mercer LLC and/or its associated companies. © 2014 Mercer LLC. All rights reserved. This contains confidential and proprietary information of Mercer and is intended for the exclusive use of the parties to whom it was provided by Mercer. Its content may not be modified, sold, or otherwise provided, in whole or in part, to any other person or entity, without Mercer’s prior written permission. The findings, ratings, and/or opinions expressed herein are the intellectual property of Mercer and are subject to change without notice. They are not intended to convey any guarantees as to the future performance of the investment products, asset classes, or capital markets discussed. Past performance does not guarantee future results. Mercer’s ratings do not constitute individualized investment advice. Information contained herein has been obtained from a range of third-party sources. While the information is believed to be reliable, Mercer has not sought to verify it independently. As such, Mercer makes no representations or warranties as to the accuracy of the information presented and takes no responsibility or liability (including for indirect, consequential, or incidental damages) for any error, omission or inaccuracy in the data supplied by any third party. This does not constitute an offer or a solicitation of an offer to buy or sell securities, commodities, and/or any other financial instruments or products or constitute a solicitation on behalf of any of the investment managers, their affiliates, products, or strategies that Mercer may evaluate or recommend. For the most recent approved ratings of an investment strategy, and a fuller explanation of their meanings, contact your Mercer representative. For Mercer’s conflict of interest disclosures, contact your Mercer representative or see www.mercer.com/conflictsofinterest