Nancy G. Ross
Sam Myler
Ever since the passage of the Pension Protection Act of 2006, plan sponsors have struggled to keep their defined benefit plans adequately funded in the midst of increasingly volatile capital markets, shorter asset and “interest smoothing” periods, and higher targeted funding levels. Efforts to manage this pension risk have ranged from simply taking a more active approach to managing plan investments through liability-driven investment (LDI) techniques, to pension buy-ins and lump-sum offers to plan participants. One de-risking technique, however, has attracted significant attention as of late: plan buyouts through the purchase of group annuity contracts.
The benefit of such an arrangement, however, can be significantly undermined by the company’s failure to carefully consider the legal and governance issues involved. As is the case with many actions in the Employee Retirement Income Security Act-covered plan universe, pension buyouts are an invitation to litigation. The sizes of these deals, both in terms of the dollar amounts and the number of plan participants, make for increased demands on all parties involved—plan sponsors, administrators, consultants, and insurers. All must remain mindful of their obligations under ERISA in order to reduce the possibility that lawsuits by aggrieved annuitants will render the buyout medicine worse than the pension-disease. By engaging in the necessary procedural prudence up front, companies should be able to ward off—or at least successfully defend—resulting litigation or enforcement actions.
Plan buyouts have been around for some time, but the sizes of two recent deals have brought this particular type of de-risking transaction to the fore. In June 2012, General Motors Company announced a deal that it had struck with The Prudential Insurance Company of America for the purchase of over $26 billion worth of annuity contracts to satisfy its pension obligations to approximately 42,000 salaried retirees. And in October, Verizon Communications Inc. announced its own buyout deal with Prudential, this one involving the purchase of $7.5 billion in obligations. With no previous pension buyout since the 1980s surpassing the $1 billion mark, many pension experts have cited these two recent deals—with their sheer size and the prominence of the parties—as signaling the beginning of a significant trend toward de-risking through dramatic plan-wide buyouts.
The Threshold Question: Fiduciary or Not?
The vast majority of significant ERISA litigation arises when a plan participant or class of participants feels that some decision made by the plan sponsor or the parties administering the plan violated the fiduciary duties owed under ERISA. However, it is important to note that these fiduciary duties are only implicated when the decision or action at issue involves an exercise of discretion over the management or disposition of the plan’s assets, or the administration of the plan. Decisions with regard to the plan that can be characterized as “strictly business”—plan creation, amendment, or termination—are not the type of decisions that the company must make as a fiduciary, and therefore are not decisions that pose litigation risk.
This distinction, while seemingly technical, is incredibly important in the context of pension buyouts: while the buyout decision itself is unlikely to expose the sponsor to fiduciary breach claims, the actual transaction and the winding-up of the plan is one that requires a host of discretionary decisions concerning the disposition of plan assets and the administration of the plan, and therefore ERISA’s fiduciary duties are likely to apply to these discretionary decisions. In the context of a pension buyout, the duty of loyalty, the duty of prudence, and the duty to administer the plan in accordance with plan documents may all need to be navigated at various points in the process.
The Duty of Loyalty to Participants
The duty of loyalty to plan participants has been referred to as “the highest known to the law.” It requires that the plan fiduciaries make decisions concerning the disposition of plan assets with “ ‘an eye single’ to the interests of the participants.”
This duty of loyalty is often implicated when making decisions concerning how to invest plan assets, and it is very likely that it would similarly apply when deciding among annuity providers. As one court opined, the choice of annuity provider is “possibly the most important decision in the life of the plan.” Therefore, the interests of the participants in the security of their pensions should be the central consideration when choosing an annuity provider; plan assets should only be used to purchase the safest available annuities. A plan sponsor would surely risk claims by participants that the sponsor breached its duty of loyalty to the participants if evidence was uncovered that the plan sponsor chose an annuity provider based on business relationships with the provider or the cost of the annuities to the company.
The Duty of Prudence
ERISA’s duty of prudence requires that fiduciary decisions be made with the appropriate degree of skill, prudence, and diligence necessitated by the circumstances. Given the importance of the decision regarding the terminal disposition of a participant’s pension assets, it is likely that courts will view pension buyout decisions as demanding an especially high degree of prudence. However, it is important to keep in mind that the outcome is not the yardstick by which prudence is measured. Prudent decisions are instead ones that evidence diligent investigation of all available options, the performance of acts consistent with the terms of the plan, and a decision aimed at appropriate goals given the circumstances.
The duty of prudence will undoubtedly demand that the plan sponsor thoroughly vet the insurer’s solvency, the diversification of its investments, the size of the buyout relative to the size of the insurer, and any other considerations that may bear on the security of the participant’s annuity under the contracts so as to avoid throwing the plan participants aboard a sinking ship. U.S. Department of Labor Interpretive Bulletin 95-1 sets out requirements for properly evaluating the financial, operational, and legal strength of the annuity provider under consideration.
The Duty to Pay Benefits Owed Under the Plan
Fiduciaries also have a duty to pay participants the benefits that they are owed under the plan. Complex issues (i.e., issues beyond the scope of this article) often arise concerning what documents constitute the “plan” and the benefit owed under it. When purchasing a terminal annuity, the plan sponsor must be careful to purchase an annuity that makes good on the promised benefits under the plan. An annuity that pays a benefit at all inconsistent with the participants’ understanding of what the plan promised is likely to spawn claims that the sponsor breached its obligation under the plan and violated its fiduciary duties owed to the participants.
Mitigating Litigation Risk Through the Use of Independent Fiduciaries
The above considerations are just a small sample of some of the thorny issues that may arise before, during, and after the decision to de-risk through a buyout. Because a little care today may avoid a great deal of trouble tomorrow, legal counsel may want to encourage the appointment of an independent third party that can prudently vet potential insurers with an “eye single” to the interests of plan participants.
By appointing and delegating this task to an independent fiduciary, the plan sponsor can approach the de-risking from more of a business perspective—focusing more on price than on the tricky legal and fiduciary issues. In fact, the Department of Labor has suggested that appointing an independent expert capable of identifying appropriate insurers will help sponsors comply with their fiduciary duties. Now, the choice of independent fiduciaries will likely be a fiduciary decision in and of itself, but this, and whether it is necessary to appoint an independent fiduciary to select your independent fiduciary, is a topic for another day.
Nancy G. Ross is a partner in the Chicago office of McDermott Will & Emery and is head of McDermott’s ERISA litigation practice group. Sam Myler is an associate in McDermott’s Chicago office.
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