The effect of settlements on the income statement and other critical financial parameters

In this article we review the effect of settlements on sponsor financials. Our principal focus will be the effect of a settlement on a firm’s income statement, and critically whether and how a settlement may have an effect on so-called pension income, an issue that often comes up when a sponsor considers settling defined benefit plan liabilities. But we will also cover other critical financial parameters.

As a way of introducing these issues, we’ll begin with (the relatively intuitive issue of) the effect of settlements on the balance sheet. Then we’ll go to the more gnarly issue of the effect of a settlements on the income statement.

Settlement and the balance sheet

The balance sheet generally provides a market-basis snapshot of the value of a firm’s DB plan assets and liabilities (the Projected Benefit Obligation/PBO). From these numbers, the plan’s status (vis a vis the firm’s overall value) as a net asset or liability (net over- or under-funding) may be determined. (Thus, on this view, an overfunded plan would be a net asset to the firm; and underfunded one would present a net liability.) Settlement of a liability “at book” generally removes an equal amount from both assets and liabilities, leaving the net over-/under-funding unchanged.

Where a plan is underfunded (before settlement), the settlement will reduce the plan’s funded percentage. This is relevant for plan finances and may affect minimum funding requirements (see “Cash Flow” below). But the effect of the plan-as-a-financial asset on firm value is unchanged (as noted, net over-/under-funding is unchanged).

This point needs to be emphasized. These are firm financials, not plan financials, and the risk a plan presents is determined relative to the firm as a whole, not relative to the plan. Thus, one relatively small but significantly underfunded plan may simply be immaterial to a firm’s financial condition.

Income statement effects

Settlement triggers two income statement effects that may reduce the sponsor’s net income. First, any unrealized actuarial losses are subject to accelerated recognition at settlement. For example (and oversimplifying somewhat), losses related to interest rate or asset performance experience that is lower than assumed rates may be (under current accounting rules) smoothed over future service. When a portion of the plan’s liabilities are settled, a portion of those unrecognized losses must be recognized in/run through the income statement as an expense.

Second, for many DB plan sponsors, return-seeking plan investments (e.g., in equities) in the DB plan’s asset portfolio may produce “pension income” – an “expected return on assets” (EROA) that will reduce plan costs and may even throw off positive income. If, post-settlement, the plan continues the pre-settlement asset allocation (e.g., 60/40), the amount of these return seeking assets will go down, and the “pension income” attributable to them will also go down, with a negative effect on the sponsor’s income statement.

Pre- and post-settlement asset allocation

In understanding the effect of a DB plan on sponsor finances/sponsor financials, it’s important to keep in mind that, while it may have some regulatory consequences (e.g., under ERISA’s minimum funding requirements), the “percentage” of plan underfunding – plan assets divided by plan liabilities – is not the relevant number for firm decision making. What matters is the risk the plan presents to the firm overall.

Crudely, the amount of risk a plan presents to a firm might be defined as the dollar amount (not the percentage) of its net unfunded liabilities. But in a context in which a firm is pursuing a “glide path” strategy, where a certain percentage of plan investments are allocated to liability driven investments (LDI) with the idea of reducing plan risk, it makes sense to understand plan risk in terms of the plan assets and liabilities that aren’t part of that LDI strategy. Thus, we would define the risk a plan presents to a firm as the amount of its “at risk” liabilities net of its “at risk” assets.

Saying it with numbers

It may be easier to illustrate what we are saying with some numbers. Consider a firm with a net worth of $1 billion, that has a DB plan with $80 million in assets and $100 million in liabilities. Under the glidepath investment strategy adopted by the firm, currently (pre-settlement) half of the plan’s assets are “LDI-ed” – e.g., $40 million of plan assets are invested in duration matched bonds against $40 million in liability. That $40 million piece of plan assets/liabilities is (in effect) “de-risked” (and, assuming the LDI strategy is effective, can be ignored).

In this situation, the risk (to the firm) that the plan presents is the remaining $40 million in (return seeking) plan assets and $60 million in plan liabilities. Saying the same thing a different way: theoretically, all the volatility the plan presents to the firm is generated by the positive/negative performance of that remaining $40 million in assets/$60 million in liabilities. And, pre-settlement, that is where the pension income – with its positive effect on the firm’s income statement – comes from.

Settlement is a de-risking transaction

Settlement is (indeed) the ultimate de-risking transaction – it makes the associated liabilities literally disappear from plan financials. And because it is a de-risking transaction, unless it is funded out of the de-risked portion of the plan’s portfolio, it will reduce the overall risk the plan presents (and so reduce the amount of pension income the plan throws off).

Consider our example. Let’s say the plan settles $20 million in liabilities and funds that settlement half from LDI assets and half from return seeking assets. Post-settlement the plan will have $60 million in assets and $80 million in liabilities. $30 million in assets and $30 million in liabilities will be “LDI-ed.” And $30 million in assets will be “at risk” (invested in return seeking assets) against the remaining unhedged $50 million in liabilities.

To repeat – what matters to the firm here is dollar amounts not percentages (not the plan’s financial condition relative to itself but relative to the firm). In that context, going from $40 million in assets/$60 million in liabilities at risk to $30 million in assets/$50 million in liabilities at risk is an overall reduction of the risk the plan presents to the firm. With a necessary negative effect on firm (pension) income.

Alternatively, if the entire $20 million is settled out of LDI assets, then post-settlement there would be $20 million in LDI assets against $20 million in plan liabilities, and (as was the case pre-settlement) $40 million in return seeking assets and $60 million in at risk liabilities. With no negative effect on pension income.

To say all of this another way – if you don’t fund a settlement out of LDI assets, you are deciding to go further down the glidepath, increasing the amount of the plan’s assets/liabilities that have been de-risked.

Many sponsors may want to do just that – to see the net effect of that sort of settlement as a feature not a bug. But sponsors concerned about the effect of a settlement on pension income should consider keeping the “at risk” asset allocation stable through the settlement by (in effect) funding the settlement out of the LDI portion of the plan’s asset portfolio.

Cash flow

Cash flow is generally driven by ERISA minimum funding requirements, which in certain circumstances will compel (or severely encourage) the sponsor to contribute to the plan. Very generally, ERISA minimum funding requirements are driven by the plan’s funded percentage. We are not going to go into these requirements in detail. We will only make the following observations:

• If a plan is underfunded, the sponsor is (with several exceptions) required to fund the shortfall over 15 years.

• If the plan is less than 80% funded, certain benefit restrictions (including restrictions on settlement) apply.

• Interest rate relief – most recently in the

   

  American Rescue Plan Act of 2021 (ARPA)

   

  – significantly reduces ERISA minimum funding requirements; recent interest rate increases have (to some extent) reduced that relief.

The following chart shows ARPA interest rates vs. market rates.

As ARPA, 24-month average, and spot rates converge, interest rate relief ceases to apply.

Overhead

As we noted in our last article on this topic, if DB liabilities are left on the books, the sponsor will have to continue to pay annual Pension Benefit Guaranty Corporation premiums (at least $96 per participant in 2023) and administrative expenses (typically around $50 per participant per year). Axiomatically, these substantial per capita costs mean that sponsors enjoy the greatest return for settling the smallest benefits.

Because a settlement at book will generally neither reduce nor increase the dollar amount of plan underfunded vested benefits, it will generally not affect the amount of PBGC variable-rate premiums (VRP) the sponsor owes. If settlement is “above book” (e.g., where the sponsor pays a premium over book to buy an annuity), funding will be (marginally) reduced and VRPs will marginally increase. Similarly, if settlement is “below book” (e.g., where a lump sum is paid out using a “lookback month” interest rate that is higher than current rates) funding will be (marginally) increased and VRPs will be marginally reduced.

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We will continue to follow these issues.