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An Independent Fiduciary Protects All Parties

With rising interest rates and CEO’s tired of pension-related balance sheet surprises, the volume and size of annuity transactions is bound to explode.

Experience teaches that exuberance in financial markets and products can lead to some very painful losses.  The Department of Labor is concerned.  It has seen this movie more than once.

Multiple factors go into the corporate decision to “de-risk” the balance sheet by purchasing annuity contracts.  Months of work go into this decision.  One key factor is the cost of the annuity, as well as the cost of executing the transaction.  While these transactions can be expensive to execute, senior corporate managers are also incentivized, and have a duty of loyalty to the company, to minimize these expenses.  Lower expenses enhance earnings.

However, annuity pricing is efficiently correlated to the credit quality of the issuer of the annuity.   In other words, lower credit-quality issuers charge less for their products.  The corollary is also true; higher credit-quality annuities are more expensive.

Left to their own devices, corporate managers are incentivized to purchase the cheapest annuity available even if it reduces the credit quality of the issuer.  This pressure is very strong.

Plan fiduciaries and participants, however, have a different view.  They are interested in the strongest credit quality issuer available, price be damned.  Remember, prior to the annuity purchase, the pension plan is funded by a diversified pool of assets, thereby mitigating investment risk.

An annuity purchase,however, substitutes a single issuer for this diversified pool.   The pensions of thousands of plan participants are dependent on this single issuer.  The issuer goes bankrupt, the pensions are lost… forever.

The conflicts for senior managers (some of whom are plan fiduciaries) in executing these transactions are real.  Should they pay up for higher credit quality; or, should they sacrifice credit to enhance earnings.

ERISA provides a single answer.  Fiduciaries must act in the interests of participants.

In the early 1990’s the bankruptcy of Executive Life Insurance Co. provided a huge wake-up call.   Many plans were invested in Exec Life products and they absorbed huge losses.

In response,  the DOL issued guidelines in IB 95-1 setting forth numerous requirements regarding the purchase of annuity contracts.  Post-Executive Life,  the DOL requires that a plan purchases the “safest available annuity”.   In reaching this determination, the DOL requires that 6 six factors be analyzed, price of the annuity is not one of the factors.

Recognizing the potential conflicts of interest and the competing pressures of corporate managers, these IB 95-1 suggests that an independent fiduciary be hired to make the the “safest available annuity” determination.

Unfortunately, plan sponsors don’t like hiring Independent Fiduciaries. They don’t like paying the fees and they don’t like a second set of eyes reviewing their judgments.  If corporate managers want to purchase an annuity from XYZ Insurance Co, they don’t want a third party telling them that they should purchase the annuity from DEF Insurance Co.  And, they really don’t like that an Independent Fiduciary will retain its own lawyers and advisors for the transaction.

Ironically,  the intensity of the resistance by senior managers to hiring an Independent Fiduciary actually illustrates and proves the very conflicts of interest outlined above.

Corporate managers who forgo an Independent Fiduciary might one day be in the position of having to prove to the Department of Labor that they transcended these conflicts and acted in the interests of plan participants.  In the context of large losses (possibly $ billions) That will be a hard argument to make.  The DOL will be very suspicious.  Remember, there is personal liability for breaches of fiduciary duty.

In the end, an Independent Fiduciary will make decisions in the interest of the plan participants.  However, the corporate managers can take great comfort from knowing that the conflict of interest is significantly mitigated by the hiring of the Independent Fiduciary.  Whether they understand it or not, the Independent Fiduciary provider significant protections to the corporate managers.

Corporate managers should focus on executing their corporate strategies.  Let the Independent Fiduciaries wrestle with the complexities of purchasing annuity contracts.

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