Wednesday, May 9, 2012

Ford Lump Sums and the Possibility of Adverse Selection

Leon LaBrecque, JD, CPA, CFP®, CFA, Managing Partner, LJPR, LLC

As probably everyone is aware, Ford Motor Company is preparing to offer a series of one-time voluntary lump-sum pension payments to its salaried retirees. The purpose of the lump sum is to reduce Ford’s pension liabilities, under the concept that some retirees will opt for the payment, thereby removing their pension liability from Ford’s books (and the balance sheet).  Of course, the retiree decision is highly individualized, so we’ve been working on a comprehensive White Paper for our Ford clients, but as I worked on the section of the paper ‘shifting of mortality risk’, it occurred to me that this action (the lump sum payment) could actually increase liabilities to Ford, at least on a relative basis.  Here’s why:

When a pension plan wants to offer lump-sum benefits, it is required to make the calculations based only on interest rate and unisex mortality.  In other words, to the Ford GRP, all 63 year old retirees are exactly the same in the amount of time they will live.  If a plan is paying monthly benefits, and someone dies early, the pension plan gains (because the liability went away and the money stayed in the plan).  This is called an actuarial gain. If a retiree takes the lump sum payment, Ford has removed the liability, but it has also eliminated the possibility of any actuarial gain (the actuarial gain has been shifted to the retiree’s family).

So, let’s take a simple example:  There are four 63-year-olds in the pension plan, all of whom are receiving either a single life benefit or a reduced joint and survivor benefit of the same monthly amount:
  1. Tom, a 63 year old male, single with an adult child, high blood pressure and a history of heart disease.
  2. Candace, a 63 year old female, single with no children, marathon runner, yoga practitioner, and in perfect health with a living nonagenarian mother and aunts.
  3. Mike, 63 in poor health, married to Sue, 63, in great health.
  4. Kathy, 63 in good health, married to John, 63 in poor health.
Under the current pension & actuarial rules, Ford’s liability is exactly the same for each of the retirees due to the unisex mortality table, even though according to the chief actuary of Social Security, 63 year-old women will outlive 63 year-old men on average by 2.83 years.   It’s likely that Tom will predecease Candace, and that Sue and Kathy will probably outlive their spouses, So, with the four above participants, if the healthy people lived 5 years longer than the table and the people in poor health lived 5 years shorter, there would have been actuarial (mortality) gain on Tom and Mike, and actuarial losses on Candace and Kathy.

From the pensions’ liability standpoint, it would be a wash.  Now, let’s look at the situation with the lump sum payments. Ford is required to offer the same amount to all four participants, let’s say its $483,000. Tom and Mike would possibly take the lump sum and Candace and Sue would not (life expectation considerations). Same scenario as before, healthy people live 5 years longer than assumed, unhealthy people live 5 years less. Although Ford reduced its liability on Tom and Mike, it also gave up the actuarial gain; it retains the liability on Sue and Candace AND suffers the actuarial loss. This could potentially increase the overall liability.

In other words, by offering a lump sum, it’s logical that the retiree who may benefit from it (I am going to estimate about 20%) will take it, leaving a cohort of healthy retirees who cost the plan more in the long run.  The plan reduces liability by 20%, but increases the remaining liability with mortality experience.  Balance sheet gets a boost because of the pension math; it's brilliant.

Maybe in the future, plans will send bacon and butter gift packs and hang-gliding coupons to retirees.