The Challenge of Pension De-risking
PENSION
SETTLEMENT
STRATEGIES
Deutsche Bank Securities Inc., a subsidiary of Deutsche Bank AG, conducts investment banking and securities activities in the United States. Deutsche Bank Securities Inc. is a member of NYSE, FINRA and SIPC. Lending and other commercial banking activities in the United States are performed by Deutsche Bank AG, and its banking affiliates. © 2013 Deutsche Bank AG. All Rights Reserved.
Pension Risk Management.
Strategic advice and innovative pension
de-risking solutions.
Deutsche Bank’s pension franchise is an
industry-leading, award-winning participant in the diverse
and growing global pension de-risking market.
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leveraging Deutsche Bank’s global capabilities across
banking, capital markets, and institutional sales
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and capital markets experts across four continents.
Our ambition is to continue providing innovative
risk transfer solutions to corporate pension plans.
Contact:
Kevin Mclaughlin
Director, Head of US Pension Risk Management
+1 (212) 250-4250 | [email protected]
Paul Puleo
Managing Director, Head of Pension &
Insurance Risk Markets
+1 (212) 250-0665 | [email protected]
AEGON
€12,000,000,000
Population-based longevity risk transfer January 2012Rolls Royce and
Bentley Pension
Fund, sponsored
by Bentley Motors
£500,000,000
Bespoke longevity swap syndicated to a reinsurance counterparty March 2013
Select Transactions
BMW
£3,000,000,000
Syndication of longevity risk to consortium of hedge counterpartiesFebruary 2010
Best Bank Overall 2012
Best Bank for Longevity Risk 2012
ILS Deal of the Year 2011
Rolls Royce
£3,000,000,000
Syndication of longevity risk to consortium of hedge counterparties
November 2011
Pension Settlement Strategies 3
Deutsche Bank Securities, Inc.
60 Wall Street
New York, NY 10005
Kevin McLaughlin
US Head of Pension Risk Management
212.250.4250
[email protected]
www.db.com
Evercore Trust Company, N.A.
55 East 52nd Street, 23rd Floor
New York, NY 10055
William E. Ryan
Managing Director &
Chief Fiduciary Officer
212.849.3576
[email protected]
www.evercoretrustcompany.com
MetLife
501 Route 22
Bridgewater, NJ 08807
Matthew V. Kasper, CFP®
National Director, U.S. Pensions
908.253.2760
[email protected]
www.metlife.com
NISA Investment Advisors, L.L.C.
150 North Meramec Ave., 6th Floor
St. Louis, MO 63105
Gregory J. Yess, CPA
Managing Director, Client Services
314.721.1900
[email protected]
www.nisa.com
Prudential
280 Trumbull Street
Hartford CT 06103
Glenn O’Brien
Managing Director, Pension Risk Transfer
917.339.4418
Glenn.O’[email protected]
www.prudential.com/pensionrisk
Sponsors
WHY PENSION PLANS ARE WEIGHING
SETTLEMENT OPTIONS
4
With pension risk a key balance
sheet issue and last year’s landmark
deals much on their minds, plan
sponsors are considering a variety
of de-risking possibilities
PREPARING FOR THE END GAME
9
When pension risk transfer–or
any pension risk management
technique–is in your sights, it is
important to understand the
work involved
THE GROWING CHALLENGE
OF LONGEVITY
14
The good news is that we’re all
living longer. The bad news is that
longer lives pose more difficulties
for pension plan sponsors
Contents
I
t’s been an interesting time to be a defined benefit (DB) plan sponsor. Interest rates have suddenly started moving up, and plan funded status has risen with them. Plans are beginning to hit liability driven investing triggers. Maybe this time plan sponsors will get serious about minimizing funding volatility.When it comes to de-risking, DB plans have a range of choices. What links these choices is a clear direction. “For many plans, the goal is to ratchet down the funded status volatility of the pension plan,” says David Eichhorn, Managing Director, Investment Strategies at NISA Invest-ment Advisors. “If this isn’t done there is a risk to participants and a risk at an enterprise level that could require more contributions. Many of our clients are interested in a serious reduction of funded status volatility. Some may be thinking about offloading the plan to an insurer, and some may de-risk internally.”
DB plans aren’t a growth industry. There are few plans that are active, open and growing. Many are closed or frozen. It’s well understood that the growth in future pension assets will come from defined contribution plans. “DB plans for so long have served as an invaluable benefit for workers and their families. However, because of changes in the economic costs of maintaining these plans, and administrative complexities, many large companies view them today as an albatross,” says Norman P. Goldberg, Vice Chairman at Evercore Trust Company.
These trillions still need to be managed. For corporate plan sponsors, the pension manage-ment task needs to be accomplished with the least effect possible to the corporate balance sheet. “Companies have been trying to reduce the volatility of costs associated with running pension plans,” says Ari Jacobs, Senior Partner and Global Retirement Solutions Leader at Aon Hewitt. “The ultimate step in this process is to reduce liabilities by transferring them. Companies with larger liabilities as a percentage of market capitalization are more likely to be thinking about this – those with pension liabilities of at least 20% to 25% as a percentage of market capitalization.”
The focus on pension risk transfer moved
up a significant notch last year, with deals com-pleted by Ford, GM and Verizon. “The trend to pension risk transfer is being driven by the sheer size of obligations today, the cost of managing these funds and the associated funding volatil-ity,” says Kevin McLaughlin, Director and U.S. Head of Pension Risk Management at Deutsche Bank. “It’s this volatility that’s of most concern to companies, particularly if the liabilities are quite large in relation to the balance sheet.”
The move to de-risk, as opposed to settling the assets, is well established. “Pension plan sponsors are looking at de-risking actions,” says Edward Root, Vice President & Actuary and Head of U.S. Pensions at MetLife. “The pace picked up dramatically around 2008 with PPA and FAS 158, which increased funding requirements and brought pension plans closer to mark-to-market accounting. The recession, declines in equities and interest rates at the same time made for a perfect storm. Funded status has been very volatile since then.”
Interest in investment solutions such as LDI, which rely on identifying and mitigating risk, has grown dramatically. “Defined benefit pension plan sponsors are surrounded by risk – longev-ity risk, interest-rate risk, equlongev-ity risk,” says Rohit Mathur, Senior Vice President at Prudential. “They are more aware of the risks they are carrying. Over the past 12 years, according to a Milliman study, the largest U.S. pension plans lost 30% of their funded status twice and are still carrying considerable pension deficits. They face rising contributions over time to close the funded status gap.”
ENTERPRISE RISK
“There’s been a culture in corporate America to retain pension risk,” says Prudential’s Mathur. “But plan sponsors are re-thinking that decision and realizing they should focus on managing their core business instead of their pension plan. As plans are becoming better funded, CFOs and treasurers are asking themselves whether their pension plan is the best place to take risk. Many are choosing to de-risk.”
It’s been rather a long road to get companies
to this point. “Many first-generation LDI solu-tions were good programs,” says Jess Yawitz, Ph.D., Chairman & CEO at NISA Investment Advisors. “But the support from the CEO or CFO wasn’t always there. Now we see pressure to de-risk coming from the upper floors of the building. Now plan fiduciaries are able to get the seal of approval to make changes to the plan to reduce funding volatility in advance.”
The impetus for this new focus on pension funding volatility doesn’t just come from the plan sponsor. “Analysts and rating agencies are now more savvy about the effects of a deficit in the pension plan,” says NISA’s Eichhorn. “They know that the pension fund is a liability of the company, that underfunding is a form of debt, and that there can be large cash flow implica-tions. That’s really why pressure to solve this problem is coming down from the C-suite.”
STAKEHOLDER CONCERN
“There’s been an escalation of stakeholder concern about pensions,” says Prudential’s Mathur. “Shareholders, credit analysts and rating agencies are all looking at the impact of the pension on the company’s valuation and capital structure. With this public spotlight on pension risk, companies are looking for ways to achieve contribution certainty and eliminate funding volatility so that they can put greater focus on their core business.”
Not all companies are affected equally by volatile pension funding ratios. “Looking at pen-sion plans industry by industry,” says Deutsche Bank’s McLaughlin, “airlines can’t handle the cost base of their plans. Big communications and technology companies are moving from an old tech to new tech world. Generous defined benefit pension packages in a low interest-rate environment are unaffordable in a competitive new tech industry. Industrial companies can of-ten have pension obligations across many coun-tries and these can be large in relation to other balance sheet items. Consumer cyclicals find that the pension cash needs can be highly correlated with the cash needs of their businesses, which can be problematic. Other industries are less
af-Why Pension Plans Are
Pension Settlement Strategies 5
fected, but nonetheless may look to transfer risk within a few years.”
The fact is that for many companies a DB pension plan isn’t workable in their current business model. “I severely doubt that most shareholders would make a conscious decision to have a pension plan operating alongside their main business,” says Scott Kaplan, Senior Vice President and Head of Global Product and Market Solutions for Prudential. “In most cases a pension plan today does not help in attracting and retaining talent. In fact, a pension plan could be a management distraction. We view it as a risk management issue. A company needs to generate free cash flows. The pension plan is taking meaningful risk and often generating significant funding volatility. That can have the effect of diverting cash flows from core opera-tions into the pension fund.”
While it is true that funding ratios are ris-ing, it is also true that turbulent markets don’t always have positive effects on pension plans, particularly if the assets and liabilities are not
well matched. “Changing the asset allocation will have a major impact on your funded status volatility,” says NISA’s Eichhorn. “But market volatility going up will also make plan volatility rise. As interest rates have gone up recently, funded status has risen, but so has funded status volatility.”
ADOPTING LDI
All decisions really flow from the choice of whether a company wants to continue to own its pension plan or not. In either case, the plan needs to prepare. “There are five main types of de-risking actions,” says MetLife’s Root. “You can change pension plan design, increase funding, change the investment strategy, offer lump sums or purchase a pension buyout. We’ve seen many plan sponsors close or freeze their plans. Many have increased their contributions above the minimum required contributions, which can be paid for with cash, debt, or equity. The main investment strategy changes involve adopting LDI, matching assets closer to liabilities, which
usually includes increasing fixed income alloca-tions. Dynamic de-risking creates a glidepath for changing the asset allocations at pre-determined triggers. Lump sums became more attractive with the now phased-in change from a 30-year Treasury rate to a corporate bond rate for lump sum pricing. Finally, a pension buyout can involve a partial risk transfer for retirees only or a full risk transfer in conjunction with a plan termination. De-risking actions can be used separately, or they can be used together, either sequentially or at the same time.”
THRESHOLD OF ZERO RISK
Quantifying an acceptable level of risk is key to the pension planning process. This is because it is never a foregone conclusion that the plan sponsor will eventually sell the plan. “Pension plans can choose their risk level,” says NISA’s Eichhorn. “But the key driver here is, ‘What is the goal?’ If the primary goal is to reduce the plan’s volatility and sponsor’s enterprise risk, buyouts and LDI hibernation strategies may look substantially similar. It is possible to approach the threshold of zero funded status risk with LDI, without incurring the immediate payment and loss of flexibility required to offload the liabilities to an insurer.”
“Transferring assets to an insurer isn’t the only prudent solution to pension de-risking,” says William E. Ryan III, Chief Fiduciary Officer at Evercore Trust Company. “Over the next few years, if interest rates continue to rise and funding goes up, then the most affordable solution may be to de-risk the plan but continue to manage it under an LDI strategy. However, in a higher interest-rate environment, lump sums will become more expensive for the plans to pay, and given the interest-rate and general market performance, the need for plan sponsors to make large additional contributions to fund the plans should decrease, making annuitization a more attractive option for companies. This won’t happen next year, but in the next three to five years, we expect more companies will be investigating this option.”
This investigation represents a sea change
With pension risk a key balance
sheet issue and last year’s landmark
deals much on their minds, plan
sponsors are considering a variety
of de-risking possibilities
in the corporate approach to pensions. “Thirty years ago, the world was viewed as simpler by pension funds,” says NISA’s Yawitz. “It was considered to be an asset-only world. But things have changed. Funded status is more important than asset performance. It’s important to under-stand the liability denominator. That has always been our focus at NISA. When LDI is initially adopted, the first phase is generally to lengthen duration of existing bond portfolios to increase the liability hedge. But for many sponsors it’s not enough just to get a 40% or 50% hedge. And unless you’re ready to allocate additional assets to fixed income, to achieve more hedge you need derivatives.”
“In the current millennium,” Yawitz con-tinues, “Many pension funds are systematically making an effort to implement LDI. Total funded status is driving actions by plan sponsors. Plans are buying more long duration physical bonds. We see plans with both explicit and implicit triggers based on interest rates or funded status. When those triggers are hit, the resultant steps are risk-reducing. If they contribute cash to the plan, it’s used to buy long bonds. Over two-thirds of our clients are invested in long duration bond benchmarks.”
HIBERNATING THE PLAN
There’s plenty of help available for corporate plan sponsors looking to weigh their options. These include the use of asset managers able to devise and manage a dynamic LDI strategy with an aim of gradually moving to full funding, hibernation or risk transfer to an insurer able to provide a variety of annuity-based alternatives. “Looking at pension de-risking in general, we see three primary alternatives under current law,” says Evercore’s Ryan. “The investment solution is LDI, which is a bond-heavy strategy that is often used in conjunction with a frozen plan, or even in active plans. The second alternative is using lump sums to settle payments to former participants. The third alternative involves using a fiduciary to help in the annuitization of all or part of the liabilities. Under ERISA, these annui-ties need to be provided by a U.S. insurer.”
To even contemplate a pension settlement strategy, a company needs to have a fully or more likely overfunded plan. “Companies have the option to raise debt and use the cash to plug the pension funding gap,” says Prudential’s Mathur. “We don’t have a crystal ball, but we do expect that more companies will do this. When the plan is fully funded, companies have more choice in terms of how to manage this risk and whether risk transfer makes sense. We are certainly preparing for more companies to make that choice.”
Largely a corporate finance decision, it can be complicated to make these kinds of decisions,
even at a time when companies are flush with cash. “Companies need to weigh the pros and cons,” says MetLife’s Root. “What is the cost of filling the funding gap? What are the other uses for that cash in the company? What is the dif-ference between the accounting and economic liability?”
FROZEN, NOT THAWED
“Different corporates will face different pres-sures,” says Deutsche Bank’s McLaughlin. “Some will look at running an in-house solution, work-ing the assets more. If you have a large in-house asset management capability, you can do this.
continues on page 8
All plan sponsors are aware of their fiduciary duties. The duties of a fiduciary include loyalty and reasonable care of the assets within custody. All of the fiduciary’s ac-tions are performed for the advantage of the beneficiary. In the case of pension risk transfer, there is a heightened sense of fiduciary duty, so much so that in some cases plans hire independent fiduciaries as part of the process.
To understand the nature of the roles and responsibilities imposed on a company by its pension plan, it pays to reconsider how the situation works in the normal course of business. In a corporate pension plan, the company is both sponsor and fiduciary, with this role usually executed via an investment committee.
When it comes to pension risk transfer or the decision to sell both the assets and the risk of the pension plan to an insurance company, these roles may need to be divorced. “The decision to terminate a plan and go forward with annuitization is the plan sponsor’s,” says Norman P. Goldberg, Vice Chairman at Evercore Trust Company. “The implementation decisions are made by the fiduciary. There is some disagreement as to whether you need an independent fiduciary, but the largest companies have found it more desirable to use an independent fiduciary.”
Under the Department of Labor’s Interpretative Bulletin 95-1, which provides guidance on this process, the company sponsor becomes the ‘settlor’ or the entity that settles the plan with the insurer. This reflects the corporate finance nature of the decision. The fiduciary, which may or may not be the plan’s investment committee or a member of the treasury staff, then makes the decision as to which insurer should be chosen. LIMIT CONFLICTS
Examples of potential conflict are already apparent, with Verizon’s recent decision to sell its plan as perhaps the most clear-cut. “Look at the Verizon sale to Prudential for a $7.7 billion premium payment,” says William E. Ryan III, Chief Fiduciary Officer at Evercore Trust Company. “It was plain vanilla in terms of benefits and the benefits mimicked those of the plan originally. From a plan design perspective, it was very straightforward. But the plan sponsor was sued. Did the fiduciary act appropriately? Verizon had its ‘settlor’ hat on when it decided to terminate the plan. Under ERISA, the settlor can adopt, design or end a plan. In this case, Verizon was the settlor, not the fiduciary. The company appointed an external, independent fiduciary to do the due diligence and choose the insurance company to provide the annuities, which provides some clear advantages in managing any litigation risk.”
The six factors cited by the DOL in its guidance are:
• the quality and diversification of the insurer’s investment portfolio, including measures of volatility • the size of the annuity contract in relation to the insurers book of business
• the capital and surplus of the insurer
• the lines of business of the insurance company, as some types of products may be seen as more volatile/posing greater risks to the solvency of the insurer than others
• whether the annuity is supported by the general account of the insurers, in separate accounts • a comparison/consideration of PBGC versus state insurance guaranty fund coverages
“Two things are important to consider,” says Evercore’s Ryan. “First, these are examples of factors to be considered, and not an exclusive check-the-box list. Second, these factors don’t always give a clear trend to consider, and need to be carefully weighed and balanced.”
Ultimately, the fiduciary decision needs to be made for the benefit of the plan participants. “Fiduciaries should make sure that the solution is secure,” says Kevin McLaughlin, Director and U.S. Head of Pension Risk Management at Deutsche Bank. “If they follow the safest available annuity standard, this should be covered. The standard is very sensible. Jumbo deals will operate as M&A deals, rather than a technical process.”
Meeting the Fiduciary Responsibility
Pension risk transfer raises some specific fiduciary issues.
But there are tried and true ways to handle the challenges
Or you can appoint specialist managers. Others will look to get the plan off the balance sheet, using cash to do it.”
The decision between keeping the plan or selling it also requires a cost-benefit analysis. “The consideration is the delta between the GAAP liability and the cost of the insurance buy-out,” says Deutsche Bank’s McLaughlin. “Should I pay that delta? And if yes, how should I finance the cost? Should I use cash or raise debt, and how will the market view the transaction?”
What is clear, though, is that fewer companies are opting to keep their DB plans open and active. “Some of our clients are going down the road from open to closed,” says NISA’s Eichhorn. “They are looking to reduce the risk profile of the pension plan, perhaps considering a full de-risking or sale.”
Others are more blunt. “Once a plan is fro-zen, it rarely thaws,” says MetLife’s Root. “A plan freeze is often a tacit admission that the plan will terminate. The question becomes when and at what cost.”
“We do expect to see an eventual ‘rush to the door’ to insurers and a queue building as plans become fully funded,” says Evercore’s
Ryan. “Insurers will price and make available these contracts according to risk and capacity. Fi-duciaries judging whether or not to use annuities may be concerned not only about this queue, but also about the financial stability of the ERISA pension insurance program through the PBGC. As stronger and more fully funded/less risky plans annuitize, they no longer need to pay PBGC premiums, reducing a significant source of PBGC funding. What we are concerned about is that these two factors will feed upon one another, and exacerbate the significant financial challenges facing the PBGC and pension insur-ance system for the remaining covered plans.”
These questions are coming to the fore, as the annuitization options gain traction at the large end of the DB pension market. “In 2012, we saw the big three transactions,” says Aon Hewitt’s Jacobs. “Ford used lump sums to settle a portion of their retirees and terminated vesteds; GM used lump sums for certain retirees and then purchased annuities for those that were left; and Verizon pur-chased annuities for retirees. These are representa-tive of the many different varieties of segmenting the population and the settlement solutions.”
There’s plenty of potential for more pension settlement deals. “There are still up to $3 trillion of liabilities in the U.S. DB market,” says MetLife’s Root. “In the next five years, we expect to see a giant move to transfer risk. The market is very
robust, but yet it could still take up to 20 years to fully de-risk.”
And though capacity may become a prob-lem, demand does not yet outstrip supply in the insurance industry. “We see capacity of at least $30 billion to $40 billion a year in buyouts,” says MetLife’s Root. “The capacity could rise to $100 billion a year, if there are new entrants to the market. Insurers may also partner with reinsurers to grow the market.”
Insurers and asset managers disagree about where the pressure points are in the market. “At the jumbo end, there are only a few insurance companies who have capacity and expertise for these types of deals,” says Scott Kaplan, Senior Vice President and Head of Global Product and Market Solutions for Prudential. “The size of the long-dated corporate bond market is more of a constraint for pension plans than insurance capacity.”
Although the big pension risk-transfer transactions get press, many plan sponsors are merely considering their options rather than doing deals. “The trend of de-risking is fairly well-established, with several strategies to choose from,” says NISA’s Eichhorn. “Annuity purchases are one end on a spectrum. And while they will remain attractive for some, we don’t expect the majority of DB plans will choose the annuity route.”
“It is possible that the optics of a buyout may be better,” says NISA’s Eichhorn. “We did some work after the recent large deals about the effect on a sponsor from an enterprise risk perspective. It was very, very hard to discern a difference between annuitization and complete internal de-risking except on price. In a buyout, there is a signal to the market of the commitment to de-risk, and this may be worth the price to some. When de-risking internally, the company doesn’t have to come up with the cash on day one.”
Optics from a corporate finance standpoint may be enough of an incentive for some compa-nies, but other observers point to the attractive-ness of annuity deals for participants, who may have concerns about the ability of their company to keep up pension payments far out into the fu-ture. “Risk transfer can be good news for retirees because it ensures the security of their benefits,” says Deutsche Bank’s McLaughlin.
A pension buyout isn’t the only solution. It is possible to do a lift-out, where only a segment of the population is subject to buyout. It is also possible to do a buy-in. “When a company uses a buy-in,” says Prudential’s Mathur, “the assets remain in the pension plan. In a buyout, the assets and risks are transferred to an insurance company. This transfer triggers settlement ac-counting and removes the pension plan from the balance sheet.”
The attractions of annuitization versus
hiber-nation aren’t lost on managers. “Annuitization is an option, but for most of our clients, it’s not the main end play,” says NISA’s Yawitz.
Hibernation is a strategy that meets a num-ber of corporate finance criteria, namely very low funded status volatility, but it may require the use of derivatives. “Many of our clients that can’t get enough duration or fixed-income sensitivity in the physical markets are using derivatives to increase their LDI hedges,” continues Yawitz. “Most of our $70 billion notional in derivative positions represents overlay strategies with these LDI clients. We feel we are a leader in using de-rivatives – interest-rate swaps and swaptions - in duration extension programs.”
Keeping the plan in-house does leave spon-sors with more options as far as asset alloca-tion goes, although some are rarely used. “An internal de-risking means that a company retains the option to re-risk,” says NISA’s Eichhorn. “This can mitigate the need for contributions, while still continuing to execute a path toward hibernation. The plan would then sell risk assets as funded status improves.”
“A candidate to re-risk may be 80% funded, but already divested of most of its risk assets,” says NISA’s Eichhorn. “It may decide to re-risk, if the risk/reward trade-off is favorable. It could be a tactical view that you take if you think risk assets are oversold.”
ACCELERATE PLANS
The hibernation strategy may be an end in itself, or it may be a stepping stone. “We know that a whole host of companies do not want to transfer their pension plan,” says NISA’s Eichhorn. “But no matter which camp you are in, the hiberna-tion strategy is a great way to get the plan to the lowest level of risk while you consider a transfer. All the clean-up you need to do to the portfolio before transferring takes time. By having a hiber-nation portfolio, you can be sure that the swings in markets won’t erode funded status.”
The current market environment makes all of these discussions ever more relevant. “In the first six months of 2013, interest rates increased 80 basis points,” says Deutsche Bank’s McLaugh-lin. “Many more U.S. corporations will be fully funded. But it happened so fast that most companies haven’t had time to react. But it’s very significant. Given all the pain, this will very obviously accelerate plans to de-risk.”
Depending on how the pension risk transfer market develops, the industry may have to adjust. “We may need new solutions if the insur-ance industry can’t write enough annuities to meet demand,” says Aon Hewitt’s Jacobs. “There aren’t any capacity constraints at the moment, but the barriers to entry into the mega-transac-tion market is significant, so new entrants will not come along too easily.” 4
We may need new solutions if the
insurance industry can’t write
enough annuities to meet demand
Pension Settlement Strategies 9
P
ension risk management is both an art and a science. But mostly it’s a compli-cated process. No matter what the plan sponsor’s ultimate goal is, it pays to understand all the steps involved in preparing the plan for pension risk transfer or any other long-term ap-proach to pension management.Talk to any plan sponsor and asset manage-ment is often the focus of the conversation. What is the plan’s approach? If it is using LDI, then what is the balance between the hedging assets and the return-seeking portfolio? And so on. But when it comes to thinking through pen-sion risk transfer or other de-risking strategies, the place to start is the liability. “It is important that the liability is mapped to the true market volatility,” says David Eichhorn, Managing Director, Investment Strategies at NISA Invest-ment Advisors. “How much can it swing over a year? It is important to get the volatility of the liabilities fully calibrated when designing a hedge strategy. Plans may find they have more risk than expected. We have seen some common mea-sures of risks significantly mis-estimate funded status volatility.”
Nailing down the liability has implications for all plans, no matter what the ultimate goal is. Pension plans that have existed for tens of years have been subject to revision and benefits changes, and that can make it difficult to assess liabilities. “We think it is very important that you make sure you measure the liability correctly,” says Jess Yawitz, Ph.D., Chairman & CEO at NISA Investment Advisors. “The determination sits with the actuary and the consultant. But you want to make sure there are no disguised op-tions, no caps or floors as there are in a cash bal-ance plan, for instbal-ance. There is nothing worse than hedging the wrong liability.”
DATA REQUIREMENTS
There are practical aspects to the prospect of transfer. The administrative effort is as important as the liability health check. “Getting the liabili-ties into a fit state is the most time consuming part of the process,” says Scott Kaplan, Senior Vice President and Head of Global Product and Market Solutions for Prudential. “It can take several months to ensure the quality and state of your data.”
For plan transfer, “readiness is essential,” says Ari Jacobs, Senior Partner and Global Retirement Solutions Leader at Aon Hewitt. “The census data requirements are higher than the plan has seen in the past. Plan documents need to be ready and possibly amended as needed. And importantly, plan sponsors need to understand the liquidity of their asset base.”
“For jumbo buyouts, there’s an investigation phase, where the plan works with its advisors,” says Edward Root, Vice President & Actuary and Head of U.S. Pensions at MetLife. “This can take over a year. Next, a feasibility study will involve reaching out to insurers to get preliminary indicative pricing. Then the plan needs to figure out their de-risking strategy such as doing a buyout with lump sums or a buyout only. This phase would include sharing asset and mortality information and serious pricing. Finally, the execution phase takes three to six months.” Some practitioners suggest that the com-plexity of these transactions is on a par with an M&A deal. “Terminating a plan and transferring the assets is a collaborative effort,” says William
E. Ryan III, Chief Fiduciary Officer at Evercore Trust Company. “Many parties are involved. The plan sponsor needs to double check the plan funding status, which can be more complicated that it sounds. It needs HR and recordkeeping to check who is covered, and clear, comprehensive information about all the covered participants. This information then needs to tie back with the actuary’s calculations of the plan’s accrued liability and what you will be transferring to the annuity provider (including projections on any cost of living or similar benefits that need to be taken into account). This level of due diligence is on a par with, and in some measure much harder, than that for mergers and acquisition activity.”
FINANCIAL STRENGTH
Pension risk transfer is a highly regulated activity. “The insurance company selection process for a buyout is governed by DOL Interpretative Bulletin 95-1,” says MetLife’s Root. “It’s a well-documented process.”
This bulletin provides a road map for a
pen-Preparing for
the End Game
When pension risk transfer—
or any pension risk management
technique—is in your sights,
it is important to understand
the work involved
continues on page 12
sion plan sponsor choosing an insurer. This is a significant fiduciary decision with implications for both the sponsor and the beneficiaries. It is a corporate finance decision as to whether the pension assets will be transferred, but a fiduciary decision as to which insurance company will re-ceive them. The key issue is simple: Is the insurer financially strong enough to pay the benefits over the many years that the plan still has to run? “Financial strength is a consideration when choosing an insurer,” says Prudential’s Kaplan, “as is the ability to service retirees on a commit-ted basis. This is about retirement security and it’s critical for any sponsor to be confident the insurer can provide this. So there needs to be careful consideration of the client and insurer objectives for risk management.”
FIDUCIARY STANDARD
The DoL rules that govern pension risk transfer use the language, ‘safest available annuity’ as the fiduciary standard. It’s a high bar for the fiduciary making the choice, but it also places many re-quirements on the insurer and these are evident in the group annuity market. “The annuity busi-ness is capital intensive for insurance companies,” says Kevin McLaughlin, Director and U.S. Head of Pension Risk Management at Deutsche Bank. “A jumbo deal is like a buying a closed book of business and needs to be viable for insurance company investors. It’s important to weigh up this aspect. There’s nothing like as much free capi-tal on insurance company balance sheets as one might think to support deals over $1 billion.”
In the search for the safest available annuity, the industry has been considering a variety of alternatives. One idea, which has been used in smaller transactions, is the use of multiple insurers as a way to provide a different level of safety. “Multiple insurers weren’t used in the mega-transactions,” says Norman P. Goldberg, Vice Chairman at Evercore Trust Company. “It has been done in lesser transactions. But I expect it will be used in larger ones. Big transactions will eat up capacity and multiple insurers may become necessary because of the amounts involved.”
It will also make the deal more expensive. “When you split a $1 billion deal between two insurers, each gets $500 million,” says MetLife’s Root. “Each participant then gets two insurance certificates. It diversifies insurance company risk and doubles the State Guaranty Association cov-erage. The cons are additional cost, around 1%, and the deal logistics are more difficult. Under $200 million it’s rare to split the deal.”
“Having multiple insurers annuitize a single plan has been done, but presents some significant levels of administrative and financial complexity,” says Evercore’s Ryan. “The fidu-ciary making the decision to use a syndicated structure (which could include covering different
groups of participants with different carriers, or having an insurer cover a portion of each partici-pant’s annuity benefits), and then choosing the specific insurers to use, has to determine that all of the carriers offer the ‘safest annuity available.’ Practically speaking, you have to understand clearly what would happen if one carrier defaulted. Unless each insurer is backstopping the obligations of the other (which is unlikely), participants can be left with all or a portion of their payments potentially at risk. While any default would trigger state insurance protection on the portion of each participant’s annuity held with that insurer in the event the insurer’s assets were insufficient to make payments, part of the analysis would need to understand which guaranty fund would cover which participant, and what would the level of protection be.”
In a pension risk transfer transaction, the company plan sponsor is known as the ‘settlor’, the entity settling the assets on the insurance company. “Companies can seek to diversify risk as a settlor by using multiple insurers,” says Pru-dential’s Kaplan. But that’s not easy to do with big deals like recent ones by GM and Verizon. “Transactions like GM and Verizon are complex transactions to negotiate. I would say that they are more like M&A transactions than group annuity purchases. Both GM and Verizon had definitive transaction agreements in place before the transfer took place. These deals are challeng-ing at best. They would be exponentially more complicated with more than one insurer.”
SUFFICIENT ASSETS
At the end of the day, though, the company will need to be confident that it understands its liabilities thoroughly and has confidence that the transfer of the pension risk to an insurer will be a better outcome for both the company and its pension beneficiaries.
It costs more to set up a separate account to hold the assets, but in the event of insolvency, the assets there will still be available to service the liabilities of the pensioners. “Answering the question of whether to use the general account or separate account requires balancing the cost of the separate account with the extra security it provides,” says Aon Hewitt’s Jacobs.
Scale, of course, can offset some of the cost. “The size of the plan does impact the separate account decision,” says Prudential’s Kaplan. “We do see larger plans choosing separate accounts. But it is also possible to choose pooled separate accounts and we expect to see that happening more frequently in the future with smaller plans.”
The rules governing the operation and investment of general and separate accounts are different. “Single-contract insurance company separate accounts are not always the best or only option for fiduciaries to consider. Insurance
company general accounts, for example, are heavily regulated under state insurance law,” says Evercore’s Ryan. “Expenses charged against the account are clearly laid out, and the asset types that can be held are more plain vanilla. Assets held in single contract insurance com-pany separate accounts supporting an annuity contract, by contrast, can be more diverse and exotic, though. Companies transferring assets to an insurer’s segregated separate account supporting a single group annuity contract can often negotiate the investment policy limits. For smaller plans, single contract separate accounts may not be available, but pooled separate accounts (as well as general account contracts) may be in the mix, and there are reinsurance strategies that insurers may be able to imple-ment to provide extra protection.”
STRONGER PROTECTION
In addition, experts say their extra security may justify the expense. “General account buyouts are very safe,” says MetLife’s Root. “Separate account buyouts offer extra insulation and protection. Under $1 billion, it’s been rare to see separate accounts. Deals over $1 billion are more likely to use separate accounts regardless of the extra cost.”
“Most plan sponsors that have looked at this issue have come to believe that separate accounts offer stronger protection than multiple insurers,” says Aon Hewitt’s Jacobs. “GM and Ve-rizon both used separate accounts in their deals.”
Another security issue that needs careful thought is the backstop protection for beneficia-ries. A corporate pension plan is covered by the Pension Benefit Guaranty Corporation, which is an independent agency set up in the 1974 ERISA legislation that is funded by premiums paid by those participating plans. An annuity, in the general account or in a separate account, is pro-tected by state insurance guarantee funds, with ring-fencing of assets into a separate account offering a further level of protection. “When it comes to guarantees, companies need to weigh the protection offered by the PBGC on the one side if the company continues to sponsor the plan, versus the protection offered by state insurance funds that backstop insurers should they become insolvent,” says Evercore’s Ryan. “Companies need to make sure that participants are protected. It is a difficult issue to analyze be-cause you are comparing apples and oranges – a single insurance arrangement with some serious long-term financial issues (the PBGC) as opposed to multiple state insurance guaranty funds with better funding, but in some cases lower levels of coverage. Depending on the facts and circumstances, including the long term financial prognosis of the federal pension insurance
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program, though, we think that participants’ annuities should be well protected, on average, by the state insurance guaranty funds.”
One complication to the comparison has to do with the funding of both options. “You can’t directly compare state insurance guarantees with PBGC protection,” says Deutsche Bank’s McLaughlin. “State insurance funds are not funded. One way to maximize state insurance protection though may be to use multiple insur-ers, as each contract would trigger protection.”
GOOD LIQUIDITY
Delivering a pension plan to an insurance com-pany isn’t a simple task. It’s a complex transition management exercise that is planned over a number of months. One issue that needs to be decided early on is the form in which the assets will be delivered. Will they need to be transferred in cash or will the insurer take a partially in-kind portfolio?
“For deals less than $100 million insurers prefer cash,” says MetLife’s Root. “Over $1 billion, insurers are willing to take some or all in assets-in-kind. It provides economies of scale and can reduce the price by giving insurers the assets that they want. Plan sponsors and insurers understand the assets that are needed. They are generally investment grade bonds with good liquidity, but can include some alternatives and other asset classes. Also, assets usually are repositioned in advance of a deal if there will be an asset-in-kind transfer.”
One portfolio that may be more easily trans-ferred is one that has entered the low pension-funding volatility stage called hibernation. In this case, the portfolio is often quite similar to that which the insurers would implement themselves. “For those that are transferring assets, the hiber-nation portfolio is a desirable portfolio to hand off in-kind, which may be required of large plans in a buyout,” says NISA’s Eichhorn.
When the transfer is large, in-kind may be the only option. “Insurers do like to take portfolios in-kind, especially with larger transactions,” says Aon Hewitt’s Jacobs. “When they get billions of dollars in cash, they run interest-rate risk for too long and mitigate that by receiving bonds-in-kind. With $50 million in cash, there isn’t a big short-term interest rate risk and the cash can be put to work immediately. Putting $25 billion in cash to work would take months if not years.”
The issue that gets the most attention around pension risk transfer or buyout is the cost. Several factors must be considered in this calculation. First is the issue of what the company is buying when it pays for an insurance solution. The premium is commonly quoted as a percentage of liabilities. “When analysts look at the cost of a buyout, they often start with the GAAP liability and compare it to the insurance
premium,” says Prudential’s Mathur. “There’s an important distinction here. The GAAP liability does not reflect the current longevity position. A significant portion of the changes in the mortal-ity tables is baked into the premiums.”
The insurance premium takes account of all the costs and risks associated with the liabilities being transferred. “The accounting liability is not equal to the economic liability which is the true cost. There are three additional costs you need to add to the accounting liability to get to the economic liability,” says MetLife’s Root. “First is the present value of expenses such as adminis-trative fees, actuarial fees, investment manage-ment fees and PBGC premiums, which are about 3% to 5% of the liability. Second is the correct cost of longevity which is at least 5% because most pension plans are using outdated mortality tables and mortality improvement factors. Third is the present value of future contribution risk, which is difficult to quantify but is material. The economic liability can add up to 110% or more of the accounting liability. By way of comparison the typical cost of a buyout for retirees is 110% of the accounting liability.”
COST OF LONGEVITY
“In analyzing the insurance premium, sponsors should remember the costs they will eliminate when they transfer risk,” says Prudential’s Mathur. “Once the assets are transferred to the insurer, sponsors no longer incur administrative costs. These include asset management fees – about 2% of the GAAP liability, although this can vary; default credit risk attributable to running a single-A bond portfolio – about another 2%; and pure administrative expense – roughly 0.4%. Also off the table are PBGC variable and fixed rate premiums, due to rise to 1.3% of unfunded vested benefits in 2014 (and 1.8% in 2015) from 0.9% in 2013, with a per-participant fee that is also rising from $42 to $49. There is a cost to settle by moving to an insurer, but the company is eliminating expense.”
Put simply, “pension plans already own these costs,” says Prudential’s Kaplan. So in analyzing the cost equation, plan sponsors need to think about their own calculations for market risk, longevity risk and the other risks that they are defeasing by transferring the assets and liabilities.
Of course, timing may be an issue as well. “For those plans that are considering annuitizing but aren’t sure, the hibernation strategy is an alternative that allows you to be price and time sensitive,” says NISA’s Eichhorn. “It means you can negotiate and wait six months or a year until the price and time are right.”
At the end of the day, the question of pen-sion risk transfer poses fundamental choices for the corporate sponsor. “The corporate finance consideration starts with the comparison of
the economic liability to the settlement cost,” says Aon Hewitt’s Jacobs. “We typically find that lump sum costs are somewhat lower and annuity costs are slightly higher than the plan’s economic liability. Once that is determined, the company needs to look at the cash-flow implica-tions of the settlement strategy and its impact on future cash contributions. It’s also important to understand the accounting implications. The future P&L impact will be different depending on the funded status and size of the plan.”
And the considerations don’t end there. “Governance is also an important issue in pension risk transfer,” says Prudential’s Kaplan. “From the settlor’s perspective, there is a discus-sion required with the board of directors about the appropriate products for accomplishing the desired goal. They need to evaluate the cost and timing of each. They need to select the 95-1 independent fiduciary. It’s a process that requires time and effort.”
REWARDED BY THE MARKET
A big question at board level has to be how the enterprise can gain from pension risk transfer. “At Deutsche Bank, we help companies look at the economics of moving the plan off the bal-ance sheet and assessing whether the company will be rewarded by the market for doing this,” says Deutsche Bank’s McLaughlin.
The magnitude of that reward may depend on the size of the pension fund relative to market capitalization or the company’s main business. “De-risking actions can affect the company’s cash position, earnings per share and funded status,” says MetLife’s Root. “The upside is that de-risking reduces volatility and future contribu-tions, giving the company greater flexibility to deal with their core business. If the pension plan is a large percentage of the market value of the firm, then the pension plan may be driving the corporate finance decision.”
This isn’t an easy or quick process. “Some companies intend to de-risk over time,” says Deutsche Bank’s McLaughlin. “They need to work through the implications of possibly transferring the risk. As it will have an effect on P&L and bance sheet numbers, companies may want to al-low analysts time to get their heads around these plans and digest them. There is also the granular point of figuring out how to fund a transfer of risk, using cash or raising debt.”
That said, expect more activity in this market sooner rather than later. “Activity in pension risk transfer is market driven,” says Deutsche Bank’s McLaughlin. “This mid-year the average U.S. pension fund is 14% better funded. We see potential for long rates going above 3% at the long end and this will trigger more interest in an-nuities. There’s no incentive for companies to put a huge amount of cash into settlements.” 4
L
ongevity risk — the chance that pension beneficiaries may live longer than expected — is becoming more important to pension plan sponsors. “Among all the asset-liability prob-lems that are so acute, longevity is overlooked,” says Scott Kaplan, Senior Vice President and Head of Global Product and Market Solutions for Prudential. “When the Scale BB mortality tables are published [by the Society of Actuaries], we estimate it could add approximately 5% to 6% to the published pension benefit obligation (PBO) numbers for most plans.”Longevity risk hasn’t been an issue for U.S. plans, particularly those sponsored by companies, until recently, so they rarely offer inflation-linked benefits. Changes in lifespan have an exponentially greater effect when the pension benefit is linked to an inflation index. But the U.S. is not immune for the improvements in health and lifespan in developed countries.
The Society of Actuaries does not update its mortality tables all that regularly. Scale AA improvement schedule was issued in 1995 and the RP-2000 Mortality table in 2000. These are used in common pension valuations, such as those required under the Pension Protection Act of 2006. Scale BB is an interim update that shows, unsurprisingly, that mortality rates have declined markedly in the U.S. Further updates to these tables are expected.
“Life expectancy is increasing in all Or-ganisation of Economic Development (OECD) countries,” says Kevin McLaughlin, Director and U.S. Head of Pension Risk Management at Deutsche Bank. “So much so that the mortality tables can be out-of-date almost as soon as they are adopted. In the U.S., because of the lack of indexation, this issue is less severe.”
NEED A STRATEGY
The effects can still be dramatic. “The new U.S. Scale BB mortality tables may have an estimated 3% to 6% impact on the pension liability when adopted,” says Deutsche Bank’s McLaughlin. “These tables were constructed on data from the U.S. Social Security population. Individual corporate pension populations may be quite different, with participants who may be longer-lived. I don’t think U.S. corporates have grappled with longevity risk. Once Scale BB is finalized and adopted, there will be an increased recognition
of longevity risk. If a company keeps its pension plan on the balance sheet, it is going to need a longevity strategy and that should mean a longevity swap market developing here.”
Not everyone agrees that longevity risk should be that much of an issue. Rather than look at the amount that the new mortality tables may add to the overall liability bill, some suggest that looking more closely at the contribution of longevity risk to the key metric of funding volatility. “There’s more talk than substance to the conversation about longevity risk,” says Jess Yawitz, Ph.D., Chairman & CEO at NISA Invest-ment Advisors. “It can be another item to mark up and price.”
“When someone is buying longevity risk, they price the transaction at current expecta-tions,” says David Eichhorn, Managing Director, Investment Strategies at NISA Investment Advisors. “You can’t go back and transact at Scale AA. The new scales – e.g., Scale BB – will bake current expectations of longevity into the liabilities. These current tables are both reason-able expectations for longevity and the starting point for annuity pricing. How much funding volatility is there around longevity and Scale BB? We estimate annual funded status volatility is less than 1%, compared to 10% to 15% for equities and 10% to 12% for liabilities. So the volatility attributable to longevity is very modest, but it is important to think about and manage it.”
SUBTLE DIFFERENCE
Ways to manage the uncertainty associated with lifespan improvement projections include annuity products and longevity swaps. “The U.K. has developed some solutions, such as longevity swaps that may be useful to those plans that are not moving risk off the balance sheet,” says Ari Jacobs, Senior Partner and Global Retirement Solutions Leader at Aon Hewitt.
In a longevity swap, a plan sponsor sells its economic exposure to longevity in the pension plan to a counterparty, thereby reducing or eliminating the risk. The plan then carries coun-terparty risk to the swap provider.
This market is in its infancy in the U.S., but as longevity rises up the pension agenda as a risk to manage, plan sponsors will be looking to other markets for pointers. “The U.K. has been a role model for de-risking exercises around the
world,” says Rohit Mathur, Senior Vice President at Prudential. “They are several years ahead of the U.S. in LDI and pension risk transfer. The U.S. has caught up in terms of LDI, but there’s a subtle difference between the two when it comes to pension risk transfer. Cost of living increases are more prevalent in the U.K. than in U.S. corporate plans and that’s driven the market toward pension buyouts and longevity insur-ance. There could be some appetite for longevity insurance here down the road.”
One reason that longevity swaps may take off in the U.S. is the potential inability for all plans to de-risk in the manner that they desire. “There are lessons for the U.S. in the U.K. experi-ence with COLA,” says Prudential’s Kaplan. “There may be a problem with supply. When interest rates rise, there may be a flood of plans looking for the door, wanting to buy long-dated corporate bonds.”
Any plan sponsor appetite for longevity insurance would be met with open arms in the market. “We expect to see growth in longev-ity risk management over the next few years,” says Prudential’s Kaplan. “We have a mortality business across a number of countries, and a sig-nificant appetite and capacity to help companies manage this risk.”
It’s not just insurers who want to get in on the act. “We are trying to create a global market in longevity swaps,” says Deutsche Bank’s McLaughlin. “It’s a more popular solution in the U.K. and Canada. Longevity hurts more if the pension is inflation-linked, which they typically are in these countries, but this is not so in the U.S., and where the simplicity of the annuity is more powerful.” 4
The Growing Challenge
of Longevity
The good news is that we’re all
living longer. The bad news is that
longer lives pose more difficulties
for pension plan sponsors
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