2 Penbridge Advisors Bridging The Pension Gap Bridging the Decision Gap Penbridge s extensive knowledge of the pension risk transfer market and insurance pricing and underwriting expertise enable plan sponsors to assess the true cost of settling pension obligations. With Penbridge s impartial analysis, sponsors can compare alternatives and make an informed decision about whether and when to pursue a PRT transaction. Bridging the Information Gap Penbridge s advisory services, executive education workshops and PRT database provide plan sponsors with what they need to know across all key facets of PRT. The Penbridge database is the only database covering the US PRT market. Bridging the Governance Gap Penbridge helps plan sponsors navigate the unique challenges of the PRT transaction process. To ensure a transaction is completed within an appropriate fiduciary structure, Penbridge can identify and coordinate the necessary actions and the associated responsible parties, including legal, investment and annuity placement advisors.
3 Executive Summary 1 An LDI-type immunization with a matched fixed income portfolio is generally the most cost-efficient, low-risk investment strategy leading up to a PRT transaction. Close monitoring of assets and annuity buy-out costs is critical throughout the process, including any offering of lump sums. For large plans, assets-in-kind (AIK) transfers can avoid the trading and yield-loss costs associated with traditional all-cash transactions. All insurers that responded to our survey on AIK practices indicated a willingness to use AIK as a form of premium payment for annuity buy-outs. For AIK, insurers generally consider fixed income assets classes more acceptable than alternatives, but valuation preferences vary significantly. Introduction While many defined benefit plans have adopted investment strategies designed to reduce risk, plan sponsors thinking about pension risk transfer (PRT) transactions may not yet have considered what additional steps they need to take to position their assets to go through the process efficiently and with minimal asset liability management (ALM) risk and cost. In the first half of this paper, we cover the asset positioning issues common to all plans that are preparing for termination. In the second half, we discuss the specific topic of assets-in-kind transfers, drawing upon the results of a survey of U.S. insurers we recently conducted, Assets-In-Kind Practices of PRT Providers. In light of the unprecedented size of last year s General Motors and Verizon PRT transactions and the expectation that more large transactions will take place, many plan sponsors and insurers alike need to be better prepared to arrange such AIK transfers. It s Different for Termination The investment strategies employed for termination of a defined benefit plan are different than those used for an ongoing plan. For a terminating plan, the combined requirements of sufficient funding to purchase an annuity buy-out contract, coordination with insurers and full distribution of plan assets present a unique set of conditions under which the investment strategy must be carried out. We will assume in this paper that a plan sponsor is working towards a standard plan termination which necessitates the purchase of a group annuity buy-out contract from an insurance company. 1 It is true that if a sponsor is planning to partially de-risk by offering a lump sum window or by purchasing a group annuity carve-out for certain participants many of the concepts presented here are still relevant. But, these situations are not so all-encompassing; they represent ongoing plans that don t need to liquidate everything or attain time-sensitive full funding. By limiting our scope to terminations, we streamline the discussion and emphasize the full importance of the concepts and strategies as they are presented in their most critical context. 1. Per IRS Revenue Ruling
4 2 Contribution Risk Among the most obvious questions a plan sponsor will ask before deciding to terminate a plan is: What s the current value of the plan s assets? and What will the buy-out cost? The answer to the first question should be readily ascertainable. As to the second, the plan sponsor should work with an advisor with expertise in underwriting and pricing annuity buy-outs from the perspective of an insurer. Assuming the plan is like most plans somewhat under-funded on a buy-out basis, the plan sponsor needs to prepare to top up the plan s assets to the buy-out level over the months it typically takes to go through the termination process. During this time an unpleasant surprise in any additional funds needed is more disruptive and perhaps damaging to the company than when a plan is ongoing and market gains and losses can be absorbed over time. Furthermore, as the buy-out date draws nearer and contributions are made to bring the plan s assets closer to the estimated buy-out premium, the risk-reward asset allocation trade-offs that exist for an ongoing plan dwindle. As an illustrative example, consider a plan with $95 million in assets planning to do a buy-out that costs $100 million. As shown in Figure 1, if the transaction were to occur immediately, the plan sponsor would need to contribute $5 million. Buy-out Cost 100 Asset Value 95 Sponsor Outcome -5 Contribution ($millions) Figure 1: Illustrative contribution needed to fund buy-out Buy-out Cost 100 Asset Values Sponsor Outcomes Figure 2a: Impact of asset volatility +5 Post excise tax But, suppose the plan sponsor is 6-12 months away from being ready to transact (Figures 2a-c). Figure 2a is a simplified illustration showing what happens if the asset value varies in that time by ±$15 million. The plan sponsor must pay $20M if asset values decline by $15M, and has an excess of $10M if asset values increase by $15M (ignoring income tax). But if the plan is over-funded at termination, the sponsor will have to pay an excise tax on the reversion of excess plan assets. 2 The sponsor might end up with only $5 million or less. In other words, there is only a partial reward for good investment performance scenarios and a full penalty for bad ones. 3 Suppose the plan sponsor decides to eliminate asset volatility by moving into cash. Aside from the low yield on cash, the same asymmetric contribution risk problem exists because the plan sponsor is exposed to changes in the cost of the buy-out (Figure 2b). Buy-out Costs Asset Value 95 Sponsor Outcomes Post excise tax +5 Figure 2b: Impact of buy-out cost volatility 2. Internal Revenue Code Section The 50% excise tax is nondeductible and thus paid over and above any income tax (i.e., total tax could be 85%). However, the excise tax rate is reduced to 20% if at least 25% of the would-be reversion is shared with participants or contributed to a qualified replacement plan in accordance with the IRC. 3. In the case where the plan is already over-funded, the same conclusion would be reached by a similar analysis.
5 Immunizing the Portfolio 3 As the plan approaches full funding on a buy-out basis, the solution to eliminate this unfavorable asymmetric ALM risk is to immunize the funded status of the portfolio, i.e., create an asset portfolio whose value moves closely in sync with the cost of the buy-out. That way, the value of the assets and of the buy-out can both move, but there is minimal contribution risk. As shown in Figure 2c for our example, all outcomes are essentially the same, i.e., the required contribution is fixed at $5 million. Buy-out premiums will generally move directly with the price of investmentgrade bonds of the same duration as the plan s liabilities. So this type of portfolio will immunize the risk quite well. It s no coincidence that insurance companies who are sensitive to the same risk will use exactly this type of portfolio themselves. Liability driven investment (LDI) and dynamic asset allocation strategies involve transitioning the asset mix from equities and alternative assets to more fixed income in order to match the duration and cash flow profile of 80-5 the plan s liabilities. In the context of an anticipated plan termination, the Figure 2c: Portfolio immunization strategy needs to be coordinated not only with improvements in funding levels and monitored changes in insurers annuity pricing levels, but also with any lump sum window the plan sponsor may choose to offer. This is also the right time to consider how to insulate against the lump sum valuation basis, if offering a lump sum window. Repositioning for Lump Sums Buy-out Costs Asset Values Sponsor Outcomes Recently, many plan sponsors have been offering lump sums to plan participants. 4 Plan sponsors need not be contemplating plan termination in order to offer lump sums. But, for those who are, it is now quite common to first offer lump sums to at least some of the plan participants. Whether or not to offer lump sums, and to which groups of participants, is not a subject for this paper. 5 Here we are concerned only with the impact of the lump sum offer on investment strategy. Depending on whether the offer is for terminated vested members only or if it includes retirees, both the size and duration of the residual portfolio can be significantly altered As shown in Figure 3 for a typical plan, the overall plan liability duration will become shorter if lump sums are offered only to terminated vesteds, as these have longer than average duration. Conversely, lump sums paid to retirees will lengthen the liability duration. Either way, it is essential to adjust the investment strategy to provide flexibility for these variations before the lump sum program is undertaken. Whatever the utilization rate, any lump sum program will generate the need for more short- Resulting Duration 17.0 Retirees 16.0 Terminated Vesteds % 10% 20% 30% 40% 50% 60% 70% 80% Utilization Rate Figure 3: Illustrative Impact of lump sum utilization on plan duration 90% 100% 4. Effective in 2012, a less expensive basis for calculating lump sums in accordance with the Pension Protection Act of 2006 became fully phased in. 5. The economics of the decision is a function of market timing, plan design and the effect on the buy-out cost for those participants who choose not to take the lump sum. There are significant legal and HR considerations as well.
6 4 term liquidity and a need to adjust the resultant ALM position. And if the goal is to continue on to a termination, it is an opportune time to re-evaluate asset allocation of the portfolio with this end game in mind. It won t be known exactly how much cash is needed to make lump sum payments until the participant election forms are returned and tallied. But the typical time frame of several months to get such a program completed should allow ample time to properly consider which assets to liquidate. If a full LDI strategy is already in place before the lump sum window is opened, it may be a straightforward exercise to adjust the portfolio by liquidating bonds matching the duration of the expected liabilities that are being discharged through lump sums. Otherwise, this can be the right time to sell down certain assets so that the resultant portfolio is better immunized. That would generally include selling non-fixed income assets and perhaps also certain fixed income assets that are causing the overall duration to be too short or too long. One other consideration about the timing of liquidation concerns the fact that the discount rate basis on which lump sums are calculated depends on when the lump sum offer is made and on the plan s established stability period. After it has been decided to offer lump sums and the discount rate has been determined, estimated lump sum payments are better hedged with cash. But until that time, the plan is better hedged by being in duration-matching fixed income. Liquidating the Asset Portfolio Before looking at the alternative of assets-in-kind transfers, we discuss what is traditionally the last step in preparing the asset portfolio for an annuity buy-out liquidation. Until recently, U.S. insurers have typically required cash for an annuity buy-out. 6 In practice a plan of significant size cannot sell its assets instantly. And rushed execution may cause the plan to get less value from the market for their investments, especially for less liquid assets that have wider bid-ask spreads. It s helpful if the plan has been anticipating this issue while going through the stages above, i.e., moving toward more liquid fixed income instruments in the later stages of immunizing the portfolio, and selling less liquid assets when possible to satisfy lump sum cash demands. Even if the plan is already immunized and has no lump sums to pay, the portfolio manager should be opportunistically exchanging less liquid assets for more liquid ones. 7 In addition to the problem of bid-ask spreads adding to transaction costs, there are two other problems that arise as the plan sells invested assets for cash. Most importantly, the portfolio will no longer be immunized (refer to Figure 2b, above). The most efficient way to deal with this is by using derivatives to add duration to the asset portfolio. Adding duration can be done by buying Treasury futures or by entering into interest rate swaps (pay floating; received fixed) as bonds in the portfolio are sold. The other problem is that portfolio returns will generally drop. Cash plus a derivatives overlay that adds duration will generally not yield as much as corporate bonds because of liquidity and default risk premiums. 8 So there is a trade-off between liquidating too early and liquidating too late. The derivatives positions should be reversed as close as practical to the time when the buy-out deal is agreed because that is when the price of the annuity contract becomes fixed. The process that the insurance company goes through to invest the cash premium it receives from the plan is exactly the same, only in reverse: it hedges interest rate risk with derivatives; it unwinds the derivatives as bonds are purchased; it opportunistically buys less liquid, higher-yielding assets over time. Equally notable is that the insurance company incurs 6. The practice of AIK transfers has been ongoing and relatively standard in the UK for some time. 7. For a partial buy-out (aka carve-out), the problem is not as acute, since not all assets need to be liquidated. However, the manager does need to be mindful that the resultant portfolio be appropriate in both composition and duration for the remaining pension liabilities. 8. More exotic derivatives may be available that address this issue; but then the cost and liquidity of the derivatives themselves become an issue.
7 Sponsor Contribution 2 $10M DB Plan Capital Markets 1 4 Sell investments $995M $1,005M $1,005M Premium Annuity contract 3 Buy investments Insurer virtually the same costs as the plan did for transactions, bid-ask spreads and lost yield while only partially invested. For a large transaction, these costs on both sides of the transaction become disproportionately larger. That is because selling or buying large blocks can move the market itself, which is similar in effect to a wider bid-ask spread. In practice portfolio managers can reduce this problem by taking more time to sell or buy; but that can exacerbate the lost yield issue. Figure 4 illustrates the way this happens for a $1 billion deal. In this example, it shows that it ultimately costs Figure 4: Traditional buy-out illustrative investment cash flows the plan sponsor an extra $10 million to pay for its own liquidation costs as well as the investment costs for the insurer which it pays indirectly, as the insurer must include these considerations when pricing the deal. 5 Assets-In-Kind at Termination A premium payment with assets-in-kind is a direct transfer of asset ownership, effectuated in practice by changing the registration of the assets owner. AIK is Transfer investments (value $1,000M) Plan Insurer possible when the plan is invested in the same kinds Annuity contract of assets that the insurer would seek to back the plan s benefit liability. It effectively bypasses many of Figure 5: Theoretical illustration of buy-out using assets-in-kind the problems of a traditional cash annuity purchase transaction where the plan needs to sell assets and the insurer needs to buy them. It reduces transaction costs and mitigates out-of-market risk without using derivatives and lower-yielding cash. When setting investment assumptions for pricing, the insurer can include consideration of the projected yield on the in-kind assets to be transferred, reducing investment uncertainty and perhaps allowing the insurer to offer a lower price. Figure 5 illustrates how this works in theory. Until recently, even the largest annuity buy-outs completed in the U.S. were transacted for cash. 9 They were still not large enough to warrant changing the standard cash-only protocol because AIK transfers do have a couple of other complicating issues: 1) the assets that the plan holds may not be assets that the insurer wants; and 2) the parties need to agree on a fair price. It simply wasn t worth it to try to work through these issues with multiple insurers who hadn t used AIK transactions before. 10 As stated above, the costs of transacting in cash become disproportionately large as deal size grows. For the multibillion dollar deals done with Prudential in 2012, using AIK was an obvious decision. And with more large buy-out deals anticipated, more insurers have been working to get comfortable with AIK transfers. 9. The largest we know of between 1990 and 2011 was about $600 million and that was split between three insurers. 10. Because the bidding process is competitive, the identity of the selected insurer generally isn t known until the deal is actually placed. A lot of extra effort would have been required in AIK negotiations between the plan sponsor and the insurers who were not selected.
8 6 Penbridge Assets-In-Kind Survey It is important for plan sponsors and their advisors to consider the practices of insurers to decide first whether to pursue an assets-in-kind arrangement, and then how in practice to prepare the asset portfolio and carry out the transfer optimally. Penbridge Advisors recently surveyed the insurers in the U.S. buy-out market about their AIK practices and preferences. Two of the nine insurers are not currently offering traditional buy-outs to plans of sufficient size for AIK transfers to be a consideration. Of the remaining seven, six responded to the survey. We wish to acknowledge American General, MassMutual, MetLife, New York Life, Pacific Life and Prudential for their thoughtful efforts in helping us to assemble robust information about the current state of AIK practices for pension buy-outs. In the context of our discussion of AIK issues which follows, we have summarized key findings from the survey. 11 Aside from pension buy-outs, all six insurers responding to the Penbridge survey have accepted AIK transfers, either in connection with an acquisition of a business or a block of insurance liabilities. But in connection with a pension buy-out, only three of the six have utilized an AIK transfer, all three having done so as recently as Nevertheless all six insurers said that they would consider receiving in-kind assets. Answers were quite divergent to the question of what minimum size a buy-out transaction would need to be for AIK to be considered. They ranged from $50 million to $500 million, but most insurers indicated they had not established a hard minimum. The breadth of responses may reflect differing degrees of comfort in going through the process. But, it may also reflect some insurers willingness to accommodate the AIK process if that is what the plan sponsor has decided to do. Perhaps they reason that even if the size is too small for AIK to be efficient they are no worse off than the other insurers in a competitive bidding situation. Acceptable Assets Insurers asset portfolios reflect their Insurer regulatory and surplus requirements, Asset Class A B C D E F their mix of business and their willingness to assume risk. For portfolios backing annuity buy-outs, this primarily consists of fixed income assets whose combined cash flows and duration are consistent with those of the buy-out liability. It is typically quite similar to a full-ldi strategy for a Treasury Bonds Investment Grade Corp. Bonds High Yield Bonds Private Placement Bonds Commercial Mortgages CMBS / ABS Real Estate pension plan. Insurers may have little or Preferred Stock no appetite for certain types of assets, Private Equity including many which are perfectly fine for an ongoing DB pension plan to hold. Hedge Funds Unit-linked / Pooled Funds The survey question on which asset types would be acceptable Derivatives (to be novated) for AIK generated some of the most Figure 6: Survey results for Which asset classes might be acceptable for an in-kind transfer? interesting results (Figure 6). All insurers included fixed income asset classes. For all other asset classes, either 3 or 4 of the insurers indicated that they were acceptable; and, quite interestingly, it was different insurers for different asset classes. 11. The compiled results of the AIK survey are available on the Penbridge PRT Database.
9 Even if a certain asset class is generally acceptable, the specific asset may not be suitable, as insurers need to manage duration as well as credit and exposure limits within the entirety of their investment portfolio. Most carriers said that they would in fact need to evaluate specific assets within each asset class for suitability; and they generally agreed that duration, credit quality, issuer credit limits, and their view of the issuer would all be relevant in that regard. But, should certain assets be unsuitable for the buy-out business, several insurers said they would consider using them to support another line of business. 7 Asset Valuation As to the all-important question of how assets would be valued for an AIK transfer, every company answered the survey differently! All three of the suggested answers got votes. Four of the insurers made additional comments none of which were alike. And one insurer selected two of the suggested methods. It is indicative of AIK s newness in this market that there was so little market consensus in this area. Companies clearly differ in terms of their flexibility, as one of the three suggested answers was Company only sets the valuation basis and another was Any mutually agreeable non-biased basis would be acceptable. The third suggestion, Average value, within a corridor, of independent appraisals put forward by each party, has its own complications. First, parties must agree on how wide the corridor is. But then what happens if the prices differ by more than the corridor is it subject to further negotiation, or are those assets automatically off the table? Further negotiation sounds very reasonable. But if the parties know to expect that, their independent appraisals could start out too biased, which would defeat the purpose of using this method. One company suggested using an agreed-upon third party to do some of the pricing. Another suggested different methods for different asset classes. Asset classes which are more heavily traded could use publicly available [inexpensive, unbiased] pricing sources. Which assets these are may vary not only by asset class, but also within asset classes depending on the asset s credit quality, liquidity and complexity. Assets such as private equity and real estate may require truly independent appraisals. Clearly, it may be quite a challenge to manage negotiations with several insurers at once on different valuation methods. On the other hand, if a plan sponsor decides to lay down the law in terms of what valuation method must be used, they may lose participation from some insurers in the bidding process. Beginning discussions with insurers well in advance will allow time to negotiate terms, to establish an agreeable valuation methodology (including the use of an independent third party where needed), and to enable review of the plan s asset portfolio by the insurers. Being Practical Sponsor Contribution $2M Sell problem assets DB Plan $199M Capital Markets $201M cash + investments ($800M) Contract $201M Buy investments Figure 7: Practical illustration of buy-out with hybrid approach Insurer Based on the survey responses, there were other implications for implementing an AIK buy-out transaction in practice. One clearly helpful piece of practical advice that emerged was that that sponsors would do better disposing of less desirable assets themselves, provided there is sufficient lead time. Realistically, then, the process may look like the hybrid approach shown in Figure 7 (a combination of Figures 4 and 5). Here, 20% of the assets are sold, and 80% are transferred. This preserves most of the benefit of an AIK transfer, without forcing the parties into uncomfortable
10 8 compromises. In this example, the plan sponsor s contribution of $2 million still represents a savings of $8 million relative to the traditional approach shown in Figure The plan sponsor and its advisors may not know in advance those assets for which agreement is possible on both acceptability and valuation. One surveyed company suggested a dry run which could definitely help both in terms of knowing which assets still need to be liquidated and ensuring no last-minute misunderstandings at transaction time. Taking this idea to the next level, the whole bidding process could be conducted iteratively gradually narrowing in on the right insurer, the right assets to transfer, and the right valuation basis. It is quite plausible that, in spite of the plan sponsor s good planning and determination to proceed with the buy-out transaction, an impasse could be looming on certain assets. For example, the plan s asset manager may have had a lot of difficulty selling certain assets at what they considered a reasonable price. Or, it wasn t known until very near the appointed transaction time that agreement couldn t be reached with the preferred insurance company regarding certain assets. One possible solution to this problem would be to delay the payment of part of the premium until those assets could be converted to cash. There would be a slight adjustment to the total premium to compensate for the time value of the delayed receipt. Surveyed insurers appear not to have definitive views on this idea. Those willing to consider it would need to negotiate acceptable terms. Conclusion Close monitoring of assets and annuity buy-out costs becomes more critical as a DB plan prepares for a buy-out transaction. For plans working toward termination, an LDI-type immunization with a matched fixed income portfolio is generally the most cost-efficient, low-risk investment strategy. This is true for both small to mid-size plans that will need to liquidate all their assets (using derivatives to hedge) as well as for large plans that can use assets-in-kind transfers so long as the assets are acceptable to insurers. For large annuity buy-out purchases, AIK transfers can save money and reduce risk for both the plan sponsor and the insurer. Perhaps insurers AIK practices will converge somewhat over time; but for now, it is an evolving practice, with most insurers having limited experience. Plan sponsors should discuss AIK with their annuity placement advisors up front. And if AIK is to be pursued, annuity placement firms should in turn begin discussing it with insurers very early in the placement process. 12. As noted earlier, the case of a carve-out allows more flexibility. There is little pressure to liquidate unacceptable assets which can be retained by the residual plan. If the resultant asset allocation is out of line, it can be adjusted over time.
11 About Penbridge Advisors and Its Principals Penbridge Advisors provides pension plans with unbiased information and advisory services on the U.S. pension risk transfer (PRT) market and products. In addition to working with plan sponsors directly, Penbridge works to form functional partnerships with select pension advisors and service providers that seek to incorporate PRT analysis into existing offerings. Co-founded by Steve Keating and Robert Goldbloom, Penbridge provides pension plans with free access to the industry s only database covering the PRT market. The database, which is currently used by more than 300 plan sponsors and advisory firms, includes information on PRT products, annuity placement specialists and insurance providers. Penbridge s advisory services include plan termination underwriting assessments and customized buy-out price monitoring services to help plan sponsors decide on PRT strategy and timing. Penbridge also delivers PRT education workshops to corporate boards, C-level executives and pension plan committees. To access the PRT database, please visit Steve Keating Steve is Co-Founder and Principal of Penbridge Advisors. He provides strategic pension risk transfer advice to plan sponsors, advisory firms, insurance companies and asset managers. As a recognized thought leader and advisor in the US PRT market, he testified at the June 5, 2013 hearing before the ERISA Advisory Council on Private Sector Pension De-risking and Participant Protections. Prior to Penbridge, Steve was Founder and Managing Director of CAMRADATA Analytical Services PRT business, where he designed and launched the industry s first PRT database now owned by Penbridge. Previously, Steve was Head of the Pension Solutions Group at Lazard Freres and also was a Senior Consultant at Hewitt Associates. Robert Goldbloom Robert is Co-Founder and Principal of Penbridge Advisors with broad experience in the areas of pensions, insurance and investments, and particular expertise in pension risk transfer. At Penbridge, Robert advises clients on PRT pricing, products and market practices, and their implications for DB plans. Robert previously served as CFO of Global Pensions at AIG and as Senior Vice President at American General with overall responsibility for the management, operation and financial results of the US Pensions Department. There he developed a number of group annuity products, managed asset liability risk, and oversaw the pricing and underwriting of well over 1,000 diverse DB pension plans. He is a Fellow of the Society of Actuaries and a Chartered Financial Analyst. For more information, please contact: Penbridge Advisors, LLC One Stamford Plaza 263 Tresser Boulevard, 9th Floor Stamford, CT P: F:
12 Copyright Penbridge Advisors, LLC September 2013.
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