The Voices of Influence iijournals.com PENSION & LONGEVITY RISK TRANSFER. for INSTITUTIONAL INVESTORS

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1 The Voices of Influence iijournals.com PENSION & LONGEVITY RISK TRANSFER for INSTITUTIONAL INVESTORS

2 Reducing Pension Risk: The Myths Holding Back Plan Sponsors ROHIT MATHUR AND SCOTT KAPLAN ROHIT MATHUR is a senior vice president of Global Product and Market Solutions, Prudential Pension & Structured Solutions, at Prudential Retirement in Iselin, NJ. rohit.mathur@prudential.com SCOTT KAPLAN is a senior vice president and head of Global Product and Market Solutions, Prudential Pension & Structured Solutions, at Prudential Retirement in Iselin, NJ. scott.kaplan@prudential.com Recent history has not been kind to U.S. pension plan sponsors. Twice in the past 12 years, America s corporate definedbenefit (DB) plan sponsors have seen their plans funded statuses deteriorate more than 30% in market downturns. 1 This dramatic decline has strained plan sponsors finances and compelled the 100 largest corporate pension plans in the U.S. to make approximately $230 billion in pension contributions between 2009 and Although the recent equity market rally and rise in interest rates have improved funded status to 88%, the funding index remains well below levels witnessed in (See Exhibit 1.) Plan sponsors who once maintained well-funded plans may now be pressured by large plan deficits that require significant contributions over time, 2 while concurrently addressing heightened stakeholder concerns over financial statement volatility and reduced strategic flexibility. Given the rising cost of maintaining DB plans, many companies have taken steps to reduce pension benefits. Across the Fortune 100, the number of companies offering DB plans that remain open to all employees declined from 53 in 2007 to 30 in Since 1998, 23 companies of the Fortune 100 have frozen their pension plans, while 17 have closed them. 3 In addition to curtailing pension benefits, many companies say that they are focused on managing the risks posed by their DB plans, with the primary aim of reducing the volatility of funded status and the level of required contributions. Accounting, regulatory changes, and increased scrutiny by shareholders and analysts are contributing to the trend of de-risking. In addition, awareness of longevity risk appears to be on the rise. Just as increasing life expectancy trends have made longevity risk an urgent and decisive issue for pension plan sponsors in the United Kingdom, updated mortality studies under way today in the U.S. and Canada are beginning to bring similar pressures to North America. 4 A number of respondents to the recent survey sponsored by Prudential and conducted by CFO Research said that obligations from their companies DB plans are placing constraints on their firms performance. 5 (See Exhibits 2 and 3.) In fact 43% of finance executives are concerned that obligations from their companies DB plans constrain cash flow 36% feel that pension obligations restrict their ability to invest in growth opportunities PENSION & LONGEVITY RISK TRANSFER FOR INSTITUTIONAL INVESTORS

3 E XHIBIT 1 Pension Plan Funding Volatility Source: Milliman 100 Pension Funding Index. E XHIBIT 2 To What Extent Do the Obligations from Your Company s DB Plan Constrain Your Company s Financial Performance in the Following Areas? Source: Balancing Costs, Risks, and Rewards: The Retirement and Employee Benefits Landscape in 2013, CFO Publishing LLC, INTENSIFYING INTEREST IN PENSION RISK MANAGEMENT SOLUTIONS U.S. companies interest in reducing DB risk is also made evident by the survey, which found that 54% of executives say their companies have implemented, or are likely to implement, risk management strategies, such as liability-driven investing (LDI), which reduce a plan s exposure to interestrate risk. Implementing LDI typically results in a higher allocation to fixed income within a plan s portfolio so that the value of the plan s assets and liabilities will be similarly impacted by changes in interest rates; 45% of executives indicate that their companies have already transferred, are somewhat likely to REDUCING PENSION RISK: THE MYTHS HOLDING BACK PLAN SPONSORS

4 E XHIBIT 3 To What Extent Do You Agree with the Following Statement About Reducing DB Risk at Your Company? Source: Balancing Costs, Risks, and Rewards: The Retirement and Employee Benefits Landscape in 2013, CFO Publishing LLC, transfer, or are very likely to transfer DB risk to an insurer in the next two years. In fact, in the same survey, 47% of finance executives queried felt that pension risk transfer enables them to concentrate on their fundamental business activities, rather than directing energy and resources toward pension risk management. Discussion about risk transfer solutions seems to be heating up. One-third of the companies surveyed have discussed DB risk transfer solutions with their consultants within the past year, while roughly the same percentage have discussed DB risk transfer with their boards of directors. In 2012, a defining moment occurred for the U.S. risk transfer market when General Motors reached an agreement to transfer certain salaried retiree benefit obligations to Prudential as part of a plan to reduce pension obligations by approximately $26 billion. That groundbreaking transaction was quickly followed by a $7.5 billion pension buyout transaction between Verizon Communications and Prudential. Clearly, the risk transfer standard had been set, and the U.S. marketplace appears primed for a groundswell of de-risking. Nevertheless, while finance executives interest and awareness of pension risk management is high, we have yet to see more large companies implement de-risking, and in particular risk transfer solutions. The question, then, remains: What precludes U.S. DB plan sponsors from unburdening themselves of onerous pension obligations? A forthcoming white paper from Prudential Retirement examines this phenomenon in detail. Titled Reducing Pension Risk: The Five Myths Holding Back Plan Sponsors, the white paper explores the misconceptions that are preventing U.S. DB plan sponsors from implementing pension derisking solutions in today s economic environment and demonstrates why each of these misconceptions is fallacious. DISPROVING THE MYTHS OF PENSION DE-RISKING While several plan sponsors are currently evaluating de-risking solutions, there is clearly a gap between the intentions and actions of some companies with respect to DB risk reduction. Propelling this gap is what Prudential refers to as the myths of pension de-risking. A few of the more consequential myths are as follows: PENSION & LONGEVITY RISK TRANSFER FOR INSTITUTIONAL INVESTORS

5 Partial LDI strategies have significantly reduced DB risk. Risk transfer solutions can only be executed once a DB plan reaches or exceeds full funding. Transferring DB risk to an insurer is cost prohibitive. Reducing DB risk may be prudent, but it may reduce shareholder value. Shedding light on these myths can help plan sponsors clearly analyze and implement risk reduction measures. PARTIAL LDI STRATEGIES HAVE SIGNIFICANTLY REDUCED DB RISK While LDI methodologies continue garnering interest as ways to mitigate DB plan risk, the implementation of these strategies will result in meaningful risk reduction only if significant amounts of plan assets are allocated to fixed income. A partial LDI strategy that addresses only the interest rate risk posed by a portion of liabilities (by duration-matched fixed income), and that retains a large allocation to equities and other risky assets to hedge remaining liability, does not significantly reduce risk. 6 Such a strategy remains significantly exposed to equity and interest rate volatility. Scenario testing conducted by Prudential found that a partial LDI strategy only modestly reduces pension risk, as compared to a typical 65% equities/30% fixed income/5% cash investment strategy. Clearly, LDI strategies leave sponsors exposed to longevity risk or the risk that a plan s participants will live longer than expected, resulting in higher benefit payments. Population data show that the retired lifetime that is, the period from retirement to death for the average U.S. male has increased 27%, or four years, in the past three decades. 7 As shown in Exhibit 4, pension valuation tables have typically lagged behind actual experience, resulting in a significant increase in pension liability in every recent decade as these tables were updated. While most plan sponsors have become attuned to the investment risk that is inherent in their pension plans, longevity risk is a significant yet often-ignored risk, which cannot be addressed through investment strategy alone. E XHIBIT 4 U.S. Pension Plan Sponsors Face Increasing Longevity Risk Increase in Liability due to Mortality Table Updates Source: Prudential calculations: 1980s using GAM 71 Mortality Table, 1990s using GAM 83 Mortality Table, 2000s using RP 2000 Mortality Table, Current using RP 2000 Mortality Table with PPA improvements, and Proposed 2014 using RP 2000 with Scale BB improvements. REDUCING PENSION RISK: THE MYTHS HOLDING BACK PLAN SPONSORS

6 One way for sponsors to enhance an LDI strategy is to couple it with the purchase of longevity insurance from an insurer. This provides plan sponsors with certainty as to the amount that they will have to pay each plan participant, even if a participant lives longer than expected, in exchange for a fee paid to the insurer. 8 RISK TRANSFER SOLUTIONS CAN ONLY BE EXECUTED ONCE A COMPANY REACHES OR EXCEEDS FULL FUNDING Some pension plan sponsors may believe that risk transfer is possible only when their plans approach fully funded status. As a result, they are waiting to implement de-risking solutions and appear to be relying on improved market conditions to close the funding gap. This belief is likely based on awareness of the challenges that underfunded plans face in executing the most prevalent risk transfer transaction the pension buyout. In a recent survey of finance executives, 27% said they would be more likely to transfer DB risk to a third-party insurer if the funding level of their plans increased. However, there are solutions that enable sponsors to transfer risk even if their plans are not fully funded most notably, the pension buy-in and a robust LDI strategy, along with longevity insurance. 9 The buy-in is an insurance contract that enables sponsors to transfer longevity, investment, and interest rate risk to an insurer for a subset of a plan s participants. The buy-in contract is retained as a plan asset, and its value closely tracks the value of the plan liabilities covered by the contract. Furthermore, the plan sponsor continues to maintain a direct relationship with its participants. It also allows sponsors to preserve funded status and does not trigger settlement accounting. A buy-in also provides sponsors with a phased approach to transferring risk, as sponsors can eventually convert it to a buyout. Similar to a buyout, executing a buy-in significantly reduces future contribution volatility, because the insurer providing the buy-in assumes the risks associated with the liability covered by a buy-in. Although common in the U.K., with nearly $11 billion in such transactions being executed since 2010, 10 the first U.S. pension buy-in didn t occur until 2011 (a $75 million agreement between Prudential and Hickory Springs Manufacturing Company). TRANSFERRING DB RISK TO AN INSURER IS TOO EXPENSIVE For some plan sponsors, the prospect of engaging in a pension risk transfer agreement may seem cost prohibitive. However, when finance executives were surveyed regarding the factors that would most likely incite their firms to transfer DB risk to an insurer, only 25% of respondents said that it was too expensive for them to consider. 11 In actuality, the true and economic cost of transferring pension risk is lower than what many sponsors and analysts presume, because the cost of transferring risk includes many of the same costs that sponsors will incur even if they do not transfer pension risk. A disaggregation of the costs of a retiree buyout a transaction that transfers all of a sponsor s DB plan risks and liabilities to an insurer is illustrated in Exhibit 5. In this example, the total cost of the retiree buyout is 112% of the DB plan s Generally Accepted Accounting Principles (GAAP) liability for its retirees. The buyout premium includes a capitalization of the following costs that would be borne by the plan sponsor over time, regardless of whether or not they transferred risk via a buyout. 12 Administrative expenses and PBGC premiums. Plan sponsors incur annual expenses related to participant servicing and plan administration which are estimated to be $40 per participant each year and PBGC expenses per person of $42 in 2013, $49 in 2014, and indexed after Investment management fees to manage assets, assumed to be 25 basis points annually. Credit defaults and downgrades. A sponsor employing an LDI strategy will incur ongoing costs within the bond portfolio related to credit defaults and downgrades, which is assumed to be 24 basis points annually. 13 Mortality improvements. Exhibit 5 reflects a change in the mortality basis from the Pension Protection Act prescribed table using Scale AA, to the RP2000 generational table using Scale BB. Since the buyout premium is a one-time payment to the insurer, the premium must account for all of these future costs. Of course, executing a buyout also means PENSION & LONGEVITY RISK TRANSFER FOR INSTITUTIONAL INVESTORS

7 E XHIBIT 5 The Disaggregated Costs of a Retiree Buyout Source: Prudential analysis. that sponsors are paying for these costs up front in a single payment, rather than gradually over time. These costs account for 11 percentage points of the 12 percentage-point premium for the buyout in excess of the GAAP value of the retiree liabilities. REDUCING DB RISK MAY BE PRUDENT, BUT IT MAY REDUCE SHAREHOLDER VALUE Some plan sponsors may be reluctant to adopt DB risk-reduction strategies out of a concern that these solutions may negatively impact key financial metrics, and hence lower firm valuation. However, maintaining a DB plan has potential costs to shareholders, because it increases the likelihood of very high levels of required contributions in the future, which constrain cash flow and could negatively impact firm valuation. La Jin, Robert C. Merton, and Zvi Bodie were the first to empirically demonstrate the relationship between the riskiness of a company s DB plan and its equity risk in their 2006 paper, Do a Firm s Equity Returns Reflect the Risk of Its Pension Plan? 14 The riskiness of a DB plan is based on how the plan s assets are invested and the composition of the plan s liabilities. This empirical finding makes intuitive sense, because a pension deficit is a form of leverage, and the more highly levered a company, the higher its stock s beta. According to Morgan Stanley, stock prices of pension-heavy companies those with pension liabilities in excess of 25% of their market capitalization tend to be more correlated with the equity markets, and hence have higher betas. 15 A company with a higher stock price beta will have a higher weighted average cost of capital (WACC). In addition, shareholders perceive pension liabilities as riskier than corporate debt because the magnitude of a pension deficit is volatile, as is the stream of contributions required to service the deficit. Risk reduction reduces the likelihood of significant plan contributions caused by factors such as poor equity market returns, persistently low rates, and longer life spans. As a result, risk reduction can raise the lower end of the valuation range of a company, assuming a valuation derived by discounting the future cash flows of the company. In addition, risk reduction could positively impact a company s valuation by lowering its beta and WACC. REDUCING PENSION RISK: THE MYTHS HOLDING BACK PLAN SPONSORS

8 E XHIBIT 6 Analyst Reactions to Recent Transactions Source: Doing the Right Things GM Further De-risks Pension: Positive for Equity Holders, Credit Suisse, Equity Research. June 4, Analyst reactions illustrate the impact of the transaction on perceptions, are not meant to imply endorsement of specific analysts views, and do not necessarily represent the views of all analysts. CONCLUSION Prudential s forthcoming white paper Reducing Pension Risk: The Five Myths Holding Back Plan Sponsors will demonstrate that the conventional wisdom about DB plans is false. Discarding the myths discussed in the paper can help broaden the range of options that sponsors are willing to evaluate when formulating the long-term strategy for their plans. A wider range of options is essential to providing plan sponsors with the flexibility needed to achieve their long-term objectives. It is also critical that plan sponsors begin evaluating risk management solutions, because executing many of these solutions such as a pension buy-in or buyout requires significant lead time. Proactive evaluation of these solutions will enable plan sponsors to successfully execute DB risk-reduction strategies at the time of their choice. Of course, the decision to transfer pension risk is based on the specific nuances and demographics of each particular plan. To determine which solution is right for their companies, plan sponsors should work with their actuaries and advisers to Examine the health of their plans, Consider how management of the plans impacts the companies, and Explore the available pension risk transfer solutions. Buyouts and buy-ins, along with the emergence of longevity insurance in the U.S. market, offer the certainty of outcomes that sponsors need, along with the benefit security that participants demand. Forwardthinking plan sponsors who make time today to reexamine the assumptions surrounding their pension plan obligations will be able to confidently chart the right course for their pension and their company and they will be at an advantage over those who don t. ENDNOTES 1 Milliman 100 Pension Funding Index. 2 Companies have received temporary relief from addressing their funding gaps with the enactment of an interest rate stabilization law (the Moving Ahead for Progress in the 21st Century [MAP-21] Act). According to a recent study by Towers Watson ( Pension Plan Funding Obligations Under MAP-21, September 2012), in the absence of a rise PENSION & LONGEVITY RISK TRANSFER FOR INSTITUTIONAL INVESTORS

9 in interest rates, contributions will increase to pre-map-21 levels in a few years. 3 Towers Watson, Retirement Plan Types of Fortune 100 Companies in October 2012, pp Kessler, A. The Driving Forces Behind Pension Risk Transfer. European Pensions, December Balancing Costs, Risks, and Rewards: The Retirement and Employee Benefits Landscape in CFO Publishing LLC, Partial LDI strategy is assumed to have a fixed-income allocation of 45%, with a duration that matches liability duration, and an equity allocation of 50% (cash 5%). This definition of partial LDI is somewhat consistent with asset allocations reported in Milliman s 2013 pension study (Milliman, 2013 Pension Funding Study, pp. 4-5). Per the study, the largest plans have increased their allocation to fixed income from 28% of assets in 2005 to 41% in 2012, and have either attained their desired allocation or have not reached the next trigger point along their glide path to de-risk further. 7 McDonald, M., and C. Marcks. Longevity Risk and Insurance Solutions for U.S. Corporate Pension Plans. Prudential Financial, Ibid. 9 Balancing Costs, Risks, and Rewards: The Retirement and Employee Benefits Landscape in CFO Publishing LLC, LCP Pension Buy-ins, Buy-outs and Longevity Swaps, (Page 30 lists transactions in excess of 100mm.) 11 Balancing Costs, Risks, and Rewards: The Retirement and Employee Benefits Landscape in CFO Publishing LLC, To facilitate a comparison of a buyout with initial GAAP liability, all costs that plans incur are computed over the life of the liability and capitalized (present valued). 13 Prudential analysis of credit default and downgrade costs for a typical AA corporate bond portfolio. 14 Jin, L., R. Merton, and Z. Brodie. Do a Firm s Equity Returns Reflect the Risk of Its Pension Plan? NBER working paper, Morgan Stanley, How Corporate Pension Plans Impact Stock Prices, May 28, DB plans add about 73 basis points to the WACC of the S&P 500, for the median company. Disclaimer This discussion document describes product concepts that are not final. It has been prepared for informational purposes only. It is not an offer to enter into any agreement. This document does not completely describe the terms of any potential transaction or final product design, and any transaction would be subject to applicable legal and regulatory requirements; internal, legal, and regulatory approvals; and final legal documentation. Any indication of pricing provided in this document is for illustrative purposes only. Prudential does not provide legal, regulatory, or accounting advice. Therefore, an institution and its advisers should seek legal, regulatory, and accounting advice regarding the legal, regulatory, or accounting implications of any insurance or reinsurance contract. This information is provided with the understanding that the recipient will discuss the subject matter with its own legal counsel, auditor, and other advisers. Prudential Retirement Insurance and Annuity Company (PRIAC) and The Prudential Insurance Company of America (PICA) provide insurance products for U.S. pension plans but are not authorized to provide insurance products for U.K. pension plans. Neither PRIAC nor PICA nor Prudential Retirement are authorized or regulated by the U.K. Prudential Regulation Authority or regulated by the Financial Conduct Authority, nor do they offer insurance or reinsurance in the United Kingdom. PRIAC does provide off-shore reinsurance to companies that have acquired U.K. pension risks through transactions with U.K. plan sponsors. PRIAC is not authorized or regulated by the Office of Superintendent of Financial Institutions for Canada or by the Financial Services Commission of Ontario. Guarantees are based on the claims-paying ability of the insurance company and are subject to certain limitations, terms and conditions. Reinsurance contracts are issued by Prudential Retirement Insurance and Annuity Company (PRIAC), Hartford, CT PRIAC is not a United Kingdom (U.K.) Financial Services Authority (FSA) authorized insurer and does not conduct business in the U.K. or provide direct insurance to any individual or entity therein. Prudential Financial Inc. of the United States is not affiliated with Prudential plc. which is headquartered in the United Kingdom. Securities products offered by registered representatives of Prudential Investment Management Services, LLC (PIMS). To order reprints of this article, please contact Dewey Palmieri at dpalmieri@iijournals.com or REDUCING PENSION RISK: THE MYTHS HOLDING BACK PLAN SPONSORS