Global Institutional Annuity Market Update Liability De-Risking / Plan Terminations Mid-Year 2012 Hewitt EnnisKnupp, An Aon Company 2012 Aon Corporation Brief Description: This newsletter reviews the international annuity market in the first half of 2012, how the General Motors announcement affects other sponsors considering an annuity purchase in the near future, and the financial impact of offering retiree lump sums.
Mid-Year International Market Update United States In the first half of 2012, there were105 annuity placements worth a total of about $745 million, as reported to us by the insurance companies surveyed below. This greatly surpassed the annuity placement premium in the first half of 2011, which totaled $252 million. The majority of premium in the first half of the 2012 was placed with MetLife, Mass Mutual and Principal, respectively. In July, another $523 million of annuity premium was transacted through Hewitt EnnisKnupp. Therefore, we expect year-to-date sales through the third quarter to be over $1.5 billion and that the level will be well over $10 billion by year-end 2012, after the General Motors transaction closes with Prudential. The data comes from a survey of true pension annuity close-out deals (in addition to buy-ins and carve outs in advance of full close-outs) from 10 insurance companies (11 companies from 2005 to 2009) currently active in the annuity marketplace. Other industry sources report similar data but may include other types of placements, such as early retirement incentive programs, annuitization of defined contribution plan balances, and internal conversions of unpurchased defined benefit annuities. Insurance companies currently surveyed include: American General Life John Hancock Life Massachusetts Mutual Life ( MassMutual ) Metropolitan Life ( MetLife ) New York Life Pacific Life Principal Life Prudential Insurance Company of America Transamerica Life United of Omaha Life 1
No single insurance carrier has monopolized the industry in the last several years. Industry sales leaders in terms of total premium have been: Year Market Leader 2005 Principal 2006 John Hancock 2007 Transamerica 2008 MetLife 2009 MassMutual 2010 MetLife 2011 Prudential Annuity placement inquiries have been on the rise, even with the continued low interest rate environment. As sponsors decide to de-risk their pension plans, they are contemplating various options such as partial plan settlements, dollar cost averaging strategies and other liability risk management solutions. The trend to inquire about annuity placements coupled with client consideration of lump sum windows creates an opportunity for firms to lower the potential volatility in their defined benefit plans. We strongly anticipate an increase in placements over the next 12 to 24 months. 2
Immediate annuity purchase rates fell over the first half of the year by about 20 basis points. Deferred rates fell 10 basis points over the same time period. The reason for the decline is that insurance annuity rates are tracking with the fall in market interest rates. The chart below illustrates annuity pricing and market interest rates since January 2007. 7.0% Historical Sample Annuity Pricing Rates Deferred Rate (Duration=15) 6.0% Immediate Rate (Duration=7) 30-Year Treasury Rate 10-Year Treasury Rate 5.0% Interest Rate 4.0% 3.0% 2.0% 1.0% Jan-07 Apr-07 Jul-07 Oct-07 Jan-08 Apr-08 Jul-08 Oct-08 Jan-09 Apr-09 Jul-09 Oct-09 Jan-10 Apr-10 Jul-10 Oct-10 Jan-11 Apr-11 Jul-11 Oct-11 Jan-12 Apr-12 Jul-12 Note: Rates are derived from a Hewitt EnnisKnupp survey completed monthly by eleven insurance companies currently active in the marketplace. (3/31/2012 and forward excludes Transamerica, which is currently on bidding hiatus.) The rates since 2011 are derived from the highest (most aggressive) interest rates available in the marketplace on plain vanilla cases as of the last working day of the calendar month. Since rates vary so much intraday, quotes are generally only held open for a couple of hours on the day they are published. 3
Immediate Annuity Rates Deferred Annuity Rates Rates as of: Low High Low High 8/31/12 2.55% 2.85% 3.15% 3.53% 7/31/12 2.57% 2.87% 3.14% 3.52% 6/30/12 2.79% 3.05% 3.35% 3.73% 5/31/12 2.67% 2.90% 3.26% 3.64% 4/30/12 2.77% 3.07% 3.42% 3.80% 3/31/12 2.94% 3.24% 3.65% 4.03% 2/29/12 2.88% 3.18% 3.55% 3.93% 1/31/12 2.90% 3.20% 3.51% 3.89% 12/31/11 2.97% 3.27% 3.45% 3.83% 11/30/11 3.23% 3.53% 3.66% 4.04% 10/31/11 3.09% 3.39% 3.68% 4.06% 9/30/11 3.07% 3.37% 3.60% 3.98% 8/31/11 3.28% 3.58% 3.96% 4.34% Note: Pricing interest rates can vary for many reasons. For estimate purposes, the low end of the range should be the starting point for cases that have complex plan provisions, contain data that has not been scrubbed, have cash balance and/or employee contributions, etc. Extra conservatism for such circumstances should possibly be added to lower the estimated rate even further. The Aon Hewitt Pension Risk Tracker reported that the aggregate U.S. funded ratio of all pension plans in the S&P 500 had significant improvement during the first quarter, from 81.5% to 88.5%. Marginally higher corporate bond yields used to discount pension liabilities caused pension liabilities to decrease by 0.4%. Ten-year treasury yields jumped up by 0.34% over the first quarter and credit spreads narrowed by about 0.26%, which increased corporate bond yields by about 0.08%. Finally, pension assets continued to increase, by about 8.2%, due to strong performance in the equity markets during the quarter. The funded ratio fell through April down to 85.2%,through May down to 79.2%, and rebounded in June only to about the level at the start of the year, 81.0%; thereby giving away all the gains for the year. In the second quarter, pension liabilities shot up by 9.0%, primarily due to a significant drop in corporate bond yields used to discount pension liabilities. Ten-year treasury yields fell by 0.56% over the quarter, while credit spreads narrowed by about 0.14%, resulting in one of the historically low corporate bond yields of 3.90% at the end of the quarter. Pension assets did not help much and were overall flat for the quarter with negative equity returns nullified by positive bond returns. 4
Canada During the first two quarters of 2012, group annuity total premiums placed with the major Canadian insurance companies were at $308 million for the first quarter and $118 million for the second quarter, for a total of $426 million. The second quarter 2011 year-to-date total annuity placements, in comparison, totaled $481 million. This low premium activity level may provide opportunity to potentially obtain competitive pricing until the end of 2012, as several Canadian insurance companies search for new sales in this space. This window of opportunity may be quite favorable for the purchase of group annuity contracts, and it may be optimal for some plans to act in a timely manner. Finally, in August 2012, the Canadian Institute of Actuaries (CIA), the national organization of the actuarial professionals in Canada, revised their discount rate guidance for estimating the cost of purchasing non-indexed group annuities for hypothetical wind-ups and solvency valuations. This discount rate guidance for estimating annuity pricing for non-indexed pensions, which uses Government of Canada long-term bond yields (GoC) plus a 90 basis points (bps) margin at the valuation date, was revised by a decrease of 10 bps, to reflect an 80 bps margin over the GoC bonds. This change was a result of the collection of market information on pricings by the CIA in the second quarter of 2012 and as such, was judged to be appropriate. For more information, please contact Tony Ioanna at +1.514.982.5189. 5
United Kingdom There were 27 cases written in the first quarter of 2012 in the UK, with a total value of 491 million. This is less than half the number of cases written in the record-breaking prior quarter and less than 16% of the value written in the prior quarter. We believe this partly reflects a trend that some providers can come under pressure to complete transactions prior to their year end. However, the first quarter of 2012 was more successful than the first quarter of 2011, when 348 million of business was placed. Pension Insurance Corporation (PIC) topped the universe of providers, writing almost 70% of all business placed in the market during the first quarter. MetLife, Legal & General (L&G) and Aviva continued to write smaller deals successively over the quarter. Lucida also made a positive start to the year with a fresh transaction. Other providers, that tend to focus on larger transactions, did not place new business in the first quarter, with some auctions curtailed by trustee concerns over funding volatility in the quarter. There were no deals of ground-breaking proportions in the quarter. Despite the market's focus on pensioner buy-in opportunities, the actual business placed in the first quarter was unusually mixed: Three of the four PIC transactions were related to full scheme buy-outs. These were for two Denso (high-tech manufacturer) schemes where the transactions included cover for additional risks and terms to secure benefits that were still accruing for active members, and for the Mercers' Company. Their fourth transaction was a pensioner buy-in of over 100 million (advised by Aon Hewitt). The Lucida transaction was also unusual, as it related to the securing of deferred members. These relate to the Newell Rubbermaid UK Pension Scheme (also advised by Aon Hewitt) and follow a previous placement of pensioner liabilities with Lucida. There was a pattern of follow-on transactions occurring with the larger deals in the first quarter. The transactions for Newell, Denso and the undisclosed PIC buy-in all relate to employers that had conducted previous bulk annuity transactions, allowing them to more easily get ready for a further placement. Placements nearly doubled in the second quarter of 2012: 45 cases were written for a total value of 914 million. PIC again topped the universe of providers, writing over 44% of all business placed in the market during the second quarter, with MetLife, L&G and Aviva continuing to write smaller deals successively over the quarter. Pipeline activity remains buoyant in terms of quotations being sought. Pricing opportunities continue to be available for schemes holding gilts. The opportunity to swap gilts for a pensioner buy-in, which provides a higher return as well as a longevity hedge, continued over the second quarter. There were no longevity swap deals during the first quarter, but there was a longevity swap deal covering 1.4 billion of pensioner liabilities for Akzo Nobel during the second quarter. For more information, please contact Paul Belok at +44 (0) 20 7086 8089. 6
Mexico In Mexico, pension plan topics are relatively new. As mentioned in previous issues, the retirement savings culture is not common. However, the Mexican government is making efforts to promote it since the Social Security Law change in 1997. In 1997, Social Security Law passed from a Defined Benefit scheme (Law 73) to a Defined Contribution scheme (Law 97). Employees in Law 73 are the transition generation. They will be entitled to select the benefit they want to receive (either Law 73 or Law 97). The annuity market is linked to Social Security pension payments and there are 10 insurance companies that provide Social Security life annuities. Only a couple of companies offer private retirement life annuities. Cumulative premiums for the last two years and the first half of 2012 are as follow: Premiums Figures in US (000s) Period ending 2010 2011 2012 Mar $256,704 $267,460 $312,490 Jun $549,114 $516,012 $604,112 Sept $821,168 $814,554 $0 Dec $1,132,037 $1,124,940 $0 Exchange Rate: $1 USD = 14 Mexican pesos During 2009, total annuity premiums were $650 million USD, so there was a 74% increase for 2010. However, there was a decrease of 0.63% in 2011. Premiums in the first half 2012 increased by 17% from the first half of 2011. Every year more Pension Plans are implemented. While the transition generation of Social Security is decreasing and the new generation is increasing, the annuity market and retirement savings culture will acquire greater importance in Mexico. For more information, please contact Patricia Barra at +52 (55) 5340.2800 x2821. 7
General Motors Announces Pension Settlement Is this the Tip of the Iceberg for Group Annuity Placements? On June 1, 2012, General Motors Co. (GM) announced it will be eliminating approximately $26 billion in pension liabilities by offering a one-time lump sum option to 42,000 of its 118,000 salaried retirees and beneficiaries. For those 76,000 retirees and beneficiaries that were not offered the lump sum plus those that do not elect the lump sum, annuities will be purchased through a group annuity contract with Prudential Insurance Company. This group annuity contract will be the largest of its kind issued to date. As shown on page 1, this transaction could end up larger than all of the 1,300 transactions completed over the past seven years combined. What does this mean for plan sponsors that are contemplating reducing their pension obligations through the purchase of annuities in the future? How will a transaction of this kind affect insurance company capacity? We believe that these partial plan settlements are just the tip of the iceberg. While the insurance industry has written about $10 billion in premium since 2005, our studies have shown that the current insurance company capacity is over $60-80 billion per year. There are nine insurance companies currently active in the group annuity market. While several insurance companies such as The Hartford and John Hancock have exited the market in the past few years, there are several companies considering entering the market in the future. Insurance companies are also looking at unique ways to structure jumbo transactions as defined as over $1 billion USD. All transactions to date have been structured as a single premium cash transfer. The approach plan sponsors and insurers are contemplating include asset-in-kind transfers. This involves the insurance company, plan sponsor and advisors working closely together to determine an asset mix that the insurance companies can accept whereby creating an optimum portfolio for both parties. Insurance companies find group fixed immediate annuities (retirees) attractive because it can serve as a natural hedge to their life insurance line of business. Therefore, we do not see that annuity pricing or capacity will be an issue in 2012 or 2013. According the Glenn O Brien, Managing Director, Pension and Structured Solutions at Prudential Insurance Company of America, The cost and complexity of managing a pension plan in today s environment has made pension risk transfer and partial risk transfer strategies much more attractive to sponsors and their investors. Helping to secure retirement income for participants and provide risk reduction for businesses is something our industry can do on a large scale. The GM transaction has answered many of the questions that have been in the market for a few years and provides a path forward for other sponsors. Ed Root, Vice President at Metropolitan Life Insurance Company, states Jumbo Defined Benefit Pension Plan Sponsors (those with liabilities over $1 billion) have been very interested in doing Pension Risk Transfer (PRT) deals for several years. However, there has been a delay in transactions due to the recession and its negative effects on funded status, the disconnect between accounting liabilities and economic liabilities, [coupled with] a reluctance by many plan sponsors to be the first jumbo deal. The PRT market will likely accelerate now that GM has announced its groundbreaking PRT deal. This deal legitimizes PRT and forces all plan sponsors to ask the question Should we do this also? The most likely candidates for PRT are frozen DB Pension Plans that have no new entrants and have stopped benefit accruals. A plan freeze is tacit admission that a plan sponsor will do PRT but now it is a question of the right timing. Large PRT deals will usually start first with the retirees only (such as in the GM deal) because it is much easier and quicker than including the actives and terminated vested participants. 8
The life insurance industry does have a large capacity to transact billions of dollars in PRT deals in addition to the GM deal. We don't see any near term capacity issues. As the market continues to expand in the next few years we expect to see new life insurance company entrants, perhaps from the UK market, as well as new deal structures that will add to industry capacity. There are also many financial issues for a plan sponsor to consider when looking at pension plan settlements. Issue Considerations Group Annuity Liabilities Can be 10% larger than PBO Anti-Selection Risk, if lump sums offered to retirees Asset Decisions and Allocations before settlement actions Today s Low Interest Rates Settlement Accounting Can increase costs 5 15% Need to address liquidity, hedging, and an in-kind portfolio transfer Will rates remain low? If no settlements now, prepare for environment deemed more favorable Impact on results and ties to mark-to-market accounting trend For more information on the GM pension settlement actions and considerations for plan sponsors, please see Aon Hewitt s white paper on the topic: https://ctech.rproxy.hewitt.com/hig/filehandler.ashx?fileid=6742 9
The Financial Impact of Offering Retiree Lump Sums In recent months, several high-profile companies have announced large-scale pension lump sum offers to their retirees and other former employees. The simple goal is one of reducing their corporate pension plan financial risk. Notwithstanding such offers by GM, Ford, and many other prominent sponsors, lump sum initiatives are not new. Their re-emergence coincides with a critical change in pension law. Prior to the Pension Protection Act, lump sums were typically calculated using the 30-year Treasury yield as a discount rate. This made lump sum payouts of vested pension benefits considerably more expensive than purchasing annuities to settle the same obligations. Annuity options were especially attractive relative to lump sums when credit spreads widened, lowering their relative value. However, there have been times, especially in an inverted yield curve environment, where lump sums could appear more cost effective than annuities. Ever since the Pension Protection Act transitioned the minimum lump sum basis to corporate bond yields, lump sums have been viewed as a very attractive liability mitigation option to remove pension obligations. With the Ford and GM announcements, these sponsors are offering lump sums to retirees receiving annuity payments. While it has been atypical for plan sponsors to offer lump sums to retirees in the past, we have seen it very sporadically. However, it is likely that we may see other companies choose this derisking strategy. Sponsors are now asking, is it worth doing a lump sum offering to retirees? While there are numerous factors to consider, we want to focus on one core factor - economics. Is it economically better to offer a lump sum than not? There are two critical financial issues that plan sponsors need to consider: 1) How many people are going to take the lump sum? 2) Once lump sums are paid, remaining benefits must either be paid from the plan as before, or settled via an annuity purchase. So how large is the residual benefits cost? These two issues go hand-in-hand when deciding the economics. How Many Will Take It? While no formal studies exist, our experience tells us that when active employees or terminated vested participants are offered a lump sum during plan termination, a high percentage of participants will opt for it. Although this varies by plan, we might see as high as an 80% to 95% range for actives and a 60% to 80% range for terminated vesteds. These take rates will depend on many behavioral economic issues such as age, gender, benefit size, wealth, health, and many other factors. There is a different dynamic with take rates for lump sum windows for terminated participants as part of a de-risking strategy. These options have become very popular with Aon Hewitt s clients. Our recent survey showed that 13% of our pension clients have decided to implement lump sum windows where their terminated vested participants can elect a lump sum. Also we found that another 42% are considering the option. We are now gathering data to determine whether lump sum take rates will be as high for a lump sum window as with a plan termination. Under a termination, a participant has to make an election because the plan is going away. However in a lump sum window, the participant is not forced to make a decision per se because the plan will still exist after the offer has expired. Again, another dynamic one needs to consider is that unlike retirees, terminated vesteds participants are not receiving a benefit check, so their decisions may not have an immediate financial behavior-altering consequence for the individuals. 10
The GM and Ford dynamics provide an even further differentiation because lump sums are offered to participants who have commenced annuity payments. The new question is what will take rates be for retirees? As we have inferred, it may not be an easy decision for retirees to make. Jennifer Orzell, Assistant Vice President and Actuary at Mass Mutual says, Retirees may now be in a position where they need to decide if they want to take the risk of managing a lump-sum investment versus continuing to receive their guaranteed lifetime income. It may be an overwhelming decision for someone to make several years into retirement. Although very true, the economics again may dictate whether to offer the lump sum or not. Does it matter - Purchasing Annuities for the Rest or Leaving Them in Your Plan? If you offer a retiree lump sum, what do you do with the remaining retirees who do not take it? Ford decided to leave the remaining retirees on its balance sheet, while GM decided to purchase annuities with Prudential for its remaining retirees. Regardless of approach, there is a dynamic called anti-selection risk that insurers will price into the assumed remaining liability. Plan sponsors may also want to account for anti-selection cost in their remaining PBO, should they choose to hold it within the plan. The source of anti-selection risk is simple. Insurance companies will assume standard longevity assumptions for a representative group of annuitants because everyone is homogenous and should reflect the general population, all other things equal. However, if individuals can choose whether they want to take a lump sum or not, then it stands to reason that people who think they are healthier will keep the annuity and people who are not as healthy will take the lump sum. Evidence of this phenomenon is clear in the insurance retail annuity market. It is known that longevity in the retail space is greater than in the institutional market for situations when a lump sum option is not available. This is because less-healthy individuals will tend to prefer the lump sum, making the residual retail annuity buyer pool healthier than the general population. When you adjust for the retail distribution cost and make the offerings apple-to apples, the insurer will need to add an additional cost adjustment in the retail market for this anti-selection exposure. The differential absent distribution cost is primarily the introduction of choice in the retail annuity space. The Longevity Gamble Ultimately, it is especially difficult for younger individuals to guess their own longevity. An individual who is 40 years old, for the most part will not have as much insight into his/her remaining lifespan as will a 70 year old. Therefore, when lump sums are offered from a plan, we see that anti-selection costs are much lower for the 40 year group, than the 70 year old group. This has implications for all plans offering lump sums, but specifically companies offering lump sums to retirees. There is an additional wild card to consider and that is the percentage of individuals willing to take a lump sum. If nobody takes a lump sum, or if everyone does, then there is little or no anti-selection cost. Assuming the lump sum basis is a fair one, potential anti-selection cost will usually peak at a lump sum take-rate of around 50%. This is because the healthier people will want to maximize the value of their longer expected lifespan by taking the annuity, while others will maximize their benefits by taking the lump sum. As the percentage of individuals who take the lump sum increases well beyond 50%, then not only are less-healthy people taking the lump sum; healthier individuals are too. So the potential anti-selection cost will decline for the remaining smaller group who take the annuity. We have done sophisticated analysis at Aon Hewitt to help clients think through the anti-selection implications of a lump sum offering. Our initial view is that the cost can range from 5% to 15% of the total obligation depending on who is offered the lump sum and the overall acceptance rates. While we agree that both annuity purchases and lump sum offerings are very effective tools at helping plans de-risk, it is critical to think through all the cost and implications before executing these strategies. 11
Contact Information U.S. Team Robin Gantz, Senior Consultant Hewitt EnnisKnupp, an Aon Company +1.949.823.8533 robin.gantz@aonhewitt.com Canada Tony Ioanna, Vice President Aon Hewitt +1.514.982.5189 tony.ioanna@aonhewitt.com Steve Shepherd, Associate Principal Hewitt EnnisKnupp, an Aon Company +1.203.523.8164 steve.shepherd@aonhewitt.com Jennifer Lawrence, Consultant Hewitt EnnisKnupp, an Aon Company +1.610.834.2271 jennifer.lawrence@aonhewitt.com United Kingdom Paul Belok, Principal & Actuary Aon Hewitt +44 (0) 20 7086.8089 paul.belok@aonhewitt.com Mexico Patricia Barra Aon Hewitt Mexico +52 (55) 5340.2800x2821 patricia.barra@aonhewitt.com About Hewitt EnnisKnupp Hewitt EnnisKnupp, Inc., an Aon company, provides investment consulting services to over 500 clients in the U.S. and abroad with total client assets of over $2 trillion. Our more than 200 investment consulting professionals a result of the merger of Hewitt Investment Group, Ennis, Knupp & Associates, and Aon Investment Consulting advise endowment, foundation, not-for-profit, corporate, and public pension plan clients ranging in size from $3 million to over $740 billion. 12