Pension Funding and Risk Management White Paper Aligning Strategy To Manage Risk
TABLE OF CONTENTS ABSTRACT... 2 BACKGROUND... 2 RECENT DEVELOPMENTS... 2 THE MARKET RESPONDS... 4 NEW OPTIONS: THE CAPTIVE BUY-IN SOLUTION... 5 IN CLOSING... 7 1 Copyright Spring 2012
ABSTRACT Today, pensions are on every plan sponsor s mind. Due to recent legislative changes and current market conditions, pension plans have devolved from being perceived as major talent acquisition tools to presenting major fiduciary and financial challenges to their sponsors. In response to this shift in attitudes and emerging interest in mitigating the risks inherent in maintaining a pension plan, risk transfer markets have responded with various approaches to address the modern pension problem. This paper describes the issues facing pension plan sponsors, the solutions available to manage them and important considerations in evaluating the solutions effectiveness. The paper describes traditional and recently popular risk reduction methods, with a special focus on the captive buy-in solution. BACKGROUND In the first half of the 20th century, private pensions were typically funded through the purchase of insurance products. This minimized asset earning potential, so many corporate plans came to embrace a structure that allowed them to grow pension assets faster than liabilities. A large excise tax put a stop to stripping excess assets from plans, a strategy that was briefly in vogue in the early 1980s. However, corporations that outperform the market can still benefit from an improved balance sheet and extended periods without pension contributions. These strategies were made less attractive as U.S. policymakers decided to ensure the health of existing pension liabilities by imposing stringent funding guidelines on sponsoring corporations, emphasizing full funding and stability over asset returns. RECENT DEVELOPMENTS The U.S. pension market is going through its second secular shift in the last three decades. The first shift, in the wake of the passage of the Employee Retirement Income Security Act (ERISA) in 1974, saw asset management move away from fixed income to equity and from bank trust companies and insurance companies to investment management boutiques. The second shift had multiple drivers, but its manifestations can be anchored to the 2006 Pension Protection Act (PPA), with its emphasis on full funding and sensitivity to asset volatility. Since then, more and more corporate chief financial officers are looking at very different solutions for their plans, with a premium on cost containment and risk curtailment strategies. As noted, the shift towards stability now being seen in the corporate Defined Benefit (DB) marketplace has multiple drivers. These include: Financial regulatory changes, specifically in various Financial Accounting Standards Board (FASB) statements that have adversely affected the investment risk/reward paradigm for corporate plans, 2 Copyright Spring 2012
The PPA and its restrictions on pension smoothing and funding flexibility A global shift away from DB plans, and a concomitant rush towards plan 'freezing' (where the plan is kept in place, but no additional benefits are earned) and closings (where the plan is terminated entirely) The growing acceptability of 401(k)-style 'defined contribution' plans as the primary corporate retirement vehicle The realization in 2008 that equity markets could suffer double-digit losses, severely impacting corporate funding status These trends resulted in an effort to develop solutions to mitigate the risks that underfunded pension funds posed to their parent organizations. These plans carry the potential to cause substantial and unpredictable swings in cash and accounting costs for their sponsors. There is no typical corporate plan, as each plan has its own history and its own asset/liability ratio. Nonetheless, entirely new patterns of behavior are emerging. There has been a wholesale retreat from open-ended plans, with a rush to so-called soft (some benefits continue) or hard (no future benefits) freezes. Some estimates see as many as 50% of plans in excess of $500 million hard-freezing in coming years. This radically changes the corporate properties of the plan it ceases to become a human resource tool and is viewed entirely through a financial prism, most specifically the risk it poses to the corporate sponsor s financial health. In 2003, 4.5% of the Fortune 1000s had frozen DB plans. In 2009, this had risen to 19%, including 28% of the Fortune 500. 1 Changes to asset allocation: The traditional 70%/30% or 60%/40% equity/fixed income ratios that characterized almost all plans in the last three decades are becoming an endangered species in the corporate DB marketplace. Many plans are moving to a more conservative asset mix with an eye to matching liabilities and assets. The new asset allocation paradigm: In many ways, strategies now seen in the marketplace have been seen before. For example, variations on immunization were in vogue in the early 1980s, and are re-emerging now. The key strategy that is beginning to dominate now is liability-driveninvesting (LDI), which means different things to different people, and thus can be said to cover an investment spectrum which might start with longer-duration bond investing, immunization, interest sensitive derivatives, or annuity buy-ins. It s all about fully-funded plans: A fully-funded plan is now the sine qua non of the new pension architecture, and the vast bulk of plans will seek the path to full funding through as risk-averse and cost-effective a path as their funded status allows. 2 These levels are expected to dramatically improve by 2013, and while part of this will be hoped-for market improvement, a good percentage will have to be from increased funding levels mandated by the authorities. Once a plan is fully funded, any excess funds can only be returned to the sponsor upon payment of income tax on that 1 According to a 2009 survey by Hewitt Associates 2 A report from Diversified Investment Advisors shows 2009 funding levels of 42% at less than 60%, 43% at 60-79%, 7% at 80-89%, 4% at 90-99% and 4% fully funded 3 Copyright Spring 2012
amount plus a 50% excise tax, making an 85% tax on any surplus reversions for many sponsors. Beyond full funding: The burgeoning liabilities and shrinking assets mean that the vast majority of corporate plans are underfunded. But it is increasingly clear that when a frozen plan, and in many cases even an unfrozen plan, reaches a fully-funded or overfunded status, there is absolutely no rationale for the continued operation of that plan. It can be stated as fact that solutions will emerge that will seek to transfer this risk away from the corporate plan. The most commonly used technique is plan termination coupled with the purchase of terminal annuities, but different risk transfer solutions, like captive buy-in annuities, are emerging. These promise to be the next frontier of institutional asset management. THE MARKET RESPONDS The issue of a fully funded or overfunded plan can be a problem for a plan sponsor, especially if the plan is frozen and the participants are not earning additional benefits. If a plan is at 100% funding, the market can drop, requiring additional contributions, or the market can go up, without a cash benefit to the plan sponsor, creating a heads you lose, tails you don t win situation. While there may be ways to use a pension surplus by offering additional benefits or by reverting the assets and paying the large excise tax, the basic asymmetry still exists. A plan sponsor can transfer this risk out of the pension plan using several methods: Asset and liability matching (ALM): This is a broad term for approaches that seek to have the assets and liabilities move up and down together in response to market changes. As the liability is a series of future payments, the liability s behavior is bond-like. Therefore, the ALM approach can be anything from purchasing high quality long-term corporate bonds to the purchase of swaps that respond to interest rate movements in a similar manner to the liability, and beyond. For many of these approaches, the match is imperfect due to the long term nature of the pension obligation, which can easily be 60 years, the reaction of the obligation to changes in mortality, or other details that make a pension obligation more than a simple bond. Buy-Ins: This approach is similar to a buy-out in that it involves purchasing annuities from an insurance company. The difference is that in a buy-in the obligation to pay the retiree remains with the plan, and the annuity is owned by the plan as a plan asset. Unlike a buy-out, in which the insurance company makes payments directly to the retiree, with a buy-in the retiree still receives payments from the plan and the plan receives corresponding payments from the insurance policy. The annuity can be structured to match all or part of the payment stream from the plan, so that movements in the measurement of the obligation will be matched by movements in the annuity asset. This is a form of ALM that creates a very close link between the plan obligations and the plan asset (the insurance policies) as both are a collection of future payment streams. This approach reduces the volatility of the accounting and cash position of the plan. However, these annuities are expensive for the same reasons discussed above regarding buy-out annuities. 4 Copyright Spring 2012
Plan termination with annuity buy-out: This is the traditional way to remove all pension risk. This method involves purchasing annuities from insurance companies to pay the plan s obligations directly to the participants. At the end of this, there is no longer a pension plan sponsored by the parent company, removing all administrative, fiduciary, accounting, and cash obligations. The downside of this approach is that it is very expensive. Insurance companies charge an amount to cover their overhead and profit, as well as an additional amount to cover the substantial risk of taking a one-time payment to cover a risk lasting decades. While the prices are set by annuity insurers, they are often based on long term market interest rates. As a result, in the current low rate environment, annuity prices are high. When and if rates do rise, this option will be more desirable, but it is possible that many plan providers will rush to this option, saturating the terminal annuity marketplace and raising prices for all but the first to the door. Partial buy-out: This is a reduced version of the total buy-out option above. A pension plan can purchase annuities to cover the obligations for a portion of its population, e.g., only retirees. This option does not require the level of asset commitment of a total buy-out, although the lower cash outlay is simply due to a reduction in volume of annuities purchased. In the case of purchasing annuities to only cover current retirees, the pension plan would have effectively eliminated the most stable and predictable segment of its obligation and faced more variability in managing the remaining portion. Pension Buyouts: In a pension buyout, the pension plan is segregated from the parent company and sold to a private buyer. The transaction is based on the idea that the buyer may have a greater desire and ability to manage pension obligations and risks. The plan continues as an active plan owned by the buyer. These have been done in the U.K., but the U.S. Treasury Department has stated that pension buyouts are not allowed under current U.S. law. NEW OPTIONS: THE CAPTIVE BUY-IN SOLUTION A solution that reduces risks in the pension plan while retaining assets within the corporate family is a pension buy-in solution. In this solution, a pension plan buys annuities matching all or part of its liability as noted above, but the annuity is then reinsured to a captive insurer owned by or otherwise affiliated with the plan sponsor. In this situation, the original insurer from which the plan purchases annuities is called the fronting insurer, or front. A front is an independent insurance company that writes annuities and is willing to reinsure these annuities to the captive for a fee. The annuities held by the plan as assets are the annuities written by the front, so the plan has a contract with the front to provide the payments contained in the annuities. This means the plan does not have a direct contract with the captive, and the fronting company is legally obligated to pay the annuity payments regardless of the financial condition of the captive. In effect, the front takes on the risk of the captive s ability to pay. It may be possible to write buy-in annuities with the captive directly, but the existence of the front provides additional security for plan participants and allows for the use of the front s experts in writing and 5 Copyright Spring 2012
administering annuities. This approach is more affordable than purchasing buy-in annuities from a third party without reinsuring to the captive. With a third party purchase, the insurer demands a large premium for taking on the long term investment risk. This risk is ceded to the captive and therefore reduces the cost in the insurance contract associated with longevity risk. The captive buy-in approach would result in the plan s assets and liabilities fluctuating more or less in unison in response to market movements. Pension liabilities react primarily to market interest rate movements their value goes up as interest rates decrease and their value reduces as interest rates increase. Annuities are a fixed stream of payments and their values also change with market interest rates. Because the liabilities and the assets (annuities) respond to interest rate changes very similarly, the captive buy-in transaction effectively removes the volatility in both funding and accounting for the plan. The plan s funded status no longer varies with interest rate movements (because the assets and liabilities move together) or equity market swings (because equity holdings in the pension plan are small or nonexistent). The captive buy-in solution mitigates the issue of overfunding pension plans. As previously mentioned, underfunded plans require contributions, but overfunded plans surplus cannot be recovered without paying the majority of the excess in taxes. So the plan sponsor is effectively forced to contribute to an underfunded position during a market slump, but faces the risk of trapped assets during market improvement. By implementing the captive buy-in solution, any excess funding would be captured by the captive and therefore retained within the corporate family. Consider the following example: If a plan is 100% funded with traditional securities and the market goes up 5%, that extra cash would not be available without a substantial penalty. If, however, the same plan was invested in captive-reinsured annuities, the extra 5% would constitute a profit to the captive. This profit could be distributable back to the parent company. A captive buy-in can also add flexibility to a plan that is not fully funded. If the plan is not fully funded, but its assets increase in value, the sponsor would not have any use of this growth. With the captive, the sponsor would have considerable flexibility with regards to the amount of marginal asset increase. One option would be to contribute only the minimum required amount to the pension plan for that year and retain the rest of the captive asset earnings as dividend. Another option would be to contribute the captive earnings and deduct the contribution. In this asset growth scenario, the captive buy-in allows the pension plan sponsor to choose between contributing the minimum amount, the full amount, or anything in-between. Trapped assets present an additional concern for pension plan accounting. U.S. GAAP allows sponsors to claim overfunded pension plans as balance sheet assets. International Accounting Standards (IAS), however, limit this asset to the amount that can be expected to benefit the sponsor through either reduced future contributions or post-penalty surplus reversions. As U.S. GAAP and IAS converge, overfunded frozen plans with limited future contributions will be effectively undervalued in accounting statements. 6 Copyright Spring 2012
There are other accounting drawback results from recent changes to IAS pension accounting which would harm the P&L of pension plan sponsors, but could be mitigated with the use of a captive. Under the changes, the Pension Cost item in the P&L would only include an asset return calculated using a conservative discount rate. Therefore, any optimism about long-term asset return would not be fully reflected in the P&L. Any asset return in addition to that obtained using a conservative interest rate would be recorded in Other Comprehensive Income (OCI), not on the P&L. By moving assets into the captive, the investment return that can be recorded in the P&L would no longer be subject to the above rules, bringing any pension asset growth back into earnings. IN CLOSING The pension landscape is continually changing, altering stakeholder attitudes and presenting plan sponsors with new issues and risks. Alongside this transformation, novel solutions are being introduced to help alleviate the fiduciary, administrative, cash, accounting, and other plan sponsor challenges. While this paper discusses the current industry trends and market response, the process of arriving at the right solution depends on a range of facts around the pension plan and its sponsor. The appropriate solution for a given pension plan should be selected by achieving a thorough understanding of: That plan s circumstances, history and outlook A careful review of the potential options, their advantages, disadvantages, and latent outcomes A pension plan strategy comporting with the plan sponsor s vision, operating strategy, risk tolerance, and budgetary considerations This paper should give plan sponsors the pension background, considerations and industry insight they need to proceed with their own model for arriving at a satisfactory solution for their pension plan. 7 Copyright Spring 2012