It Pays to Be Prepared
Staying the Course Toward a Lower-risk Future Presents Opportunities For Pension Funds During Times of Market Volatility
In 2019, we witnessed the end of a very important moment when U.S., U.K. and Canadian pension funds were simultaneously at the best funded status they had experienced in 10 years. At the same time, all three markets had new entrants in pension insurance and reinsurance with ample insurer capacity, vibrant price competition and attractive de-risking pricing.
Figure 1: Pension Funding Has Peaked and Market Conditions Have Softened
U.S. Source: Milliman 100 Pension Funding Index; the 100 largest U.S. corporate pension plans, February 29, 2020 (82.2%).
Canada: Aon’s Median Solvency Ratio, Canadian DB Plans as of December 31, 2019 (102.5%).
UK FTSE 100: Aon Hewitt, “Aon Hewitt Global Pension Risk Tracker,” as of February 29, 2020 (96.9%). https://PensionRiskTracker.aon.com, accessed March 12, 2020. Funding ratio (cumulative assets/liabilities) of all pension schemes in the FTSE 100 index on the accounting basis.
Additionally, years of lower-than-expected longevity improvements meant the lowest liability pricing from insurers and reinsurers in over ten years. During the very favorable market environment in 2018 and the first half of 2019, we saw more transactions in the U.S., U.K. and Canada than ever before. Only once before had we seen market conditions this favorable—in the run up to the financial crisis—and of course that market did not last. Markets in which all factors are positive are anomalies, and once again, favorable market conditions like these have proven to be fleeting.
We are now in the midst of incredible uncertainty—the coronavirus has shaken global markets and communities, impacting the daily lives of citizens and the economic stability of small businesses and corporations. Such uncertain times have strengthened our conviction that pension de-risking is an all-weather solution for our corporate client base.
It pays to look for opportunities to reduce or transfer risk
Volatile markets often bring opportunity, so it pays to be prepared. While there can be various incentives to reduce or transfer risk, we will focus on four key opportunities.
1. Low Rates
Low rates mean that "borrow to fund" strategies are back in favor. With low rates, many highly rated sponsors can issue corporate debt at attractive yields and deposit the proceeds into the pension fund to improve funded status. Since the pension deficit is already considered debt of the corporation, this debt-for-debt exchange is likely to be considered credit neutral by rating agencies and stakeholders, though it can be credit positive if it allows the sponsor to take meaningful steps to de-risk the plan. For U.S. plans, it also eliminates variable Pension Benefit Guaranty Corporation (PBGC) premiums, which charge 4.5% on pension deficits. While “borrow to fund” strategies may not work for most in the current environment due to widening credit spreads offsetting the benefit of low rates, this can be an important strategy in a post-pandemic environment. Companies can monitor markets and be ready to transact once spreads tighten.
2. Widening Credit Spreads
Another opportunity arises when falling risk-free rates are combined with widening credit spreads. These market conditions often mean the economy is in distress, but for pension funds holding a cash flow- or key-rate duration-matched portfolio of high-quality bonds, the interest rate risk is largely hedged. Gilts, treasuries and other high-grade bonds will likely appreciate if rates fall, and if, at the same time, the economy is in trouble and credit spreads widen, there is a real opportunity to transfer risk as buy-ins are backed by spread-bearing assets. Buy-in pricing is favorable when it has an implied return above gilts or treasuries, and when credit spreads widen, buy-in pricing generally improves. It is an excellent relative value trade for a pension fund to use freshly-appreciated government bonds to pay for a buy-in that returns risk-free plus a wide spread. This trade locks in the spread to government bonds implied in the buy-in price. This locked-in gain increases funded status after the buy-in is complete and transfers all risk to the insurer.
As a case study, Marks & Spencer took advantage of the favorable market conditions over the past year and a half, acting when buy-in pricing was particularly attractive to complete a series of transactions with multiple insurers. It turned in high-grade bonds for buy-ins when buy-in spreads were favorable.
Figure 2: Case Study, Marks & Spencer (2018-2019)
"We're pleased to announce the purchase of these...buy-in policies, which provide an important contribution to the Trustee's ongoing objective of reducing the longevity risk in the scheme to increase the security of all members' pensions."Chair of Marks & Spencer Pension Trust. Graham Qakley
SIZE: £2.8 billion ($3.6 billion)
WHY: Capitalized on excellent market conditions in 2018 and 2019 to transfer risk
UNIQUE FEATURES: Series of transactions with multiple insurers
3. Weakening Currencies
It can be very cost-effective for a multinational plan sponsor to plug a pension deficit in a country with a weakening currency. Using the U.K. as an example, a multinational company headquartered outside of the U.K. that has a U.K. pension plan can more easily close a funding gap in the plan after the pound (£) depreciates. Since the first Brexit vote, the cost for a U.S. parent to plug a deficit in a U.K. plan has gone down by roughly 25%.1 The same logic holds for funding risk transfer premiums. Today, a U.S. parent with a U.K. plan can fund a buy-in premium for roughly 25% less than in early 2016. Many companies will be focused on conserving cash during these uncertain times. However, post pandemic, should we encounter a U-shaped or V-shaped recovery, this could be a key de-risking opportunity.
4. Mortality Volatility
Over a seven-year period from 2011 through 2018, there was only a modest 2.5% longevity improvement in the U.K. Given these low improvements, insurer and reinsurer pricing has decreased and many U.K. pension schemes are bringing longevity swaps to market.
One pension fund that took advantage of this opportunity was the HSBC Bank U.K. Pension Scheme. In 2019, HSBC completed the third-largest longevity risk transfer transaction ever in the market at £7 billion ($8.7 billion) with The Prudential Insurance Company of America (PICA). The arrangement is scalable and repeatable.
Options to De-Risk a Pension Fund
We have worked with many companies toward their de-risking goals over a decade or more, punctuated by major market disruptions. While volatile markets like the one we’re experiencing today may pull companies farther away from achieving their de-risking goals, for most of our clients slow and steady wins the race, and there will be opportunity to regain progress toward a lower-risk future on the other side of this event.
There are three primary types of transactions: buy-outs, buy-ins and longevity risk transfers.
Pension buy-outs have occurred in the U.S., U.K. and Canada. Almost all U.S. transactions have been pension buy-outs. In a pension buy-out, the plan pays a single upfront premium in exchange for a complete settlement of a pension liability. The obligation leaves the corporate plan sponsor’s balance sheet and transfers to the insurer, which issues annuity certificates to the plan participants and promises to pay their benefits for as long as they live, no matter what happens to the assets.
Let's look at the full plan termination of one of Accenture's U.S. defined benefit plans. The company took a series of steps that settled the entire $1.6 billion in liabilities for its retired and deferred plan participants in the U.S.
Figure 3: Case Study, Accenture (2017)
"Together, these related actions have enabled Accenture to decrease its overall pension obligations by approximately $1.6 billion, reducing future risk and administrative costs, while entrusting participants' benefits to highly rated financial institutions with core expertise in the long-term management of retirement benefits."
(U.S. plan termination)
SIZE: $1.6 billion
WHY: Reduce pension risk in the long term
• Lump sum and annuities
• Multiple insurers
Source: Company announcement. URL: https://newsroom.accenture.com/news/accenture-reduces-us-pension-obligations-by-1-6-billion-through-previously-announced-plan-termination-following-asset-transfer-to-aig-and-massmutual.htm
There are many more plan terminations like this one hoping to follow Accenture's lead, but to succeed, each of these companies will need to solve two key challenges.
The first challenge is funding. Even a fully funded plan will need a cash infusion to pay the insurer premium to buy out the liability. In the case of Accenture, the company made two cash contributions. As previously discussed, with rates having been relatively low in recent years, there has been a unique opportunity for plan sponsors to borrow to fund their pension plans. Since rating agencies view the pension deficit as debt-like, the net impact is the company replacing a variable and potentially volatile debt obligation—the underfunded pension—with a known, certain amount of debt with a fixed funding cost. By borrowing at attractive rates and contributing the proceeds to their pension plans, thereby reducing—or even eliminating—their pension deficits, companies have the potential to de-risk their plans and create shareholder value.
The second challenge is how to settle the obligations to the younger, deferred plan participants. Here, the company offered lump sum payments to the individuals to settle $600 million of the deferred liabilities. This step reduced the overall cost of the de-risking program and reduced the amount of deferred liabilities remaining to buy out with an insurer. After completing the lump-sum offer, all remaining deferred and retired members received annuities from two U.S. insurers.
In the U.S. market, buy-outs are often net present value (NPV) positive, making them incredibly compelling.
Figure 4: U.S. Pension Risk Transfer if Often Net Present Value (NPV) Positive
Source: Prudential analysis depicting market conditions as of November 2019. Assumes 100% funded plan. GAAP retiree liability reflects RP-2014 mortality table with MP-2018 and FTSE Pension Discount Curve. Costs not included in the GAAP retiree obligation include per person administrative expenses of $40 per year indexed for inflation and PBGC flat rate premium of $80 per person in 2019 indexed thereafter, plus PBGC variable rate premium of 4.30% of unfunded vested benefits in 2019 indexed thereafter, capped at $541 per person in 2019 also indexed thereafter. GAAP obligations are discounted using rates unadjusted for the risk of credit defaults and migrations and investment management fees. Credit defaults are estimated at 70 basis points per annum and investment management fees are estimated at 30 basis points per annum. Expenses are discounted using the risk-free rate. Economic Value reflects the incremental GAAP liability from discounting at the risk-free rate to reflect the certainty of honoring pension obligations.
Beginning with the GAAP liability for retirees only, we can estimate and add the costs of maintaining the plan, including administrative and PBGC expenses, investment management fees and the expected value of credit defaults and downgrades if the plan retains the investment risk. These bring the true economic liability to about 114% of the GAAP liability. A retiree buy-out usually costs about 104% of the GAAP liability—resulting in about 10% savings. The savings come from the insurer’s scale and efficiency of administration and from eliminating the PBGC premiums. They also come from the insurer’s ability to create portfolios of illiquid fixed income assets that add value for pension clients.
For U.S. companies that meaningfully reduce pension liabilities, stock performance tends to be quite strong relative to the market, immediately following the announcement of the deal. The same is true for companies in other countries where this market is active and growing. The benefits to companies that de-risk their plans are evident. In fact, in the wake of recent turbulence, one client communicated to Prudential that the prior de-risking of its plan was one of the most important strategic decisions the company has ever undertaken.
The second solution is a pension buy-in. Buy-ins have also occurred in the U.S., U.K. and Canada, though they are most common in the U.K. Similar to the buy-out, a buy-in covers all investment risk and all longevity risk, but the liability is not settled. In a buy-in, the insurer issues a group annuity contract to the pension plan to be held in the plan as a liability matching asset. The insurer pays the pension fund the exact amount needed to cover the benefits owed to the plan participants for as long as they live, no matter what happens to the assets.
Although buy-ins have historically been more popular in the U.K., we have recently seen increased momentum in the U.S. market. In 2019, a large financial services institution purchased a buy-in for more than 2,000 retirees and a pharmaceutical company purchased a buy-in for over 3,000 retirees from PICA. These two buy-ins were each in excess of $800 million, making them the two largest in U.S. history.
Buy-ins have gained popularity for a number of reasons. Firstly, a buy-in transfers risk without impacting the funded status of a plan, avoiding the need for a contribution to maintain funded status. Secondly, if plan termination is on the horizon, a buy-in can be used to lock in termination cost and avoid market volatility during the lengthy plan termination process. Plan sponsors can then convert the buy-in to a buy-out at no additional cost at the end of the process to settle the obligation.
For more details and other reasons for the rise in buy-in popularity, read our paper Getting Out With a Buy-in.
3. Longevity risk transfers
The third solution is longevity risk transfer (often referred to as a longevity swap), which is most common in the United Kingdom. A few Canadian pension funds have also done longevity swaps. Longevity risk transfer converts an unknown future liability into a fixed liability cash flow by locking in the life expectancy of the plan participants. If the participants live longer than expected, the insurer or reinsurer will pay the incremental benefits for as long as they live. This frees up the pension fund to focus on funding and investing for the fixed and known benefit payments through the locked-in life expectancy of its people.
In addition to HSBC mentioned previously, British Telecom, Bell Canada and the Marsh McLennan Companies have all executed longevity risk transfer deals.
Figure 5: Longevity Risk Transfer Converts an Unknown Future Liability Into a Fixed Payment Over Time
Source: Prudential. For illustration only.
The dashed blue line in Figure 5 shows the expected future liability cash flow for a group of U.K. retirees. The starting point is the total amount of benefits due to all living members today. Over the next fifty years or so, the line is pulled up over time by cost of living adjustments and down by mortality.
The vertical bars show the potential risk around the liability cash flow, since future longevity improvements could differ from current expectations. It is important to look at the risk this way because no one knows what medical improvements will occur or what health and demographic trends will impact people's lives. The longevity risk transfer transaction eliminates this uncertainty for pension funds. It converts an unknown future liability into a fixed and known liability cash flow, shown by the solid green line. To be specific, the pension fund pays the solid green line, which is the expected liability plus a risk fee. The insurers and reinsurers in the deal receive the solid green line and pay the pension fund the actual amount of benefits owed to the surviving beneficiaries, which is likely to be somewhere in the vertical bars (but it doesn’t have to be). If the plan participants live even longer than the stress scenario depicted here at the top of the gray vertical bars, the insurers and reinsurers in this market will pay the incremental benefits for as long as the beneficiaries live. These arrangements are fully collateralized.
Longevity hedging can be used as a stepping stone to a future buy-in or buy-out, as proven by Rolls-Royce in one of the largest and most innovative transactions of 2019.
Figure 6: Case Study, Rolls-Royce (2019)
"This groundbreaking transaction is the latest in a line of success stories for the Rolls-Royce U.K. Pension Fund, whose funding surplus is testament to exceptional risk management over a sustained period."
SIZE: £4.6 billion
WHY: Increased security for pensioners and reduced business risk
UNIQUE FEATURES: Required the novation of existing longevity swaps
Quote: James Maggs, Partner at Mercer and lead investment advisor to the Trustee
Back in 2011, after recovering from the financial crisis and de-risking its assets, Rolls-Royce entered into a £3 billion longevity swap for retirees in its pension scheme. The 2011 swap was arranged by Deutsche Bank and reinsured by PICA and several other reinsurers.
Fast forward to June of 2019, and after over a decade of steady steps toward a lower-risk future, Rolls-Royce was nearly ready to complete a buy-out. It took nearly a year of monitoring the market, but it pays to be prepared and Rolls-Royce completed a £4.6 billion buy-out with L&G that included the retirees covered by the 2011 swap. To make the buy-out work, the preexisting longevity swaps from 2011 had to be transferred from Deutsche Bank to L&G. The transfer of the earlier contracts is known as “novation.” In order to capitalize on near-perfect market conditions, both the buy-out and the novation of the existing contracts were completed within weeks of the decision to transact, proving that longevity swaps can be used as a stepping stone to a full risk-transfer strategy.
Plan sponsors can take courage in Rolls-Royce’s ten-year journey to de-risk. Like many plans navigating today’s turbulent market environment, Rolls-Royce faced setbacks along the way. But by remaining committed to de-risking, it ultimately transferred its pension obligations in 2019 before the market fell away.
Fortune Favors the Prepared
In today’s market, with historically low interest rates, widening credit spreads, weakening currencies and mortality volatility, we know that sponsors remain committed to de-risking their plans. For most, the 2020 crisis will represent a setback on the road to a lower risk future, but it is important to stay the course: to continue prudent risk management actions with appropriate investment portfolios, and to set a realistic price target while monitoring funded status and insurer pricing as markets stabilize. They should then be prepared to pull the trigger to transact on short notice when their price target is met. Pension de-risking is the ultimate chess game, where thinking three moves ahead is necessary in order to be prepared for opportunities that present themselves. While each type of transaction is different, buy-ins, buy-outs and longevity swaps all secure the benefits for members, while reducing risk for the pension scheme and its sponsor. Companies that have recently and successfully de-risked their plans prepared for many years to transact in the extraordinary market that 2019 offered. They have proven that it pays to be prepared, and we stand ready to help others follow in their footsteps to implement solutions as market volatility subsides.