Buy-Outs Gaining Traction
Part Two of Preparing for Pension Risk Transfer
TYPES OF PENSION DERISKING
There is a range of pension de-risking options available to DB plan sponsors, from investment strategies that reduce risk to transactions that fully transfer risk from the plan sponsor to a third party.
BUY-OUTS GAINING TRACTION
In 2012, Prudential completed large buy-out transactions with General Motors ($25.1 billion) and Verizon ($8.5 billion), firmly reestablishing a U.S. market for buy-out solutions. Further, there have been numerous buy-out transactions executed among mid-size companies during 2012 and 201T3. Many other companies are considering buy-out transactions as well. In a 2013 survey of senior financial executives, approximately 40% indicated that they are likely to transfer DB plan risk to a third-party insurer within the next two years.
40% of senior financial executives indicate that they are likely to transfer DB plan risk to a third-party insurer within the next two years.Prudential Financial and CFO Research, “Balancing Costs, Risks, and Rewards: The Retirement and Employee Benefits Landscape in 2013,” p.5, July 2013
In considering a buy-out, plan sponsors should weigh the cost of the transaction against the ongoing cost, volatility, and constraints associated with maintaining the plan. In a recent survey of senior finance executives, 43% indicated that their DB plan placed a constraint on the company’s cash flow; 41% indicated an impact on earnings due to volatility of plan funded status; and 36% indicated an impact on their ability to invest in growth opportunities.
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When evaluating the cost of a transaction, it is common to compare buy-out pricing to accounting liabilities. However, the calculation of pension liabilities for accounting purposes understates the true economic value of plan liabilities that an insurer would consider in pricing a buy-out.
There are two reasons for this:
First, accounting liabilities do not include the present value of certain costs that a plan sponsor bears, such as administration costs, investment management fees, and PBGC premiums.
Second, accounting liabilities today are based on outdated longevity assumptions.
For a retiree population today, the economic value of liabilities—and therefore the estimated cost of a buy-out transaction—is approximately 110% of accounting liabilities, though this amount will vary according to the characteristics of each plan.
Once updated mortality tables are adopted, the cost of a buy-out will decrease as a percentage of accounting liability, to roughly 104%
GAAP Value Buy-out Cost $100 current accounting value 110% of accounting liabilities, or $110 (varies with each plan) New mortality tables increase accounting liability to $106 104% of accounting liabilities
As discussed earlier, the new longevity assumptions, when incorporated, will add approximately 6% to the accounting liabilities of the typical pension plan. The new assumptions will not increase the estimated cost of a buy-out transaction. While longevity assumptions for pension plans are only updated once in a decade, insurers continuously update their longevity expectations based on their own experience in paying annuitants as well as on new longevity-related research as it emerges.
The result will be a buy-out transaction cost closer to 104% of the accounting liabilities. right to fully exit the DB arena, or to move measurably toward that goal by transferring pension risk for a significant portion of the plan.
New longevity assumptions will add approximately 6% to the accounting liabilities of the typical pension plan. However, these assumptions will not increase the estimated cost of a buy-out transaction.
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