Workstreams of a Buy-out Transaction

Preparing for Pension Risk Transfer

In the early stages of the transaction, the plan sponsor will select advisors, assemble the internal team, define objectives, and identify constraints while considering the feasibility of the transaction with attention to each of the six workstreams.

THE SIX WORKSTREAMS OF A BUY-OUT TRANSACTION

There are six workstreams that progress through the various phases of a transaction: Liability, Assets, Pricing, Structure/Legal, Administration, and Communication. (Click on any of the links to skip to that section to learn more.)

  • 1

    LiabilityFocus on phases one and two, Preparation and Feasibility Assessment

    This workstream involves the development of the transaction strategy from the liability perspective. Typically, this would begin with an analysis of various transaction alternatives—the type of buy-out, the inclusion of a lump-sum offering, and the population groups for whom liabilities will be transferred. The two most common scenarios are the full buy-out or partial buy-out covering some or all of the retirees of the plan.

    If mortality experience data is available (it may be required for large transactions), this workstream will coordinate the collection of experience data to be presented to the insurer. Also, the plan sponsor will provide the data files to be used for indicative and final pricing as well as any data true-ups.

     

  • 2

    AssetsWorkstream crosses all phases of the transaction

    This workstream involves the preparation of plan assets for transfer to the insurer. For sponsors of smaller plans (under $500 million in plan assets), this is typically the development of a plan for liquidating the portfolio, since the group annuity premium will generally be paid in cash. For larger transactions, in-kind asset transfers should be investigated. That process would usually start by having conversations with insurers about what assets they would consider acceptable for in-kind transfer and how the delivery of an optimal asset portfolio to the insurer could reduce transaction cost.

    In-Kind Asset Transfer: Cost Benefits 1. Transaction funds are immediately invested; avoids cash lag
    2. Tax efficient for plan sponsor
    3. Minimizes transaction costs

    A number of factors make in-kind asset transfers preferable. First, this approach assures that the funds underlying a transaction are immediately invested. Alternatively, if cash is used for a large transaction, it can take a substantial amount of time to be fully invested. This creates a cash lag where the insurer is earning a much lower rate of return for a period of time. Second, it is more tax efficient for the DB plan to buy and sell assets, since the plan doesn’t pay taxes on gains and losses resulting from transactions. Third, transaction costs can be minimized to the extent the sponsor buys the securities the insurer will ultimately want to hold. It is important to identify the most efficient way to transfer assets to the insurer to reduce possible friction costs—such as cash lag, taxes, and transaction costs—as these will impact the transaction price.

    Working with the plan sponsor, the insurer identifies the desired transaction portfolio and then determines which assets are eligible to be transferred to the insurer in-kind. The plan sponsor will determine the assets to purchase or sell to achieve the end state, and which investment managers to involve. A plan may already have investment managers who can facilitate construction of a fixed-income portfolio, or it may need to hire an investment manager to accomplish this. As the plan sponsor progresses toward execution of the buy-out transaction, the investment portfolio will increasingly resemble the transaction portfolio desired by the insurer.

    As the asset transfer date nears, comprehensive asset and liability monitoring should be put into place so that decisions can be made quickly should markets become volatile.

    If the transaction is not a full buy-out, the plan sponsor will need to be mindful of asset allocation for the remaining plan. Ideally, the portfolio desired for the remaining plan will be constructed at the same time the transaction portfolio is being constructed for the buy-out.

     

    Spotlight: Types of Assets Generally Acceptable for In-Kind Transfer

    Not all assets currently held by DB plans are of a type that insurers would ultimately want to include in the investment portfolio supporting the group annuity payments. Insurers are subject to strict capital and reserve requirements by the states that oversee them. Risk-based capital requirements dictate the minimum amount of capital to be held by an insurer to support its business.* As such, assets that require the insurer to hold higher amounts of capital are generally less desirable from the insurer’s perspective.

    Most DB plans are underexposed to assets preferred by insurers, most notably long-duration corporate bonds. Although insurers prefer long-term corporate bonds with high credit quality, insurers may take a small amount of below investment grade bonds. Insurers prefer assets with durations that closely match the liabilities. Plans with LDI bond strategies are likely much closer to the asset-liability match that insurers are seeking than are plans without LDI in place. Having an LDI strategy in place would also help to minimize basis risk as the time approaches to transition the assets to the insurer. Basis risk occurs when the price of a group annuity increases, but assets in the plan earmarked for the annuity premium do not increase in a similar manner. If assets are closely matched to liabilities, basis risk is minimized.

    Conversely, DB plans are typically overexposed to risky assets that insurers will not find attractive due to the risk-based capital regime. Some insurers may be able to take on some alternative investments as part of the transaction. However, the appetite for alternative investments will vary among insurers, can change quickly, and would generally be limited to a very small portion of the portfolio (5% or less). If a plan sponsor is considering a buy-out in the next few years, the sponsor should consider how the purchase of risky assets—especially illiquid risky assets—fits into the overall pension strategy.

    * National Association of Insurance Commissioners.

  • 3

    PricingBegins in Phase One, Preparation; Continues Throughout Transaction

    In this workstream, plan sponsors will gain an understanding of the pricing of the transaction and how alternative transaction structures and market conditions can affect price. This will include the solicitation of indicative pricing from insurers, as well as final pricing and negotiation of related documents.

    The first step in this workstream is for the plan sponsor, generally assisted by an advisor such as an investment bank, consulting firm, or an annuity placement specialist, to approach insurers via an RFI process. This may be done on a confidential basis, with the name of the prospective client not disclosed to the insurer. The goal of this initial round of engagement with insurers is to receive indicative pricing for the buy-out solution.

    Receiving indicative pricing from an insurer is the best way to estimate the cost of a buy-out. By providing details of the transaction and the appropriate participant data to an insurer, the plan sponsor will be able to obtain a reasonable estimate of the price for the transaction from the insurer. The insurer will also be able to advise the plan sponsor as to whether there are data elements that are missing or any other concerns about the transaction.

    What Insurers Require for an Accurate Pricing Estimate
    1. Complete & accurate particiant data for transaction group(s)
    2. Plan-specific mortality experience
    3. Lump sum history or plans to offer lump sums

    In order to provide indicative pricing, insurers will require participant data that reflects the age, gender, benefit amount, and form of annuity (or available optional forms) for each participant. The plan sponsor should perform an initial evaluation of participant data supporting the liabilities that may be transferred. The data should be cleansed to ensure its accuracy and completeness. For example, the plan’s recordkeeper may be keeping track of certain pension provisions (e.g., a Qualified Domestic Relations Order that splits benefits due to a divorce) manually, while the insurer will want such information on the electronic data file submitted for the transaction. The more complete and accurate the data, the more accurate the indicative pricing.

    In addition to receiving participant data, insurers may require plan-specific mortality experience in order to provide indicative pricing. This is particularly true for large transactions, and can be a helpful step for sponsors with smaller transactions as well.

    Insurers will also need to know if lump-sum payments have been or will be offered to any of the participants. If a lump-sum option will be offered to retirees, insurers may factor in an additional cost for potential anti-selection. Anti-selection occurs when less healthy retirees opt for the lump-sum option, and healthier retirees elect to receive annuity payments as part of the buy-out.

    Plan sponsors may wish to receive indicative pricing for different groups of participants (e.g., various subsets of retirees, vested terminated participants). Indicative pricing is not binding to either party, but provides the plan sponsor with the approximate cost of the transaction. This is important for planning purposes, whether plan sponsors intend to transact in the near future or further down the road.

    After receiving indicative pricing, sponsors with large or more complex transactions may choose to enter into exclusive negotiations with one insurer. In an exclusive negotiation, the plan sponsor agrees to focus its negotiations with one insurer in order to fully develop the arrangement in a time-efficient manner.

    If the sponsor continues to work with multiple insurers, there will be a final bid process from which the sponsor will select the insurer for the transaction.

  • 4

    Structure & LegalWorkstream Crosses All Phases of a Transaction

    Once feasibility is established, legal counsel will be engaged to execute confidentiality agreements, define the fiduciary process, obtain required regulatory approvals, and decide which type of structure to use for the group annuity—either the insurer’s general account or a separate account. Under a separate account, assets supporting the liabilities are segregated from the insurer’s general account and are protected from creditors. By utilizing an insulated separate account of the insurer, the plan sponsor can provide further safety for participants.

    For most transactions, the sponsor assumes the fiduciary role or shares that role with a consultant or annuity placement specialist. Recently, for larger transactions, sponsors have hired independent fiduciaries to protect the best interests of participants.

    Once the buy-out transaction is imminent, the plan sponsor will decide upon an announcement strategy. In the past, most plan sponsors announced the agreement and closing of a transaction simultaneously. However, in recent years, sponsors engaging in large transactions have announced their intent to close and locked in pricing and contract terms several months prior to the transaction close. This allows time for the sponsor to receive any necessary governmental approvals, conduct lump sum programs, continue to clean up data, and position the asset portfolio prior to closing. 

    Finally, once the buy-out transaction is complete, documentation of the process should be finalized.

     

  • 5

    AdministrationBegins in Phase One, Preparation; Continues Throughout Transaction

    This workstream entails evaluating the insurer’s capabilities to administer the payment of pension benefits and provide related customer service in accordance with industry best practices. This workstream also covers the transition of administrative services to the insurer. During the transition of administrative services, the insurer will work with the DB plan’s current recordkeeper. To ensure the transition of benefits administration goes smoothly, the insurer is likely to undertake a mock conversion process, whereby the insurer conducts a test run a month or two before final takeover to make certain all payments are being accurately calculated and transitioned.

  • 6

    CommunicationBegins in Phase Three, Structure & Refinement, and Continues to the End

    The final workstream involves establishing effective messaging for key stakeholders, both internal and external. Clear communication with plan participants is critical. The plan sponsor will need to provide information to participants as to why the change is being made and what to expect going forward. They may also wish to communicate the shift from an ERISA plan that has protective coverage from the PBGC to an insurer that holds reserves and capital to support each individual participant guarantee, and that has protective coverage from state guaranty funds.*

    Coordinating with the plan sponsor and current recordkeeper, the insurer will develop a robust communication strategy to explain the process to plan participants. Typically, this will include welcome packages and customer support for participants. If the buy-out is part of a plan termination, special care should be taken to assure that notices required as part of the termination are included in participant communication planning. Additionally, when the buy-out transaction is completed, each participant will receive a group annuity certificate from the insurer.

    A communication strategy for shareholders and the investor community may also be designed to alert them to the de-risking solution being undertaken. Orchestrating communications requires care and thoughtful timing so that no material non-public information is released. A public relations strategy should be designed as well. Finally, communication with the plan sponsor company’s board of directors throughout the process is important to provide progress updates and secure the necessary approvals.

     

     

    * CAMRADATA Analytical Services, “The Fiduciary’s Role in the Termination of Single Employer Defined Benefit Plans: A Practical Guide,” June 2012.