The Great Pension Derisking?
Thrice burned, twice shy. After experiencing steep funding shortfalls in their defined-benefit retirement plan obligations three times in a row over the past generation, corporate plan sponsors are finally fighting back, with an array of innovative weapons designed to reduce their pension liabilities.
Such pension “derisking” approaches include lump-sum payouts to vested, terminated employees; liability-driven investment (LDI) strategies that match up plan assets with pension liabilities by moving from equities to long-term bonds; and the one currently making headlines — annuitization, the transfer of a sizable percentage of pension obligations to an insurance company for a paid premium. These tactics join more-traditional approaches, such as freezing and closing pension plans. Taken together, they constitute a sea change in pension-plan treatment.
Just in time, too. “Since the financial crisis reared, there has been this stark realization by large plan sponsors that they have taken on a huge amount of equity risk,” says Evan Inglis, principal and chief actuary at The Vanguard Group. “They have these gigantic pools of assets now creating risks for the shareholders investing in them — risks they are not in business to manage, and risks that shareholders don’t want them to manage.”
Jim Davlin, vice president of finance and treasurer at General Motors, puts it this way: “We’re in the business of making great cars — that’s our core competency. It’s not managing pension investments to provide a lifetime income to folks.”
Although pension plans traditionally were thought of as long-term obligations with long-term investment horizons best suited to equities, the Pension Protection Act of 2006 (PPA) and new accounting rules changed the game, requiring sponsors to recognize their plans’ funded status each year on their balance sheets. “The sponsor’s finances are impacted on a much shorter basis, with potential shareholder repercussions,” Inglis says. “No longer are these obligations considered an investment issue. Now, sponsors realize this is a corporate finance issue.”
Catching On
Finance evidently is up to the task. Various studies indicate widespread study and action on each of the aforementioned derisking and other asset-management strategies. In a survey of 428 defined-benefit plan sponsors by Aon Hewitt, 60% are somewhat or very likely to undertake LDI strategies, moving from equities to long-term bonds as funded status improves. In another survey of 125 corporate pension sponsors worldwide, published by SEI, 57% are also pursuing LDI strategies, as are 74% of more than 100 corporate defined-benefit pension plans in yet another study, by Cutwater Asset Management.
Lump sums paid to vested employees whose jobs have been terminated are also catching on widely, with 39% of respondents in the Aon Hewitt survey likely or very likely to make a lump-sum offer in 2013. Ditto annuitization, once the backwater of derisking tactics and on more solid ground today. “If you count the number of transactions in the U.S. and the UK over the last six years, roughly $100 billion in funding obligations have now been annuitized,” says Gary Knapp, managing director, insurance and liability-driven strategies, at Prudential Fixed Income.
Prudential, for one, is now on the hook for approximately $35 billion of GM’s and Verizon’s pension obligations. Other big-name companies transferring a portion of their pension liabilities to insurers in recent years include GlaxoSmithKline ($1.3 billion transferred), Rolls-Royce ($3 billion), and British Airways ($1.9 billion).
Despite these innovative measures, the big question is whether or not pension derisking is just another fad, given that funding levels have risen with the equity markets and the slight uptick in interest rates. Although the aggregate pension deficit among plan sponsors in the U.S. is an eye-opening $482 billion as of January, that number is down $74 billion from the previous January, effectively erasing the funding erosion that occurred in 2012, according to a Mercer study. If the economy continues to improve, will derisking go the way of other well-intentioned tactics?
The answer is a resounding no, say pension analysts at Mercer, Aon Hewitt, Vanguard, and Fidelity, all insisting that derisking has sturdy legs. Says John Beck, senior vice president and national retirement practice leader for retirement consulting at Fidelity Investments: “Something has changed.”
Putting Finance in Charge
That something is born from experience. Three times over the past 30 years, aggregate plan-funding levels crashed when the fast-moving equities market ran out of gas — in the early 1990s, the early 2000s, and most recently in 2007–08, when the financial crisis took hold. “During these equity bull markets, pension plans were growing much bigger in size relative to the companies that sponsored them, creating much more potential to have an impact on the sponsors financially if and when the market turned south,” Inglis says.
This stellar performance, investment-wise, created a false sense of security, “masking the potential risks,” he explains. “The plans grew bigger, with more and more employee participants, and by the 2000s they were really big — overfunded by a significant margin. Then, markets collapsed and interest rates dropped, causing precipitous and substantial declines in funding.”
GM’s Davlin remembers the pain. “Our pension liability was so large as a percentage of our market cap that each time funding went down, the rating agencies and others doing financial evaluations considered this a substantial debtlike obligation,” he recalls. “As our funding status changed, we’d go from no debt one year to dramatically high debt the next year. Not only did we have this great liability, we also had significant asset-return risks — hoping our assets would earn their expected rate of return — and longevity risk, the possibility of [pensioners] living longer than was actuarially quantified decades ago.”
The first two times that plan funding swooned, most plan sponsors did little to reduce their liabilities, figuring funding levels would recover. (They did.) “Rather, companies looked at fixing the plan design,” says Ari Jacobs, global retirement solutions leader at Aon Hewitt. “They closed plans to new hires or went to the further extreme of freezing the defined benefit for all participants. That was pretty much the extent of the reaction.”
The third time was different. Thanks to the financial crisis and a one-two regulatory punch — the PPA and new pension accounting rules issued by the Financial Accounting Standards Board in 2007 (FAS 158) — plan sponsors now had to recognize their funding shortfalls on their balance sheets on an annual basis. The response to the rules, by and large, has been pension derisking — getting the liabilities off the balance sheet or reducing the investment risk. The solutions comprise lump-sum offers, annuitizations, and LDI schemes.
“Many of the clients I’m working with recognize the need for a more permanent derisking solution that does not put their business at financial risk to another market downturn or drop in interest rates,” says Fidelity’s Beck. Inglis agrees: “Sponsors had not learned from the two previous debacles how to manage their pension risks. These lessons now learned, finance is in charge.”
Annuitization: GM and Verizon
Leading the effort at GM is Davlin and his team, as part of his role under CFO Daniel Ammann. The giant automaker has pursued several actions to get its pension funding in order, including closing the plan to new participants to limit the growth in these liabilities and transitioning active employees to its defined-contribution plan, “all of which we will continue to pursue,” Davlin says.
Other steps were “bigger,” he acknowledges. “We needed to do more than just limit the growth in our liability; we wanted to transfer some of it to get it off the balance sheet.” For its 118,000 U.S. salaried retirees, GM first offered a voluntary lump-sum payout to a subgroup of 44,000 (13,000 accepted) and then annuitized the pensions for the rest. “These individuals get the same check every month they previously received, only now the name of the company paying is Prudential,” Davlin says. “This is actually safer for them, as Prudential is a more highly rated credit counterparty [than GM]. This is their core business.”
Together, the two tactics moved $28 billion of liabilities off GM’s books in 2012. “We’ve stopped plan growth, reduced the liability, and sort of contained the risks,” Davlin says. “We’ve decided not to wait for things to get better. I only wish in hindsight that when we were overfunded by 7% that we took the opportunity to do it then.” Better late than never.
Verizon was the other poster child for annuitization last year, via its transaction with Prudential to shift $7.5 billion in pension obligations to the insurer. During a recent earnings call, CFO Fran Shammo said the deal was part of the phone company’s “overall pension derisking strategy, which will reduce our exposure to funding and income statement volatility caused by changes in investment returns, discount rates, and longevity risks.” The transaction, he said, would lower Verizon’s future contribution requirements.
Beyond these two very large deals, most pension-annuitization transactions have been below $500 million in size. Deals in 2012 other than GM and Verizon totaled about $2 billion, says Jacobs of Aon. “There has not been a lot of activity,” he says. “Even $35 billion in a year is a drop in the bucket when you consider the $2 trillion in pension funds out there.”
He adds, “I’m not saying that there won’t be another megadeal or two this year, but these things take time to hatch.” Jacobs says that current ultralow interest rates might dissuade companies from locking into rates below where they believe the market’s fair value really is. “They’re on the fence thinking, ‘I’ll wait for rates to rise and then take advantage of this at a somewhat lower premium.’”
Prudential’s Knapp has a more optimistic view. “This is definitely the time to investigate annuitization,” he says. “While many sponsors may find this more attractive when interest rates rise and their funded status improves, it all depends on the eye of the beholder — your conviction when rates will rise and what you will do if they don’t.”
Easy Lumps
Aside from annuities, the other tactic gaining traction is lump-sum payouts. Like rival GM, Ford Motor went this route in 2012, as part of the pension-derisking strategy it has followed since 2007. The decision was predicated in large part on PPA regulations that kicked in last year allowing companies to calculate the lump sums using yields on A, AA, and AAA bonds, rather than treasury rates. Consequently, pension liabilities can essentially be settled at the same rates used to measure them.
“The government sets the procedure and the rate at which the lump sums are calculated,” says Neil Schloss, Ford Motor vice president and treasurer. “You get it done at essentially close to 100% of liability.”
Ford also closed its plan to new participants in 2004, although it has not frozen the plan for existing active employees. Like many other plan sponsors, it also has an LDI strategy in place. “We’ve moved from public equities to fixed income and other alternatives, which turned out to be fortunate for us, as we missed much of the downturn [in stocks],” says Schloss. The company was at 55% fixed income at the end of 2012, but 80% in fixed income is the company’s long-term target allocation.
In effect, Ford is doing everything that GM is doing, other than annuitization. Asked why, Schloss answers: “GM and Verizon paid a good-size premium to transfer the liabilities, although I personally think they did a neat thing. But lump sums are done at no premium, at a market-rate value to the liability. Retirees who take them get 100% of a funded liability on the present value of future cash-flow streams. The benefit to the pensioner does not change. The rest is all accounting and market valuations.”
The downside to lump sums? “You need the assets to pull it off,” says Gordon Fletcher, partner in the financial strategy group at Mercer Investments.
Ford offered a lump-sum payment to some 90,000 of its pensioners. The company has not publicly stated the take-up rate, but has said it was able to shed $1.2 billion in pension liability. (An Aon Hewitt study indicates the average election rate for lump sums is 55%.) At year-end 2012, Ford’s pension plan remained underfunded by $18.7 billion. Says Schloss, “We’ll continue to evaluate options we have from both the liability side and the asset side as we go forward.”
Mix and Match
While lump sums and annuitizations get a lot of press, much of the action among large pension plan sponsors has been the pursuit of LDI strategies — carefully matching up their assets and liabilities to minimize risk.I recently covered corporate America's pension time bomb. The article above is excellent, going over the different ways corporate plans are derisking their pension plan.
Here’s how it works: A pension plan is really a series of future payment promises stretching out many years. So, by buying the right bonds (also a series of future payment promises), plan sponsors should be on the receiving end of these payments at the approximate time they need to make contributions to retirees. “When you buy bonds that make payments at the same time as the pension plan payments are due, the value of the bonds changes in the same way the pension liability changes when interest rates change,” Inglis explains.
Thus, if interest rates drop and a sponsor has bought long-term bonds, the change in their value should be commensurate with the change in the pension liability, and the net impact on their funded status is minimal. “The volatility in the bonds is the same kind of volatility in the liabilities, so you can match them up,” says Inglis. “This way, you hedge against a lot of the risk.” (click image below)
Given the current low interest rate environment, many sponsors are “dollar-cost-averaging” into these strategies by way of a “glide path.” Sponsors define a glide path based on the plan’s maximum funding level relative to its liabilities — that is, as the plan’s funding status improves, the sponsor gradually moves assets from equities to long-term bonds. “You could create a glide path that says when you get to 80% funded status, you will move 5% of equities to bonds, and when you get to 85%, you will move another 5%,” Fletcher explains. “When you get to 100% funded, you should be pretty much all in bonds, which would mean you’re virtually derisked and completely funded. For many sponsors, this represents pension nirvana.”
What’s the downside? “You have to move away from equities and the potentially higher upside they may provide,” Inglis says. “This gets back to the main point: Can you really afford to have a long-term perspective of the pension plan when your shareholders don’t have that long-term perspective of your company?”
Jacobs agrees. “The old school was growing assets through equities, which traditionally increased in value over time more than fixed-income assets, providing enough income to handle the liabilities,” he says. “The new school is having your assets and liabilities matched and moving at the same rate.”
Down the line, everyone seems to be in accord that the old school is closed up for good. “We’re seeing activity across the board on derisking, irrespective of the industry and the size of the plan,” says Fletcher. “Almost every plan sponsor is consistently looking at this.”
Inglis is reading the same tea leaves. “We might see a bit of a lull this year if rates remain the same and equities continue to rise,” he says. “But if rates do go up, it means plans will be better funded, thereby making both lump sums and group annuities cheaper. Pension derisking will continue. But you can’t wait forever to do it.”
Derisking: Caution Applies
Derisking is a hot topic right now for good reason: corporate bond interest rates are down, hiking pension liabilities. But it’s not for the faint of heart. Here are some caveats to consider:
• With the stock market breaking records, will migrating from equities to long-term bonds as part of a liability-driven investing strategy miss the party and lead to “regret risk”?
• For every $100 in liability, pension plans have only $77 of assets, according to Standard & Poor’s. While annuities freed General Motors and Verizon from many pension promises, many plans are not willing or are not able to fund the full value of an annuity purchase.
• Lump-sum buyouts are a great way to shrink pension-plan volatility. The difficulty again is having enough in assets to do it. There are also accounting rules governing unrecognized plan losses, which can be troublesome in a lump-sum transfer.
• Freezing plans is another option, but it has limited impact on derisking — you’re only restricting the buildup in new liabilities.
Of course, it's important to keep in mind that while derisking makes perfect sense for corporations, the long-term effect of cutting DB plans isn't positive because it ultimately weakens retirement security for millions of workers anxious about retirement and at risk of succumbing to America's new pension poverty.
This is why I've long argued that we need to separate pensions from businesses and have retirement money managed by large, public, well governed pension funds that can invest across public and private markets. As more and more corporations derisk, the biggest risk of all is that we accelerate pension poverty.
When it comes to derisking, I prefer implementing an LDI approach. If you want to see a plan that has mastered this approach, just check out HOOPP's 2012 results.
And derisking is going on all over the world. The FT reports, UK pension funds reject ‘cult of equity’:
The “cult of equity” is poised to become history for UK defined-benefit schemes, as the country’s pension fund managers move to favour corporate bonds and alternative investments, a new survey reveals.As you can read, UK pension funds are taking a more active approach in managing their risk. The bull market in stocks isn't changing their view to reduce equity risk or at least cap it using alternatives, derivatives and various hedging strategies.
More than a third of the UK pension schemes (41 per cent) that participated in Aon Hewitt’s Global Pension Risk Survey for 2013 expect to reduce their exposure to UK equities in the next 12 months, while more than a quarter (28 per cent) hope to pare back their allocations to global equities.
At the same time as equities are falling from grace, alternatives are gaining a following.
One-third of participating UK pension funds hope to increase their exposure to alternatives. A similar percentage are accessing derivatives and raising their allocations to active strategies as well.
“We expect to see further demand from trustees for asset solutions such as diversified growth funds and even more use of derivatives as pension schemes strive to reach their long-term objectives,” says John Belgrove, a senior partner with Aon Hewitt’s investment consulting team.
Pension funds’ shifting asset allocations are due to one reason. As their struggle to reduce giant deficits deepens, the focus on developing increasingly sophisticated asset management strategies that offer equity-like growth and bond-like volatility is sharpening. In other words, schemes want to reduce their risks while freeing up capital to be used for the purpose of filling deficits.
Schemes with more than £1bn in assets seem the most committed to diversification, with a net 37 per cent of those taking part in this research looking to increase their bond holdings in the next year.
And the survey results offer yet more evidence that the managers of UK pension funds no longer see equities as the primary source of portfolio growth.
“Despite an equity performance of around 70 per cent from the low point of 2009, pension schemes continue to display a desire to move away from the asset class,” says Mr Belgrove.
“The focus for the future is on risk management through hedging and diversification.”
Aon Hewitt analysed the investment approaches of more than 220 UK schemes, with a combined £300bn in assets.
As far as stocks, we'll see if Monday's selloff was another correction and if the facade of strength culminates in a 'Spring Sync' moment where the rally broadens to more sectors or stocks sink lower as deflation concerns reemerge.
Finally, my thoughts and prayers go out to those that lost loved ones in Boston and the hundreds of injured in this heinous attack. The world is changing and not for the better.
Below, Bloomberg's "Lunch Money" had a good discussion on Monday on all that's driving the markets: stocks, bonds, currencies, commodities, options. They also discussed the metal meltdown.