Prolonged low interest rates have prevented pension plans from riding record-setting equity markets to a higher aggregate funded status—but there is a flip side to low interest rates when it comes to risk transfers and pension debt restructuring.
Jim Gannon, managing director of asset allocation and risk management for Russell Investments, observed during a recent interview with PLANSPONSOR that, of the 10 or so mega risk transfer deals the market has seen in recent years, the moving sponsors share a few common characteristics.
“First off, these deals have all generally involved very large pension plans relative to the overall size of the sponsoring organizations,” Gannon explains. “In other words, the liability value divided by market capitalization has been very high, on average.”
These companies, from Motorola and Verizon to Bristol-Myers Squibb and General Motors, were early movers in an expanding pension risk transfer (PRT) market that saw a 120% increase in deal volume last year, reaching $8.5 billion in 2014, compared with the $3.8 billion total in 2013, as measured by the LIMRA Secure Retirement Institute. Sales in the PRT buyout market have exceeded $3.5 billion for three consecutive years, according to survey results from the insurance and financial services trade association, and the trend is expected to continue.
The early mega-movers also all generally display a great deal of financial flexibility and strong access to cash and the capital markets, Gannon notes. They were either transferring risk from relatively well-funded plans, or they had the ability to pull cash from within the company to make contributions to fund these transactions—or they had the ability to access the necessary cash through borrowing.
This is the upside to the low interest rate downside, Gannon suggests. Several of these plans were able to successfully issue debt via the capital markets (at very affordable rates), with the intent of better- or even fully funding the pension plan “with relatively cheap dollars.”
“They issued debt and then they funded the pension plan with the cash they received from investors,” Gannon continues. “When rates are low it means the funded status will be lower, because the discount rate used in funded status calculations is lower. But when rates are low that also means it’s a favorable time to issue debt, and you can use the debt to fund a PRT transaction shortfall. It’s yet another way to get pension risk off the balance sheet.”
Gannon was on an analyst’s call following the announcement of the Motorola deal, and this strategy was specifically cited by Motorola leadership. “They talked about how the low interest rate environmental seemed favorable from the borrowing perspective,” Gannon explains. “They made some strong arguments, and I think this method may make a lot of sense for some plans out there looking for a path forward towards PRT.”
Gannon says the Motorola executives cited some important benefits to this approach that largely made up for the cost of issuing new debt to cover legacy pension liabilities. “It can be really beneficial from a business performance and valuation perspective,” he explains, “because a standard bond issue you will use to fund a pension shortfall or risk transfer will have terms that are very well defined. The sponsor can say, ‘I’m issuing this amount of debt for this many years and I’ll be paying interest at this rate and this frequency.’ It is straightforward debt—and analysts deal with that kind of debt all the time when they’re analyzing companies and they can be more comfortable with this debt.”
Compare a standard bond issue with pension debt and the argument has some force. Pension debt is paid off over an uncertain number of years that is highly contingent on participant longevity, capital market outcomes, interest rate movements, and various other factors such as lump-sum payments, litigation risk and even regulatory changes.
“If a sponsor can replace this pension debt, which is difficult to value and fully understand, with debt that is much more straightforward and comfortable for analysts to understand, it can help the valuation of your company,” Gannon says. “We’ve seen this play out in real time with some of the recent deals.”
Of course, issuing debt via the capital markets is not an option for all plan sponsors, and doing so successfully requires some serious financial savviness. The sponsor will undoubtedly have to seek approval and support from beyond the HR and benefits delivery side of the business—finance and top management will play a key role and will likely have the final say on any major transaction.
“It’s somewhat of a sophisticated strategy that is going to require input from a lot of different groups, including advisory or consulting resources,” Gannon says. ”The sense I have is that this approach will continue to be concentrated among the larger companies with legacy pensions—and those companies that have strong access to cash or the capital markets. Smaller sponsors may have to freeze and hibernate their pensions to get to a point where issuing sufficient debt to cover the cost of a PRT transaction actually makes sense.”
Gannon says there has been a lot of talk that, when interest rates start going up, this will be the catalyst that finally brings funded statuses back to where sponsors want them to be, “and that will trigger another big wave of PRT transactions and more moves to liability-driven investing programs.”
“I think that’s true to some extent, but one point of caution on waiting for interest rates to climb towards historical norms, you may end up having to pay a pretty hefty opportunity premium to do PRT at the same time as everyone else,” Gannon concludes. “If all these plans are moving to do a big PRT transaction at the same time, that could absolutely impact the pricing and we could see a premium emerge out of this big rush for the door.”