In his recent work as managing director of asset allocation and risk management for Russell Investments, Jim Gannon has participated firsthand in what he calls “the ongoing pension risk transfer [PRT] boom.”
“Whether it’s the insurance companies that want to acquire the business, or the employers looking to offload some of this risk, or the consultants and advisers guiding the process—it’s been a vigorous market in the last several years,” Gannon tells PLANADVISER.
One thing to note about the action so far in 2015 is that PRT is customarily an effort that is completed towards the end of the year, but Gannon says the market has already seen “a couple really big transactions in the last couple months.” One deal in February saw Prudential Financial and MassMutual agree to take on $2.5 billion in pension liabilities from hygiene products company Kimberly-Clark. In another example staged north of the border, Sun Life Financial Inc., a large Canadian life insurance provider, agreed to take on about $4 billion in pension liabilities from telecommunications company BCE Inc.
The early moves show these plan sponsors have been thinking about transacting likely for years, Gannon suggests, because even the fastest-executed transactions take five or six months from start to finish, and most take significantly longer. Overall the economics are still quite ripe for PRT, presenting an ongoing opportunity for sponsors and advisers to work together to take control of pension risk.
Despite the economic tailwinds, PRT remains a huge challenge for many plan sponsors. Even when plans are fully funded, the sponsor will typically have to pay a substantial premium to the insurer taking on the pension benefit risk. The Mercer U.S. Pension Buyout Index, which tracks the relative cost of keeping pension debt versus selling it off to an insurer, finds the average cost of purchasing annuities from an insurer to cover pension liabilities stands around 104.4% of the accounting liability. What amounts to a 4.4% risk transfer premium may actually be a good deal, Gannon notes, because the real cost of maintaining the pension plan—factoring in staff costs, insurance premiums and other expenses—stands around 105.6% of the accounting liability.
“These numbers have started many plan sponsors on the road to a PRT transaction,” Gannon says. “They are learning just how much work goes into PRT—it’s cleaning up the benefits calculation data; it’s coming to an understanding of the market factors and how your portfolio is aligned with those; it’s finding the right consulting and advisory partners and the right insurer to actually take on the risk. All of this takes time and resources, and then you move on to negotiating the exact pricing and the underwriting. It takes quite a while to transact.”
What happens when a sponsor of a frozen pension plan realizes she isn’t ready to cut a check worth 104.4% of the entire pension plan liability, or even a smaller portion of the plan? Gannon says “hibernation” can offer a reasonable path forward when risk transfer is desired but still not within reach. It’s not exactly a groundbreaking approach to pension management, he notes, but hibernation as a distinct strategy hasn’t received as much attention compared with annuitization and lump-sum payments.
“In the simplest terms, to achieve hibernation you are taking your frozen pension plan, getting a liability driven investing program in place, and then letting the natural process of paying out benefits shrink your plan, and thus shrink your overall pension risk and the size of a future PRT premium, over time,” Gannon explains. “It’s a potential path forward for the plan sponsor who wants to do PRT but sees that it isn’t currently possible.”
Gannon says pension hibernation represents a shift from a return-seeking mindset to a position of caution and risk mitigation.
“That’s often described as liability driven investing [LDI]—but hibernation is more than that, because it represents a means of shrinking, rather than growing, the plan,” Gannon says. “With LDI you are trying to match your need for growth with a more specific goal tied to the long-term pension plan liability, but with hibernation you’re trying to put an end date on the liabilities.”
Gannon wrote an informative paper about hibernation about a year ago, and one of the main focus points was that every frozen plan at some point is going to buy annuities and terminate. The alternative just doesn’t make economic sense, Gannon observes.
“If you have a frozen plan with no intention to terminate, you’ll still be running this plan 30 or 40 years from now, with one or two participants left in it, and they’ll have to keep the plan infrastructure in place to keep paying out the benefits and keep the plan in compliance,” he explains. “Before that happens, the employer will almost certainly make a move to get out of the business of managing pensions.”
This makes PRT almost entirely a timing decision for plan sponsors that are frozen. Equally critical is spending the time and effort to identify the right insurance provider to take on the risk, Gannon says. It’s an effort made somewhat easier by strong competition among insurers for this business.
“The final timing will largely be based on price,” Gannon says. “Can they afford any necessary cash infusion? Is the funding level as high as it’s likely to get without requiring more risk taken in the portfolio? What’s the employer’s wider balance sheet look like? Can we find a suitable partner right now that wants to take on these liabilities?”
While prolonged hibernation will keep a DB plan exposed to market risk, it will also likely cause the plan to shrink over time, especially when the plan population skews older and there is a higher proportion of participants actively collecting benefits.
“In this sense a hibernating pension should see the cost for transferring risk go lower year after year,” Gannon says. “There is no free lunch, and market risk is important to consider, but as a basic principal pensions can use this approach to shrink their plan towards a point where PRT is more feasible.
“It’s compelling if you don’t have a big cash flow or a lot of financial flexibility, as an employer, to help cover the premium associated with getting the risk off your balance sheet,” Gannon concludes. “This approach can offer a path forward for plans that know they want to do PRT, but are struggling to find the cash right now. Maybe there’s a point five or even 10 years down the road when you’ll have the sufficient cash.”