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June 2014

Navigating Pension Risk: Insights From Both Sides of the Atlantic


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Plan sponsors recognize the financial threat pension risk poses to their businesses, and many are seeking solutions to resolve funding deficits and mitigate the effects of market volatility. This article explores the current financial health of defined benefit (DB) plans on both sides of the Atlantic and investigates the options available to manage and mitigate pension risk.

The funded position of most defined benefit (DB) plans on both sides of the Atlantic improved considerably in the 12 months prior to December 2013. Strong equity returns in 2013, along with higher bond yields, combined to increase the financial position of pension plans in the US, Canada, and the UK.

In the US, the funded ratio of assets over liabilities for the S&P 1500 was 87% at the end of February 2014, which is a significant improvement from 74% at the end of December 2012. In Canada, plans are well funded, with the funded ratio of Standard & Poor’s (S&P)/Toronto Stock Exchange (TSX) at approximately 98% as of December 31, 2013. In the UK, good equity returns have increased pension plan assets. However, UK plan liabilities are inflation-linked and an increased inflation outlook has put a drag on funded status. The ratio of assets to liabilities of FTSE 350 plans was 85% at the end of February 2014.

Despite the improved funding position, many pension plans on both sides of the Atlantic still face significant funding challenges, and as market volatility continues, many are still exposed to significant downside risk. Plan sponsors that wish to address pension risk face a key decision: whether to retain or transfer the risk.

To retain or to transfer

Developing and implementing a risk retention and management or risk transfer strategy potentially may add significant shareholder value, but doing so can be a significant undertaking. Although the improved funded status of pension plans means that a pension risk transfer is now within the reach of more organizations, the best course of action will depend on the particular circumstances. 

To ensure that the right decisions are made, plan sponsors must understand the risk exposure of the plan, the risk management objectives, the solutions available, and the commitment needed to carry them out. 

Before embarking on a pension risk management or risk transfer exercise, plan liabilities should be accurately measured using the best estimates available. It is also critical to understand the risk exposure of the pension plan and evaluate the threats these risks present to the stability of the plans and to the organization. 

Once the risks are understood, the risk management objectives should be clarified and a decision should be made regarding whether to remove pension risk entirely or keep certain risks on the balance sheet. Much of this decision will be based on how cost effective it is to transfer or retain risk, or to implement a combination of the two. 

Exhibit 1 illustrates some of the tools available for managing and transferring pension risk, though risk transfer and risk management options will vary by jurisdiction. Please consult your Mercer representative for information on the options available in your location. 

Exhibit 1: Tools for Managing Pension Risk

Retaining pension risk

Usually the simplest option for dealing with deficits is to retain and manage the risk internally, and for some plan sponsors this is the only option. They may decide to manage the risk internally in the short term with a view to transferring to an insurer at a future date.

The attractiveness of risk-retention solutions will vary depending on where the plan is based and its funding position. However, the range of options include:
 

  • Borrow to fund: Given current low interest rates, sponsors may borrow at attractive levels to finance the plan.
  • Asset-Liability matching: Liability-driven investment (LDI) strategies involve switching from equities into bonds with duration similar to that of the liabilities.
  • Dynamic de-risking: Under a dynamic de-risking strategy, a “glidepath” is set to take the plan toward full funding. Triggers are set at predetermined funding levels to transfer equities to bonds, and gradually de-risk the plan. (Mercer’s Dynamic De-risking Solutions site provides further information.)
  • Best-in-class growth portfolio: By carefully allocating part of the portfolio to growth assets, plans can use investment returns to improve funding positions.
  • Synthetic instruments: The use of synthetic instruments, such as derivatives, can enable hedging complex liabilities and/or freeing up capital to optimize risk and return. 
     

Transferring pension risk

Momentum in the pension risk transfer market is building. The number and size of pension risk transfers have increased significantly on both sides of the Atlantic in the past five years, with some very large “jumbo” deals taking place in the US in 2012 and, recently, a £3.6 billion bulk annuity deal in the UK. Even in Canada, where the annuity market has been static at around C$1 billion per year, 2013 broke all records with C$2.2 billion of annuities placed. 

Plan sponsors have three main options for transferring pension risk: offering a cash-out to plan members, a full pension buyout, or a partial risk transfer, which involves removing a portion of the assets and liabilities from a plan usually through the purchase of a group annuity contract with an insurer. 

A cash-out, on the other hand known as an Enhanced Transfer Value (ETV) in the UK and Ireland — allows sponsors to reduce the size of the pension plan obligations by offering members a lump sum in lieu of plan benefits. 

A full pension buyout involves transferring the assets and liabilities of the plan from the fiduciaries to a third party, most likely an insurance company, which then incurs full responsibility for meeting the plan obligations. (In comparison, a buy-in differs from a buyout in that the sponsor retains responsibility for the plan, but the economic obligation to meet payments to insured plan members is transferred to an insurer.) 

For many plan sponsors, the costs associated with a buyout have been an obstacle to transacting. However, when the full costs of retaining the plan (including administration fees and management costs) are considered, a buyout may look more attractive. 

To help plan sponsors assess the cost of a buyout, Mercer launched the Global Pension Buyout Index, which indicates the potential cost of transferring pension liabilities to an insurer, how the potential costs differ between countries, and how they move over time. The index averages four underlying indices that reflect the buyout markets in the US, Canada, the UK, and Ireland. There is also Mercer pension buyout information specific to the US, Canada, the UK, and Ireland

Addressing the full considerations of each of these options is beyond the scope of the article; however, the following sections explore their development in the US, Canada, the UK, and Ireland. 
 

Seven cash-out considerations for DB sponsors
  1. Position the lump sum cash-out option as another choice for participants to consider
  2. Consider optimal populations to whom the offer should be made
  3. Provide effective and personalized communication to participants to help guide them through their decision-making process
  4. Analyze data to ensure that it is complete and accurate
  5. Prepare to answer questions from a variety of stakeholders about the business rationale behind the cash-out offering
  6. Understand the fiduciary responsibilities as the plan sponsor
  7. Choose a provider who can effectively execute the entire cash-out program.

Preparing for a risk transfer exercise

  1. Decide what resources are needed
  2. Take legal advice and consider appropriate fiduciary process to manage the exercise
  3. Communicate with plan members and ensure strong links exist between all stakeholders
  4. When considering a buyout or buy-in, get an indicative price from an insurer
  5. Work on issues to reduce cost — for example, sectioning the membership
  6. Look at existing assets and possible changes to investment strategy to ensure a cost- effective risk transfer.

US

The US witnessed some jumbo risk transfer and cashout deals in 2012. These included Ford’s lump sum payout to plan members, General Motors’ $26 billion risk transfer, and Verizon’s October 2012 $7.5 billion partial buyout. In 2013, pension risk transfer deals continued at a similar pace, albeit not at the scale of the jumbo 2012 risk transfers. 

Conditions for pension risk transactions remain good in the US. Due to increasing interest rates through 2013 and favorable equity returns, most plans are far better funded than they were in 2012, making a potential risk transfer more attractive. As of January 2014, as indicated by the Mercer US Pension Buyout Index, the cost of purchasing annuities from an insurer was 108.5% of the accounting liability. Meanwhile, the economic cost of maintaining the liability was slightly higher at 108.7% of the balance sheet liability. 

With Pension Benefit Guaranty Corporation premiums set to increase immediately, and anticipated revisions to statutory mortality assumptions in the near future to reflect increasing longevity, pension risk transfer opportunities may be at a peak. Plan sponsors are encouraged to develop a robust pension risk strategy that reflects the evolving conditions and takes advantage of the opportunities before they pass. 

Canada

The appetite for risk transfer has grown rapidly over the past year, primarily due to the sharp improvement in funded status. Last year had the highest volume of group annuity transactions in Canadian history, and we expect 2014 volumes to easily surpass 2013. 

In Canada, members leaving the plan through termination are required to be provided with a lump sum option, so the impact of re-offering lump sums is smaller than in the UK and the US. Although the basis on which the benefits are required to be settled is expensive relative to other measures such as accounting, many Canadian plan sponsors are considering re-offering lump sums to cash out their deferred vested members as a way of settling a portion of their pension obligations.
 

Top five risk management concerns for US and Canadian pension plans

  1. Volatility in financial markets
  2. Low interest rates
  3. Financial impact of the DB plan on the organization’s performance or profitability
  4. Employee attraction and retention issues
  5. Investor/credit analyst scrutiny of the organization’s performance, profitability, and financial health.

UK

In the UK, there have been a handful of multi-billion pound longevity swaps, and a March 2014 £3.6 billion pension buy-in deal between the ICI Pension Fund and Legal & General and Prudential. Small and medium-size plans are also entering into buyouts and buy-ins.

Pension risk buyouts are relatively expensive for UK companies because their pension plans are linked to inflation. This partly explains the popularity of longevity swaps for larger pension plans as a way to hedge longevity risk. 

While the appetite for buyouts and buy-ins is strong, important considerations to bear in mind include: 
 

  • Insurer capacity: Only a small proportion of the world’s DB plans’ benefit obligations has been transferred to the insurance sector, but questions have already been raised about capacity. As interest in risk transfer continues to build, problems with insurer capacity may arise.
  • Counterparty risk: Although a plan may transfer pension risk to a third party, it is taking on the possibility that the third party might default. If this happens, the event is likely to draw negative publicity toward the plan sponsor that transferred the pension obligation.
  • The importance of getting it right: Risk transfer deals, once completed, are irreversible. Fiduciaries must be confident that the price is fair, the terms are correct, and they have carried out the necessary due diligence to ensure a positive outcome. The use of an external fiduciary, as employed by General Motors and Verizon in the US, to help oversee the process can prove helpful in ensuring a smooth transaction. 
     

Top five risk management concerns for UK pension plans

  1. The impact of low bond or gilt yields increasing liabilities
  2. The level of funding required or reducing the deficit in the DB pension plan
  3. Investment strategy; deciding the correct level of risk, the type of asset or credit to invest in, or matching assets to liabilities
  4. Volatility in the size of the deficit in the plan and the required funding ratio
  5. Investment performance, such as ensuring that the return on investments matches the DB plan liabilities

Conclusion

Plan sponsors on both sides of the Atlantic face funding challenges with their DB plans and are keen to confront them. In general, the funded status of pension plans improved considerably in 2013, but market volatility remains a threat. Plan sponsors that had taken steps to prepare for pension risk action have been well placed to take advantage of de-risking opportunities as they were presented. Indeed, many plan sponsors have taken positive action to reduce the risk exposure of their plans. 

Though the dynamics and details of pension risk management may vary, the appetite to reduce or remove pension risk is strong on both sides of the Atlantic. Whether plan sponsors choose to retain or transfer risk, preparation is vital to take advantage of market opportunities as they are presented. To achieve this, it is vital to have in place a framework that provides at-a-glance plan management information to identify plan-specific opportunities as they arise, and support a rapid response when deemed appropriate.
 

Contacts

Sean Brennan (New York)
Principal, Investments (Financial Strategy Group)
+1 212 345 1329
sean.brennan@mercer.com
Manuel Monteiro (Toronto)
Partner, Retirement
+1 416 868 2927
marcel.monteiro@mercer.com
David Ellis (Leeds, UK)
Principal, Retirement
+44 113 394 7591
david.ellis@mercer.com
Hrvoje Lakota (Toronto)
Principal, Investments
+1 416 868 2125
hrvoje.lakota@mercer.com


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