The drive to de-risk DB plans has crossed the pond
Written by Amy Kessler
September 2012
Amy Kessler discusses why North American plan sponsors are taking bold steps to de-risk corporate pension funds
Pensions de-risking has been a significant part of the pensions landscape in the United Kingdom for six or seven years, but today the United States is proving its potential to be the most vibrant market in the world for pension risk transfer - and Canada is poised to follow.
For many, the transformation now taking place in North America is surprising due to the current low interest rate environment and the under-funded status of most corpo-rate defined benefit pension plans. However, today’s changes simply make good common sense from a corporate finance perspective.
As a result, we expect bold steps to de-risk corporate pension funds to continue to capture headlines for the foreseeable future.
Why now?
Today, leading plan sponsors in North America are moving ahead with their pension de-risking strategies despite the low interest rate environment. These corporate plan sponsors recognise that rates are expected to stay low for some time to come, and that underfunded plans are a source of leverage for the company that can magnify its pension risk. In many corporate board rooms, risk awareness is rising as annual discussions sur-rounding cash contributions are intensely focused on creating stability for a lower-risk future.
Firms facing this challenge are in good company. Almost across the board, North American plan sponsors anticipated a more robust market recovery than we have experienced. They planned to reduce risk using a glide path to a lower-risk future that would be aided by the market. The challenge these firms have faced is that the glide path strategy was only meant to change the risk profile as funded status improved, and that improvement has not materialised.
In fact, plan sponsors in the S&P 500 contributed well over $100 billion to their pension plans in 2010 and 2011, but according to the Aon Hewitt Pension Risk Tracker, they began and ended this two-year period at an average funded status of just over 81 per cent. This brings us to 2012, and after more than 10 years of very tough sledding for pension funds, the conversations at the corporate board level are changing. Leading companies in North America are recognising the need to start their de-risking with bold steps now, even while rates remain low.
In the emerging trend toward de-risking, a multitude of de-risking strategies have surfaced. The goal is a future with less pension risk than the past, and companies are choos-ing a path that is tailored to meet their needs. Options range from risk management to risk transfer, and the choices featured most prominently in the headlines include:
• Liability Driven Investing (LDI) where bonds and swaps are used to match the pension liability as closely as possible;
• Lump sum offers where cash payments are offered to transfer the risk to plan participants; and
• Pension buy-in and buyout where all investment and longevity risk are transferred to an insurer.
For those who are taking action today, the calculus takes into account the fact that interest rates are expected to remain low for several years to come, that waiting for rates to rise involves real risk, and that there are potentially significant advantages to the companies that begin their de-risking sooner rather than later.
What can first movers expect to gain?
First and foremost, the early movers in each industry gain a distinct advantage in their peer group because de-risking protects the firm’s free cash flow from downside risk. In fact, cash flow is the foundation of shareholder value creation.
For the leading plan sponsors in the US and Canada who are preparing to transact today, the focus on cash has been the key lesson learned from the UK. Many of the first movers in the UK now have a lower risk profile that allows them to:
• Focus on their core business;
• Solidify their industry leadership;
• Eliminate a potential capital call;
• Create more consistent financial results; and
• Maximise their strategic flexibility in down markets.
These benefits are the greatest for companies in cyclical industries where free cash flow and liquidity are under the greatest pressure during the market disruptions that impact the pension fund.
A key factor in driving the momentum in North America today is the fact that equity analysts and other corporate stakeholders are focused intently on the impact that pension risk has on company valuation. As more analysis makes its way into the market, awareness is now very high that exposure to pension risk increases stock price volatility, firm beta and the cost of capital. This makes good sense in a world where unfunded pension liabilities are a form of employer debt that is effectively senior to shareholder equity. As such, potential losses emanating from the pension fund are contingent leverage, and the more risk there is around funded status, the more risk there is to stock price.
This link between pension risk and leverage is exactly why we see leading US companies making greater cash contributions to their pension plans today than current law requires. Many are debt-funding their plans, realising significant tax advantages, improving their funded status and de-risking to protect free cash flow going forward. The goal is to reduce risk, decrease firm beta, and lower the cost of capital while creating shareholder value by allowing the strength of the core business to drive financial results.
Apart from the corporate finance benefits, early movers to de-risk can expect less competition to purchase long-dated corporate bonds, which can lead to better outcomes from LDI and insurance solutions alike.
Why is pension de-risking going global?
Many of the leaders that have been on a de-risking path in the UK have US and Canadian affiliates. These companies have benefited from their focus on the true economic impact of pension risk, and from effectively bringing the pension fund into the enterprise risk-management framework. Their CFOs have embraced the improvement and are part of an increasing trend toward the globalisation of pension de-risking.
As more corporations succeed in de-risking, they prove that the corporate finance approach leads to more consistent financial results and a purity of focus on the core business. The trend is beginning to overturn the persistent misconception in the US that income statement smoothing and funding relief should drive decisions about risk-taking in the pension fund. We see new attitudes emerging that are focused on the economic risk and the prudent steps that can be taken to protect shareholder value.
With these changes, we are well on our way to a time when reducing risk in North American defined benefit pension plans will be the norm.
Written by Amy Kessler, Senior Vice President, Head of Longevity Reinsurance, Prudential Retirement, Prudential Financial, Inc.
Prudential Financial, Inc. of the United States is not affiliated with Prudential plc which is headquartered in the United Kingdom.
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