The driving forces behind pension risk transfer
Written by Amy Kessler
The defined benefit pension market experienced a defining moment in 2012. Pension risk transfer has now become a transatlantic trend and is increasingly accepted as a savvy, strategic choice. As the momentum builds and the market expands, firms are asking: 'Who should de-risk? How might a company determine if pension risk transfer is the right choice?'
Any company seeking a future with less pension risk than the past can use pension risk transfer to achieve its aim. This quick answer, however, races past most of the insight we have gained from the transactions that have occurred in the UK and US markets to date.
Every company that has transacted to transfer pension risk has had its own story to tell but nearly all of them relate in one way or another to the fact that pension de-risking has a real impact on corporate cash flow and stock price. Here are the facts:
• Unfunded pension liabilities are a form of corporate debt;
• That debt is effectively senior to shareholder equity;
• Any time losses in the pension fund cause the unfunded liability to grow significantly, both shareholder equity and the stock price should fall; and
• De-risking all or a portion of the pension scheme reduces the risk of pension losses and the correspond-ing risk to the stock price.
These corporate finance funda-mentals are at the core of almost every pension risk transfer transaction. They underlie a common set of goals that we observe across the market and provide an ideal point of departure for a discussion of some of the more specific motivations behind the market activity since 2006 on both sides of the Atlantic.
For the leading companies that are de-risking today, their lower risk profile 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 transcend the industry and allow companies that have led the way in pension risk transfer to reduce the risk to their bottom-line results and improve their financial performance relative to their peers.
A key indicator of pension risk is the size of a firm’s pension obligation relative to its market capitalisation. The larger the pension obligation, the more pressure there will be on shareholder equity when market disruptions result in pension losses. Pension buyout transactions actually remove all or a portion of the pension liabilities from the sponsor’s balance sheet and transfer them to an insurer. As a result, a buyout reduces the size of the plan relative to the company and alleviates the pressure on shareholder equity from pension risk.
Companies in cyclical industries may dramatically reduce overall firm risk
For companies in cyclical industries, free cash flow and liquidity in the operating business are under the greatest pressure during economic downturns. These economic conditions often occur alongside the very same market dynamics that accelerate pension losses — interest rates and equities fall simultaneously, pushing pension liabilities higher and risky assets lower. Given the fact that economic downturns and pension losses are likely to occur at the same time, cyclical companies with significant exposure to pension risk are often regarded as riskier than the market as a whole and may be said to have ‘higher firm beta’ in light of the overall business and financial risk of the company.
Of particular concern for these companies is the possibility that an economic downturn might result in pension losses that must be funded at a time when free cash flow and scarce liquidity are needed for the operating business. Noting these challenges, cyclical companies that transfer pension risk can significantly reduce overall firm risk and, in turn, bring down their firm beta and weighted average cost of capital.
Companies may face competitive pressure to de-risk
Today, equity analysts and share-holders are increasingly focused on the relative pension risk of each company within each industry peer group. As companies in several industries lower their pension risk profiles through de-risking techniques, the competitive pressure is building for peers to follow suit.
For small to midsized pension schemes, administration may be very costly and custom risk management with tailored portfolios is likely to be out of reach. In contrast, pension risk transfer arrangements benefit from custom fixed income portfolios and key rate duration hedging — two risk management techniques that are usually unaffordable or impractical for pension funds of this size. In addition, many insurers have extremely efficient large-scale administration platforms. These sources of scale and efficiency can make pension risk transfer cost effective for many schemes.
Opportunistic de-risking is a common strategy today
Often, the companies that are prepared to de-risk are those that have significant allocations to fixed income. Some have even constructed custom bond portfolios that match a portion of their liabilities as closely as possible. These portions of the pension obligations may be ready for a buyout or buy-in using the fixed income securities the plan has on hand. Moreover, in today’s low-rate environment, the scheme may view the current market as a unique opportunity to transfer appreciated fixed income assets together with a portion of the liability to an insurer. Companies pursuing this opportunistic de-risking strategy may wish to transfer their pension risk in stages and may be prepared to take decisive steps as market opportunities arise.
Longevity risk is significant and many companies believe it should be insured
Increasing life expectancy trends have made longevity risk an immediate and critical issue for pension scheme sponsors in the UK and updated mortality studies underway today in the US and Canada are bringing similar pressures to North America. These trends have a significant near-term financial impact as pension plans are required to fund their expected liabilities. In response, many savvy scheme sponsors are proactively transferring their longevity risk through pension risk transfer arrangements, such as buyout, buy-in and longevity Insurance.
Companies may use pension risk transfer to improve M&A results
More than one important transaction in the UK has been completed by a company seeking to be acquired. In these instances, the goal in de-risking the pension scheme is to alleviate the buyer’s concerns regarding pension risk and create shareholder value by de-risking the plan at an attractive price. In many instances, the buyout or buy-in premium is lower than the liability value an acquiring company ascribes to the pension because the acquirer will value the pension liabilities at risk-free rates with a conservative assumption about life expectancy. The difference between the buyout or buy-in premium and the acquirer’s view of the liability is instant shareholder value in an M&A transaction. Additional value can be created if the acquirer views the future financial performance of the company as more certain with less pension risk in the equation.
Pension risk transfer can be a key step in a corporate restructuring
Another increasingly common approach in the UK is to use pension risk transfer as a key step in the restructuring of a distressed company. In these transactions, the pension scheme actually acquires equity in the company or other corporate assets such as real estate, leases, receivables or even the company’s own products. In a successful restructuring, the pension scheme would become well funded and may even be able to annuitise the benefits, achieving retirement security for the scheme participants and allowing the company to emerge from the restructuring pension risk free.
The de-risking strategies and objectives described above may strike a chord with defined benefit pension scheme sponsors anywhere in the world. As the trend toward pension de-risking continues unabated in the UK and takes hold in the US and Canada, these are some of the motivations that are making pension risk transfer truly universal. In effect, those who transact to lower pension risk because it makes good sense from a corporate finance perspective will continue to have a great deal in common with like-minded scheme sponsors the world over.
Written by Amy Kessler, Senior Vice President, Head of Longevity Reinsurance, Prudential Retirement, Prudential Financial