Verizon annuity deal adds to pressure on long bonds
Others may face shortage of quality securities
By Kevin Olsen | October 29, 2012
Verizon Communications Inc., New York, purchased an annuity contract with Prudential Insurance Co. of America for about 25% of its pension liabilities just when demand in the high-quality corporate bond market is starting to supplant supply in a low interest-rate environment.
Early adopters of pension buyouts should not have a problem in finding quality liability-matching fixed-income investments, but problems could develop as more companies follow the lead of Verizon and General Motors Co., said Robert Collie, chief research strategist, Americas institutional, at Russell Investments, Seattle.
Only those companies with strong enough balance sheets to make the large contribution necessary to fully fund the liabilities they are transferring are looking at pension buyouts, Mr. Collie said.
Many corporate plans already are employing some kind of liability-driven investing strategy in the long credit market, causing an imbalance with supply and demand, said Travis Bagley, director of transition management at Russell. The use of buyouts by purchasing annuities is only going to increase that imbalance.
The long bond market is “not limitless in terms of capacity, and we see an increased interest in more deals and a continued lack of supply to facilitate it in the bond market,” Mr. Bagley said.
The Barclays Long A and AA credit indexes have a market value of about $680 billion; the GM and Verizon annuity contracts will take up about 5% of that, Mr. Bagley said.
Moody's Investors Service Inc. said in a credit outlook report that the Verizon transaction was credit negative for Prudential as it “increases the insurer's risk concentrations, further exposing it to the challenges of estimating longevity risk, managing a long-duration portfolio and investing any portion of the proceeds not provided through existing investments in a low-yield environment.”
Prudential also is providing GM's annuity contract, and Moody's said that transaction also is credit negative because it represents more than 5% of Pru's general account holdings. Prudential officials said they had been building up their business for years in anticipation of a big deal like GM, and thus were confident the company has sufficient capacity.
The trend of pension derisking “is very real and will continue,” said Ari Jacobs, senior partner and global retirement solutions leader at Aon Hewitt, Norwalk, Conn., which served as lead adviser for Verizon along with Morgan Stanley (MS).
As transactions like these take place, there will also be a shift in the way the assets are managed, Mr. Jacobs said. Whereas a typical pension plan has more than 50% invested in equities, insurance companies will mostly invest the assets in high-quality corporate bonds to match liabilities. Prudential and MetLife are the two largest players in the buyout market, but Mr. Jacobs said other insurance companies have the capacity to handle these large deals and are building teams to compete.
$7.5 billion transfer
Verizon announced on Oct. 17 that it will purchase a group annuity contract with Prudential to transfer $7.5 billion in pension obligations for about 41,000 retired salaried employees who began receiving pension payments before Jan. 1, 2010. Retirees formerly represented by unions are not included inthe buyout.
Verizon spokesman Raymond McConville said Verizon executives were not available for interviews.
The buyout “is part of an overall pension derisking strategy and reduces our exposure to funding and income statement volatility caused by change in investment returns, discount rates and longevity risk,” Francis J. Shammo, Verizon executive vice president and CFO, said in an earnings conference call Oct. 18. “It also allows us to transfer this liability at reasonable economics and avoid certain administrative costs while improving the longer-term financial profile of the business.”
About four months ago, General Motors, Detroit, announced the largest pension risk transfer in history, reducing its pension obligations by $26 billion through a combination of lump-sum offers and a group annuity contract for retirees in its salaried plan. Verizon already offers many of its salaried participants lump-sum options at the time of their retirement, Mr. McConville said.
“If the GM deal hadn't happened, it (the Verizon buyout) would be the largest transaction,” said Ramy Tadros, partner and head of the Americas insurance practice at Oliver Wyman Group, New York. Fiduciary Counselors, Verizon's independent fiduciary, hired Oliver Wyman to advise on the transaction.
“With GM, people thought it was a one-off deal, but with Verizon, two deals in a short period of time make it a trend, and a significant one at that. In sheer size, it is quite significant,” Mr. Tadros said.
The move toward pension buyouts and lump-sum offers began many years ago when companies started freezing and closing their defined benefit plans, Mr. Jacobs said. Derisking strategies followed the 2008-2009 financial crisis. Now, companies are looking to clear pension liabilities off their balance sheets, he said.
Before GM, the average size of a pension buyout was only $5 million to $10 million, said James Gannon, director, asset allocation and risk management, at Russell.
In terms of managing credit, interest and longevity risk against cash flow, that is the “bread and butter of what a life insurance company does,” Mr. Tadros said in a telephone interview. Managing pensions is “not a core business” for these companies. He added that Oliver Wyman has been discussing the buyout option with other companies, but declined to identify them.
“Clearly, there is tremendous activity in this space and people are rethinking their obligations to pension management,” Mr. Tadros said.
Verizon intends to contribute about $2.5 billion to the salaried pension plan in connection with the pension buyout, including a $930 million contribution already made last month. That plan had $11.1 billion in assets as of Dec. 31.
Verizon estimates it will contribute $3.4 billion to all of its pension plans this year, compared with the $1.3 billion estimated at the beginning of the year.
Messrs. Tadros and McConville declined to comment on the total amount to be transferred to Prudential. Verizon anticipates the transaction will close and the group annuity contract be issued in December.
Separately, Verizon is aiming to close its defined benefit plans for union employees to new hires and place them exclusively in the company's 401(k) plan, as part of tentative contracts with the Communication Workers of America and International Brotherhood of Electrical Workers unions, confirmed Mr. McConville.
Verizon and the unions reached a tentative agreement on Sept. 19, and the contracts are currently in the ratification process, according to Verizon's earnings statement issued Oct. 18. Union employees are in both a defined benefit and 401(k) plan.
Verizon's defined benefit plans had about $24.1 billion in assets and $30.6 billion in liabilities for a funded status of 78.8% as of Dec. 31.
GM's and Verizon's actions led the Pension Rights Center Oct. 18 to ask Congress to impose a moratorium on derisking moves by corporate defined benefit plans — including lump-sum buyouts and annuity contracts — while the impact on retirees is studied.
Karen Friedman, executive vice president and policy director of the Washington-based group, said the impact of such derisking strategies on workers and retirees is not well understood.
“I don't think anybody's had a chance to catch their breath. Taking a pause is the least we could do to ensure that we at least study what could happen,” Ms. Friedman said in an interview. She noted that while corporate pension benefits are backed by the Pension Benefit Guaranty Corp., less is understood about the backing of insurance annuities.
Peggy McDonald, senior vice president and actuary with Prudential Retirement, Hartford, Conn., said companies who are seriously pursuing pension derisking strategies “take ... seriously the need to provide retirement security” to their employees.
She noted that unlike some pension plans struggling with underfunding, “by definition in a risk transfer deal, the obligations are 100% funded.”
Mr. Collie said Russell's point of view is that with a solid insurance company like Prudential, participants' benefit security is on par with what the PBGC offers.
Hazel Bradford contributed to this story.
This article originally appeared in the October 29, 2012 print issue as, "Verizon annuity deal adds to pressure on long bonds".