PBGC premium increases leading to strategic action
More U.S. corporations with traditional defined benefit plans are strategically transferring their liabilities to insurers, although struggles with funding ratios have contributed to a lack of megadeals in the market.
Those struggles, however, have not impeded the number of pension risk transfer transactions. In fact, more U.S. corporations than ever are offloading liabilities through the purchase of group annuity contracts with insurance companies, and doing so more strategically in the face of rising Pension Benefit Guaranty Corp. premiums.
According to the most recent data from the LIMRA Secure Retirement Institute, pension buyout transactions in the second quarter of 2017 totaled $4.1 billion, well above the $1 billion during the same quarter in 2016. Experts expect a total of $18 billion to $20 billion by the end of 2017, compared to $14 billion in 2016.
LIMRA conducts a quarterly survey of the 15 financial services companies providing the group annuity contracts that U.S. corporate plan sponsors purchase.
Catherine Theroux, spokeswoman at LIMRA, said the institute expects volume to remain consistent with last year, although LIMRA avoids making specific projections because megadeals can radically alter the overall dollar value.
This increase in volume has been accompanied by a singular trend in the pension risk transfer landscape: transferring the liabilities specifically of retirees who receive smaller monthly benefits.
It makes sense there are more deals targeting participants with small monthly benefits, said Ari Jacobs, Chicago-based senior partner and global retirement solutions leader at Aon Hewitt. “Generally because of PBGC premiums, they're the most economically sound deals,” Mr. Jacobs said. “They're creating much more deal flow, bringing a lot more transactions in terms of headcount, in terms of lives to the market.”
PBGC premiums, both fixed and variable rates, have skyrocketed in the past five years following 2012's Moving Ahead for Progress in the 21st Century Act, or MAP-21, which created the hikes to give funding relief to the PBGC in the face of growing agency deficits.
The fixed rate, which is measured per participant, was $35 in 2012, but is now $69 per participant and will increase to $74 in 2018 and $80 in 2019. Fewer participants mean smaller premiums, and companies' incentives to reduce the number of participants increases every year.
“They're carving out the small-benefit participants to reduce headcount,” said Joseph Nankof, founding partner, head of capital markets/asset allocation at Rocaton Investment Advisors LLC in Norwalk, Conn. “That cuts back significantly on the number of participants in the plan.”
“If I'm paying $100 a month to a retiree but I'm paying the PBGC $80 a year just for the privilege of paying the retiree,” it makes sense to offload those liabilities, said Matthew McDaniel, Philadelphia-based U.S. head of defined benefit risk at Mercer LLC.“(Plans are paying) anywhere between $80 and $600 per person to the PBGC ... so depending on where you are in that spectrum, reducing the participants in the plan and reducing PBGC costs ranges anywhere from helpful to enormously helpful.”
Some of the most notable transactions in the past 18 months have involved retirees with small monthly benefits. Most recently, NCR Corp., Duluth, Ga., announced on Nov. 3 that it purchased a group annuity contract from Principal Life Insurance Co. that will transfer about $190 million in U.S. pension obligations, affecting 6,000 retirees whose monthly pension benefit was less than $500 as of Jan. 1.
International Paper Co., Memphis, Tenn., announced in September it purchased a group annuity contract from Prudential Insurance Co. of America to transfer about $1.3 billion in U.S. pension liabilities, representing the benefits of about 45,000 retirees and beneficiaries who currently receive monthly benefits of less than $450.
Ball Corp., Broomfield, Colo., also announced in August it had purchased a group annuity contract from Prudential transferring about $220 million, representing about 11,000 U.S. retiree benefits falling “below a certain monthly pension payment threshold in multiple U.S. plans,” company spokeswoman Renee Robinson said at the time.
Sears Holding Corp., Hoffman Estates, Ill., purchased two separate group annuity contracts from MetLife Inc. in 2017, the first in May generally affected retirees with a monthly gross benefit of less than $150, Howard Riefs, company spokesman, said at the time. In August, a second purchase from MetLife transferred $512 million in liabilities.
In October 2016, United Technologies Corp., Farmington Conn., transferred $1.8 billion in liabilities following the purchase of a group annuity contract from Prudential. Robin Diamonte, UTC's chief investment officer, said the company chose to transfer the liabilities of about 36,000 retirees who received a monthly benefit of $300 or less.
“Because of the per-head PBGC premium and administration costs, participants with low benefit balances are the most expensive to administer,” Ms. Diamonte said. “These participants are more attractive to the insurance company because they have less mortality risk and therefore the premium to transfer is lower. In addition, their monthly annuity benefit is essentially covered under state insurance guarantee limits providing an additional comfort and security to our participants (and the fiduciary).”
The whole process, Ms. Diamonte said, took about nine months. “We decided to form both fiduciary and settlor committees to help ensure a deliberative and prudent decision-making framework that considered the interests of both the participants and the sponsor. Our fiduciary committee performed several key functions to make sure that the value and security of the retiree's benefits were not lessened and that costs were reasonable. For example, the fiduciary committee performed DOL IB 95-1 due diligence on the insurance companies under consideration, selected (the) deal structure, selected the insurance company, and considered impact on the funded status before and after the transaction. Our settlor committee focused on issues more directly relevant to UTC, for example, assessing the financial viability of the deal and the impact to the company's financial statements,” she said.
“The stars were all aligned when we completed the transaction. Our funded status was strong, we were very happy with the viability of the insurance companies that bid and we felt that the we would have true economic savings. In the end, it was a win-win-win deal, for the company, our participants, and hopefully Prudential,” she added.
From a money management perspective, transferring the liabilities of current retirees is also the least risky to transfer. “When the retiree population is generally the population, not only do we have the certainty of where the cash flows are being paid,” said Scott McDermott, managing director, global portfolio solutions group at Goldman Sachs Asset Management, “but it's also where the risk is lowest, meaning they constitute the bulk of the nearer term cash flow payment.”
Variables rates also rising
Also as a result of MAP-21, variable PBGC premiums, which are determined by the level of a plan's underfunding, have skyrocketed. As recently as 2013, the rate was $9 per $1,000 of underfunding, and is now $34 per $1,000 of underfunding and will rise to $38 in 2018.
As that premium hike looms, more plans in 2017 have also accelerated contributions to their plans, which not only improves the funding of the plans and thus lessens the impact of those premiums, but also make it more feasible to execute pension risk transfer transactions.
International Paper, for example, announced earlier this year it made a $1 billion debt offering to fund a $1.25 billion contribution to the U.S. pension plan by Sept. 15, shortly before its buyout, and Hartford Financial Services Group Inc., Hartford, Conn., contributed $300 million to its DB plan to enable the transfer of $1.6 billion of its $5.65 billion in liabilities.
The Pension Protection Act of 2006 required an 80% funding ratio to be able to offer a lump sum to terminated vested participants who have yet to retire.
For group annuity purchases, many companies aim for a funding ratio above 100% to pay for the premium charged for such transactions.
“The possibility of corporate tax reform is one that has driven a couple of our clients in particular to fund the plan now,” Mr. Nankof said. Current tax law allows a plan sponsor to deduct a portion of its pension contributions based on its tax rate, so if the rate is 35% in 2017 and 20% in 2018, companies get to deduct more if the contributions are more in 2017 as opposed to 2018.
A number of corporations with large plans have issued debt to pay for large pension contributions in 2017 that would negate the minimum requirement to contribute any dollars over the next several years. International Paper, for one, contributed $1.25 billion to its plan just before its group annuity purchase, partially funded by a new $1 billion debt offering.
For pension plans with funding ratio below 100%, one element that has sometimes the sponsors from executing group annuity purchases is the premium risk inherent in those transactions. The premium charged by insurance companies can be as much as 5% over the projected benefit obligations that the company is transferring, but that could change as the number of insurance companies providing these services grows.
Mr. Nankof cited one unidentified recent transaction with which Rocaton was involved. “Pricing on that was below PBO,” Mr. Nankof said. “The conventional wisdom is that these transactions for retirees may go (for) as much as 5% premium to PBO. This is one where it went off to a discount to PBO. Something I've not seen. … It could be aggressive pricing or this could be very specific underwriting of this population. It could be the industry.”
“That could drive pricing higher or lower. I don't want to suggest this is a data point. It's not a big pool of plans where I'm saying pricing is coming below PBO in general. It's a specific case. I think for some plans, (premiums could come down) depending on the participant pool, the industry and how aggressive the bidders are,” Mr. Nankof said.
The bidders are represented by the 15 companies that currently offer pension risk transfer services. It is a small pool, but as Mercer's Mr. McDaniel notes, that market has doubled in the past few years from about eight insurance companies, so the competitiveness of the bidding process could indeed grow.
“That means better costs and better outcomes for plan sponsors,” Mr. McDaniel said. “I think it will be interesting to see over the coming years to see what the equilibrium number of insurers in that market will be. Wherein there's going to be a lot of activity, but it's a market where insurers target specific liability types, specific transaction sizes.”
“The competitiveness with which any given plan sponsor will see their liability bid really depends on the demographic profile of their plan,” said Mr. McDaniel.
“It depends on what participants they're looking to transfer (and) the complexity of the plan design,” he added.
The most frequent form of pension risk transfer has been lump sums to former employees vested in the plan but who have yet to retire. The Internal Revenue Service recently unveiled their long-awaited updates to their mortality assumptions, which affects the calculation of those lump sums.
The surprising part of the announcement, some experts say, is how late in the year the IRS chose to make it. “That has a few plan sponsors scrambling with the shortness of time to make that adjustment,” Mr. McDaniel said. “The immediate impact of that (regulation) makes lump sums less attractive for the plan sponsor, so you have to pay out lump sums that might be 4%, 5% higher than the old (assumptions).”
“It's less cost-effective for you as a plan sponsor now than it was in 2017,” Mr. McDaniel said. “It's not to say it's not cost effective, even with the new mortality update. It's a pretty fair deal for plan sponsors.”
What appears not to be happening is a rush to make lump-sum offers before those new assumptions take effect in 2018.
“(Lump sums are) losing momentum in terms of popularity because most organizations have already done them,” Mr. Jacobs said. “What's now happening after the mortality table changes, it's not that the popularity has waned, it's that everyone's done them.”
The high volume of pension risk transfer transactions has been expected, although the market has lacked the kind of megadeals that some have expected in the past five years.
It was five years ago, in the fourth quarter of 2012, that $34.5 billion in U.S. pension liabilities were transferred to insurance companies. Almost the entire volume came from two megadeals: General Motors Co., Detroit, and Verizon Communications Inc., New York, which transferred $26 billion and $7.5 billion, respectively, to Prudential.
Waiting on interest rates
Overall, a big reason corporations have not pulled the trigger on large annuity deals is because they are waiting for interest rates to rise. That has not happened, but Rocaton's Mr. Nankof suggests that eventually, they won't have to wait anymore.
“If rates stay as low as they are, plans will be somewhat reluctant to take big bites at the apple ... out of hope that rates moving higher will make the pricing more attractive. With that said, you know over time with glidepaths in place that plans have (established), with required contributions going into the plan, assuming there isn't another wave of funding relief, (as funding ratios improve) there will be more allocations to long bonds, which means they'll be more matched in liabilities. More in long bonds (means) what you gain on the liabilities you lose on the asset side with rising rates, and I think for some plans they will not see the future benefit of rising rates as a reason to hold off on annuity purchases,” Mr. Nankof said.
When it comes to considering additional annuity purchases beyond those already transacted, GSAM's Mr. McDermott noted the remaining liabilities a plan keeps are riskier.
“The volatility of that smaller piece, the duration exposure is longer, so you really shouldn't go back to where you were before now that the assets are facing an even riskier liability than previously,” Mr. McDermott said.
“You have competing factors: You're facing a riskier liability, your investment time scale is now slightly extended because you're in 'wait and runoff' mode. You don't expect to be able to do another pension risk transfer before you collect enough new retirees — enough of those actives and (terminated vested participants) convert into retirees,” he said.
“Your investment horizon is slightly extended but the risks are higher, so you've got to take those two things into account,” Mr. McDermott added.