Portfolio structure key focus for shift of assets to insurers
Updated with correction
U.S. corporate executives considering a pension risk transfer need to think long and hard about the mechanics of how best to structure the deal with an insurance company: an asset-in-kind transaction, a cash transaction or some combination of both, industry experts said.
While an asset-in-kind transaction might be appealing, given its cheaper cost to execute in terms of a premium paid to insurance companies, it also will require plans to work in advance with their advisers so that assets meet the needs of insurers.
Pension plans are tax-exempt under the Employee Retirement Income Security Act of 1974, which enables corporate plans to take on more risk. But insurers operate under tighter regulatory restrictions, which requires that plans take a more cautious approach to assets that could later be under the control of an insurer.
Group annuity purchases of less than $1 billion are often cash transactions, and those over that threshold usually involve assets in kind, or a combination of assets in kind and cash. An assets-in-kind transaction allows an insurance company to accept securities, most often types of fixed-income assets but also a limited amount of other assets, directly from the pension plan. Historically, most transactions involve the pension plan liquidating securities and transferring cash to the insurer.
Lisa Longino, senior vice president, head of insurance asset management at MetLife Investment Management, said insurance companies often prefer asset-in-kind transactions for the larger deals because of the funding delay in transferring large pools of cash into securities the insurance company wants to manage.
"Largely, the plan sponsor's preference will be dictated by the comparative cost of liquidating the portfolio, (think of this as the bid-ask spread) with a potential premium benefit offered by insurance companies in their pricing. The benefits offered can vary from insurance company to insurance company," said Scott Kaplan, senior vice president, head of pension risk transfer at Prudential Financial Inc., Newark, N.J.
According to Prudential, the cost of a buyout is about 104% of the pension liabilities being transferred. The premium paid, however, can sometimes be less depending on the nature of the deal.
"Insurance company preferences will typically vary based on their view of the specific liability and how well the particular assets available for the assets-in-kind transfer fit the liability profile. Oftentimes, the insurer and sponsor can agree on subsets of the sponsor's portfolio that would be a good fit and represent the largest value," Mr. Kaplan said.
That work has its origins in liability-driven investing, which many corporations have employed in the past two decades as they have frozen benefit accruals in their defined benefit plans. LDI increases the plan's exposure to fixed income over time to match the liability duration of the plans.
Industry experts said the question on how best to execute a buyout is increasingly coming up as more corporate plans position their portfolios for an eventual transaction after blockbuster deals in 2012 brought new visibility to the PRT option.
Detroit-based General Motors Co. and New York-based Verizon Communications Inc. effectively transformed the pension risk transfer landscaper, transferring $29 billion and $7.5 billion, respectively, to Prudential's insurance unit.
What insurers want
When assets in kind are involved, pension funds need to become familiar with the kinds of assets insurance companies want.
John Simone, New York-based managing director, head of insurance solutions at Voya Investment Management, said insurance companies emphasize capital efficiency over total returns when managing assets, which is why fixed income dominates the portfolios.
"For insurance companies, you know having a certain level of capital drives your overall ratings and the strength of your overall balance sheet is used for multiple purposes, whether or not you're getting external financing," Mr. Simone said.
Insurance companies also are regulated under state law and the National Association of Insurance Commissioners, which means they have regulatory capital requirements they have to meet, he added.
"It's very important, so assets that meet the long-term obligations of that pension plan that are capital efficient will always be preferred to investments that might have the same returns that are less capital efficient," Mr. Simone said, such as equities and alternatives.
"The vast majority of their assets are invested in fixed income," he said, "because they're useful; the best assets that meet the liabilities."
Of the total $3.981 trillion in assets managed by U.S. life insurers as of Dec. 31, 2016, which includes affiliated and non-affiliated investments, $2.874 trillion, or 72.2%, was in bonds, according to National Association of Insurance Commissioners data. Within the fixed-income allocation, $1.761 trillion, or 61.3%, was in corporate bonds.
According to the LIMRA Secure Retirement Institute, $100 billion in pension liabilities have been transferred to insurance companies since the beginning of 2012.
Of the total amount managed by life insurers, the next highest allocation went to mortgages, at $437.7 billion, or 11%; other long-term assets, which includes private equity and hedge funds, mineral rights, aircraft leases, surplus notes, secured and unsecured loans to corporations and individuals, and housing tax credits, with $161.2 billion, or 4%; and common stock, with $158.2 billion, or 4%. After that, $127 billion, or 3.2%, was held in contract loans, and $102 million, or 2.6%, in cash and short-term investments. Remaining assets were held in derivatives, real estate, other receivables, preferred stock and securities lending (reinvested collateral).
"We don't dislike equities in general," said Brian Curran, managing director, global portfolio management unit of Prudential in Newark. "Equities provide diversification, so not all your eggs, so to speak, are in a credit basket. They may generate gains over time vs. fixed income. There will be credit cycles where you will generate credit-related losses no matter how good your asset manager is."
"It also may help reduce (the) premium and make you more competitive in the market if the return expectations for those assets more than outweigh the capital you have to hold for them," Mr. Curran said.
Even more challenging
Other risky assets are even more challenging, said George Palms, Stamford, Conn.-based president of Legal & General Group PLC's U.S. retirement business. While hedge fund and private equity assets were transfered as part of the GM deal, in the past three or four years "the insurance community has ... for the most part not been willing to take those assets in," Mr. Palms said.
When executives from a pension plan were speaking with insurers a few weeks ago regarding the insurers' interest in taking on the plan's private equity assets, Mr. Palms said "everybody said 'No' right off the bat except for us. We spent a few weeks with the intermediary and the client, and in the end, we weren't able to use those assets."
The hesitancy on the part of insurance companies to take on riskier assets is because of the need for liquidity and capital efficiency and because of that, high-quality long-duration corporate bonds are by far the most desired asset class when preparing for an asset-in-kind transfer, said Timothy Braude, New York-based managing director, global portfolio solutions at Goldman Sachs Asset Management.
"It's all about trying to get a portfolio that is shaped in such a way that it does a very effective job of hedging liability up to the point of transaction while at the same time constructing the portfolio so it's primarily the kinds of securities that insurance companies want," he said.
That means employing a customized liability-benchmarking program, said Greg Calnon, GSAM's New York-based head of OCIO, global portfolio solutions — managing fixed-income assets very specifically to the liability profile of the assets being transferred.
"Then that gives you the flexibility to be ready and able to hit the bid when (the plan sponsor is) organizationally ready to," he said.
Insurance companies primarily desire high-quality credit assets, Mr. Palms said.
“Let's say the client has a good duration-matched portfolio that's comprised of AA corporate bonds … That's a great hedge right off the bat in terms of potential interest-rate changes,” Mr. Palms said. “In order to make the economics work, I can't hold a portfolio that has that credit rating. I need to get more value … We're going to look for them to buy some securities that are A rated and A- and some BBB.”
Jodan Ledford, head of client solution and multiasset at Legal & General Investment Management America, said the goal is to go with as much long-duration corporate bonds as is feasible, excluding financials and insurers. “In the investment-grade long-duration fixed-income landscape, about 50% of that is BBB, 50% A or higher. We're going to be closer to 70% A or higher and maybe upwards of 30% BBB at the right duration.”
Mr. Calnon said, broadly speaking, insurance companies try to avoid significant concentration in individual issuers, non-U.S. dollar securities and below-investment-grade fixed income, as well as bonds from financial companies and other insurers.
Insurance companies also hold large portions of investments in the types of bonds in which pension plans generally don't invest, Voya's Mr. Simone said.
"The two major differences (are) that life insurance companies tend to invest heavily in long-dated commercial mortgage loans as well as private placement securities," he said.
"The typical life insurance company will have anywhere between 10% and 15% of their assets in commercial mortgage loans and they might have the same amount in private placement securities."
Mr. Simone said non-benchmarked asset-backed securities provide attractive options to provide further diversification for insurance companies. He said "securitized allocations of solar projects, student loans, bank loans, freight, the leasing of royalty cash flows" are just a few examples.
Insurers with large money management units, such as Prudential, MetLife and Voya, have more flexibility because these units can create these kinds of securities.
"We're predominately investment-grade," Prudential's Mr. Curran said. "What will differ from insurer to insurer is whether a given insurer has an asset management unit that can provide private placement debt or commercial or agricultural business loans."
MetLife Investment Management's Ms. Longino said MetLife is more flexible on assets it will take because of the large global footprint the firm has in other asset classes.
"Plan sponsors probably have become more fixed-income-oriented in the portfolio. We usually seek public credit but really any private credit, private placements. I would say equity, real estate or alternatives, any of those you could see in an (assets-in-kind) portfolio."
She said MetLife has this flexibility due to its "very strong portfolio advisory and strategy groups."
"They spend a lot of time on capital efficiency and when we are ... thinking about asset allocation that will match the characteristics of the liabilities, we spend a lot of time on what is the right mix."
FedEx Corp., Memphis, Tenn., purchased a group annuity contract in May from MetLife to transfer about $6 billion in U.S. pension plan obligations. It was the largest such transaction since the GM and Verizon deals of 2012.
While FedEx did not disclose the specific nature of the assets transferred, the amount in FedEx's U.S. pension plans held in corporate bonds fell to $5.83 billion as of May 31 from $8.16 billion the year before, according to its recent 10-K filing. Cash and cash equivalents fell to $714 million from $1.06 billion the year before. The company's U.S. pension plan assets as of May 31 totaled $22.1 billion.