Challenges facing plans on risk transfer runway

With the recent volatility in U.S. Treasury yields, corporate defined benefit plans heavily weighted to fixed income have new challenges when considering pension risk transfer transactions.

Insurance companies that take on the liabilities transferred from DB plans should weather the storm because of their emphasis on capital efficiency, industry experts said. But falling rates mean they will charge higher premiums for group annuity purchases, which — along with plummeting discount rates and severe equity drops — will affect the ability of corporate DB plans to pull the trigger on pension risk transfer transactions.

As of March 20, the 10-year U.S. Treasury yield had dropped to 0.85% after being as high as 1.65% as recently as Feb. 5, while the high-grade 10-year U.S. corporate yields were 2.4%.

The most desired asset class for asset-in-kind transfers to insurance companies is high-quality long-duration corporate bonds, and most pension funds that manage their liability-driven investing strategies with the goal of matching those assets to the kinds that insurers desire are in decent position, ers desire are in decent position, industry experts say.

However, the Treasury yields do play a significant role for insurance companies because the two main pricing components for pension risk transfer are the liabilities and the investment returns one needs to meet those liabilities, said Mike Siegel, managing director and global head of insurance asset management at Goldman Sachs Asset Management, New York.

"The benefit payouts are not going to change based on the Treasury level, but the investment returns will, and if insurance companies are going to be receiving less investment returns going forward, they're going to charge more to transfer those liabilities," Mr. Siegel said.

"What are the implications though? It depends on plan by plan because some plans are very well-balanced, very well-hedged against low interest rates," he said.

Ari Jacobs, Chicago-based senior partner and global retirement solutions leader at Aon PLC, agreed that the absolute dollar amount of premiums will go up as rates go down. From the perspective of the cost relative to the pension liabilities, however, that cost has yet to be determined, he said.

According to the Mercer U.S. pension buyout index, the average cost of purchasing group annuity contracts for U.S. corporate DB plans was 104.3% of plan liabilities as of Dec. 31, while the economic cost of maintaining the plan was 106% of liability. More recent figures are not available.

"On a relative basis, that's the sort of the analysis (plans still need to make). Is the price appropriate compared to my liability? Am I getting a good settlement compared to my liability?" Mr. Jacobs said.

"There's different pressure on insurance companies and because of that, good prices could be found because insurance companies could be competing aggressively for these kinds of transactions," he said.

Beth Ashmore, St. Louis-based head of retirement intellectual capital at Willis Towers Watson PLC, said while corporate defined benefit plans may be well-insulated from the shock of falling Treasury yields because they are far along in their derisking strategy, they may hold off on PRT transactions.

"Other corporate priorities, quite frankly, are going to take precedent depending on the business implications we're seeing," she said.

As of March 20, the S&P 500 had returned -25.65% since Feb. 1, while the Bloomberg Barclays US Treasury 25+Y Total Return index returned 4.5% through March 19.

"Sponsors that are largely hedged (can say) we're insulated from this. We're already pretty far down the path. Those sponsors may be able to continue moving forward," she said.

There were a record-breaking 501 buyout sales in 2019, totaling $28 billion, according to the LIMRA Secure Retirement Institute. That number is expected to be smaller in 2020.

Kevin McLaughlin, head of liability-driven investing at Insight Investment, New York, said in the short term, pension risk transfer activity will slow considerably.

"I would say for the vast majority, the recent market events are going to put PRT activity completely off the table or on the back burner," Mr. McLaughlin said.

Plans have taken such a significant hit to funded status recently, they will not be able to execute transactions without large cash contributions to the plans, Mr. McLaughlin said.

Recent estimates from money manager Barrow, Hanley, Mewhinney & Strauss LLC show the average U.S. corporate pension plan funding ratio has fallen more than 12 percentage points year-to-date through March 12 to 76.6%, from 88.7% as of Dec. 31.

The lower the funding ratio, the less likely a plan is able to execute PRT transactions without injecting cash into the plan.

With other economic concerns for companies — for example, making sure they have working capital, liquidity and are able to roll over their debt — it is unlikely companies will want to make the necessary discretionary contributions, which is short-term bad news for PRT deal flow, Mr. McLaughlin said.

The deal flow will not end entirely, however. Some plans will be able to execute some kinds of transactions.

Mr. Jacobs said companies that have been planning full terminations of corporate DB plans should still see those go forward in 2020 since those kinds of transactions take a year or more to plan.

"Terminations in the docket that are scheduled for the second half of 2020 were put in motion back in the second half of 2019 and before," Mr. Jacobs said. "That market continues and will continue."

What the current volatility will affect are "liftout" transactions, simply lifting out a certain population of participants from a plan and transferring their liabilities to the insurance company. It is a shorter-term decision, Mr. Jacobs said.

Mr. McLaughlin said some of these shorter-term decisions will be difficult to execute in the volatile environment.

Insurance companies that take on the high-quality credit portfolios of plans following PRT transactions want to place those portfolios in their general accounts, Mr. McLaughlin said. "They may not have the ability to do that right now."

"For insurance companies, they're looking to broadly hold a portfolio of corporate bonds and other structured credit investments so their pricing could look somewhat (better), but it depends how much of the spread they pass through. There is a scenario where insurance companies get more aggressive if we can work our way through this short-term volatility and things normalize and spreads are still wide, and that could enable insurance companies to provide better prices," Mr. McLaughlin said.

"Generally speaking, the insurance companies will want to be able to get attractive pricing in the structured credit markets and they will be keen to keep the deal flow open," Mr. McLaughlin said.

The insurance companies that receive those transferred liabilities should expect no material change in the way they do business.

"The industry is well-capitalized and it's well-regulated, and also the investment portfolios of these companies are very well-diversified, so I have no concerns from a solvency perspective," GSAM's Mr. Siegel said.

"The longer this persists, the more credit losses you will see the industry bearing," said Mr. Siegel, "but that's expected. They are reserved for that and they hold sufficient capital for that.