MEANS AND MARKETS
HAVE ALIGNED:
Why You Should Consider De-risking Now
By Rohit Mathur and Scott Kaplan
TABLE OF CONTENTS
Introduction............................................................................................3
Why De-risk Now?..................................................................................4
De-risking Options..................................................................................7
Who Should De-risk?...............................................................................9
INTRODUCTION
A resurgent economy, strong equity markets and modestly
higher interest rates are providing a tailwind to plan
sponsors. The change in economic sentiment is driven in
large part by expectations that companies will get a boost
to cash flow from lower corporate tax rates, infrastructure
spending and reduced regulations under the new
administration.
Equities have gained over
12%, and the 10-year U.S.
Treasury has increased by
33bps since the election.1
Sponsors with well-funded plans could consider a large
pension risk transfer transaction to meaningfully reduce
risk. Other sponsors with limited de-risking budgets
could engage in targeted retiree buy-outs or borrow to
improve their plan’s funded position before embarking on
a de‑risking journey. Building a strong defense now may
position companies, particularly those in cyclical industries,
to better endure the next downturn, allowing them to
pursue growth initiatives at a time when their competitors
may be cutting back. This environment could be fleeting,
however, and we believe now is the time to prepare for a
lower-risk future.
1
2
The average funded status of
pension plans has risen from
77% Post-Brexit2 to 85% as of
March 31, 2017.
Costs of maintaining a plan
continue to rise.
S&P Capital IQ as of 5/31/2017.
Source: Milliman Pension Funding Index, as of June 2016.
3
WHY DE-RISK NOW?
Costs of maintaining a plan are increasing—Pension Benefit Guaranty Corporation (PBGC) premiums—
both flat-rate and variable rate—have increased significantly3 and are a cash drain for plan sponsors.
•• The flat-rate premium will increase to $80 by 2019, a 16% increase compared to the current rate.
•• The percentage of unfunded vested liability that must be paid in variable premiums will escalate to at least 4.2%
in 2019, an increase of 24% over today’s cost.
•• The unvested pension liability, used to calculate variable premiums, will increase next year when the IRS adopts
a new mortality basis (RP-2014 with scale MP-2016).
•• PBGC premiums are even more burdensome on pensioners with small benefits.
Plan sponsors are facing rapidly rising costs to manage their plans
PBGC Annual Premiums
$100
$90
Flat Rate
(Per participant)
$80
80
74
Variable Rate
(Per $1,000 underfunded)
$70
69
64
$60
57
49
$50
42
$40
42
35
34
$30
37
30
24
$20
14
$10
9
9
2012
2013
$0
2010
3
2011
2014
2015
2016
2017
2018
2019
Source: PBGC (http://www.pbgc.gov/prac/prem/premium-rates.html)
Favorable economic conditions and anticipated tax reform—An improved outlook for growth and
gradual Federal Reserve monetary tightening policies have helped equities advance and interest rates
recover from their mid-summer lows. The average plan is now 85% funded, compared to 79% one
year ago.4 Funded status is expected to improve further if tax reform proposals are implemented.
Sponsors may want to consider accelerating pension contributions to maximize higher tax deductions
as tax rates may be lowered to 15% or 20% under current proposals. Additionally, if implemented,
the proposed one-time lower tax rate on overseas earnings should encourage companies to repatriate
cash, which could be used for pension contributions.
4
Source: Milliman 100 Pension Funding Index, March 2017.
4
Funded status has improved since Brexit
Milliman 100 Funded Status
125%
123.1%
120%
115%
110%
105.8%
105%
100%
95%
90%
88.0%
85.3%
85%
82.0%
80%
78.6%
77.1%
75%
20
00
20
01
20
02
20
03
20
04
20
05
20
06
20
07
20
08
20
09
20
10
20
11
20
12
20
13
20
14
20
15
Ja
n16
Fe
b16
Ma
r-1
6
Ap
r-1
Ma 6
y-1
6
Ju
n16
Ju
l-1
6
Au
g16
Se
p16
Oc
t-1
No 6
v1
De 6
c16
Ja
n17
Fe
b17
Ma
r-1
7
70%
Source: Milliman Pension Funding Index, March 2017.
As funded status improves, plan sponsors face an increasingly asymmetric risk and reward
profile—Sponsors that retain risk assets as funded status improves receive diminishing economic
benefits as excess funds cannot be used for other business purposes and are disregarded by rating
agencies in their evaluation of leverage, while downside risk grows. Equity markets also possess
asymmetric characteristics. An analysis of Shiller’s Cyclically Adjusted Price to Earnings ratio (CAPE),
a measure widely used in the market, reveals that the stock market is richly valued today, with a CAPE
ratio of 29.2 in April 2017, which is in the 95th percentile of historic market valuations.
5
Equity markets exhibit significant asymmetry
Shiller P/E Ratio
140
120
100
FREQUENCY OF OBSERVATIONS
80
60
40
April 2017 Ratio: 29.19
(Average: 16.8 Median: 16.1)
Falls within highest 3.91% of observations.
20
7
0
1
3
5
7
9
11
13
15
17
19
21
23
25
27
29
31
33
35
37
39
P/E RATIO
Source: Robert J. Shiller, www.econ.yale.edu/~shiller/data/ie_data.xls. Historical data is on a monthly basis, dating back to 1881.
Interest rates have risen, signaling a strong domestic economy and prospects of higher inflation.
However, lackluster growth in the rest of the developed world sets a ceiling on U.S. rates. The United
States is among the highest yielding developed countries, with 10-year government bonds in Japan
and Germany close to 0%. Plus, continued demand for long-dated bonds from pension plans and
insurers, and potentially reduced bond supply under the new administration’s tax reform proposals,5 is
likely to put continued pressure on long bond yields. These factors suggest sponsors are better off not
waiting for a further rise in interest rates, since a low-for-longer rate scenario cannot be ruled out.
Efficient pension risk transfer market—The pension risk transfer market continues to evolve with
the entry of new players and innovative solutions, such as the recent multi-insurer split transactions
executed for PPG, Kimberly-Clark and Philips. Sponsors with plans of all sizes can find a competitive
market for their de-risking needs, with over 26 transactions executed last year in the $100 million to
$1 billion range, and two transactions over $1 billion. WestRock, United Technologies and PPG are
some of the more well-known firms to transfer pension risk in 2016.
5
Rohit Mathur, Peter Kahn and Nida Ozair, "Accelerate Pension Funding and De-risking Ahead of Tax Reform: A Less Taxing Exercise," Prudential Retirement, June 2017.
6
41
43
45
DE-RISKING OPTIONS
Well-funded plans—Plans that are well-funded may want to consider a
pension buy-out to address risk. In recent years, sponsors have focused on
transferring liabilities associated with retiree populations, which are the most
efficient to buy out.
•• Large retiree buy-outs—Retirees are typically the largest pool of plan participants,
so plan sponsors can settle a significant amount of liability for an attractive price.
Large scale buy-outs are the most effective way to achieve significant risk and
expense reduction. General Motors, Verizon and Motorola are among the prominent
sponsors that have executed large retiree buy-outs to address pension risk.
Underfunded plans—Plan sponsors with underfunded plans have multiple
solutions. They can either target a specific population to buy out today, or
issue debt to improve the funded status of their plans before embarking on a
de-risking strategy.
Retiree liabilities:
•• Shorter life expectancy
•• Less longevity risk
•• Reduced investment risk
•• No behavioral risk
•• Targeted small-benefit retiree buy-outs—Targeted buy-outs can help sponsors
de‑risk with maximum benefit, while respecting their limited de-risking budgets.6
Plan sponsors can work with a consultant, and partner with insurers who can provide
insight on current market pricing for cohorts within the retiree population. The retiree
cohorts offering the greatest efficiency are those with the smallest benefits, those that
have been in retirement the longest, and those who worked in blue collar positions.
The most common approach to selecting a target population is to start with retirees
having the smallest benefit, because they tend to have shorter life expectancy than
those with larger benefits, as benefit size is generally indicative of wealth and access
to quality healthcare. Therefore, an annuity for a small benefit participant will be less
expensive per dollar of pension benefit than an annuity for a large benefit participant.
Additionally, small benefit cohorts also offer another opportunity for cost savings
since PBGC premiums and administrative costs are significantly larger on a relative
basis for small benefit cohorts.
This type of strategy may offer the certainty plan sponsors want and the benefit
security plan participants need. However, before deciding which population to
annuitize, the sponsor should consult the plan’s independent fiduciary to ensure the
selection process was conducted in accordance with applicable laws and regulations.
•• Borrowing to fund7—Companies can also reduce expenses and enhance their
capital structure by taking advantage of a borrow-to-fund strategy to replace volatile,
expensive pension debt with lower cost, fixed‑rate obligations. Despite the recent
rise in interest rates, this could still be a net present value (NPV) positive strategy
for certain plan sponsors. In fact, just this year, several notable plan sponsors have
issued debt for this specific purpose, including FedEx Corp. ($1 billion), Delta Air
Lines ($2 billion), DuPont ($2 billion) and Verizon ($3.4 billion). This comes on
the heels of a robust second half of 2016, when more than $3.2 billion of pension
contributions were made using a borrow-to-fund strategy.
argaret McDonald and Peter Kahn, “Pension Risk Transfer on a Budget: Plan Sponsors Take Aim at Targeted Buy-outs,” Prudential Retirement. Published in the 2016 Institutional
M
Investor Journals’ Guide to Pension and Longevity Risk Transfer, Fall 2016.
7
Rohit Mathur, Scott Kaplan and Peter Kahn, “Borrowing to Fund Pensions Could Enhance Shareholder Value,” Prudential Retirement, May 2016.
6
7
Small benefit liabilities are the least efficient for plan sponsors to hold
140%
126%
117%
120%
113%
111%
109%
100%
100%
75%
80%
60%
50%
40%
25%
20%
0%
40%
15%
10%
5%
1%
<$1,250
<$2,500
<$5,000
<$10,000
Total
Annual Benefit Size
The smallest benefit sizes
are the most expensive
liabilities for the sponsor
to maintain. As you
can see, the economic
liability for these benefit
sizes is high due to
administrative costs,
PBGC expenses and
investment management
expenses which are
disproportionately large
relative to the size of
the benefit.
Economic Liability as a % of GAAP PBO
Headcount as a % of Retiree Total
GAAP PBO as a % of Retiree Total
Note: GAAP and economic liabilities reflect RP-2014 mortality table with MP-2016. GAAP liability is calculated by discounting projected cash flows using
spot rates along the Citigroup Pension Discount Curve. Economic liability is calculated by discounting projected cash flows using spot rates along the
Citigroup Pension Discount Curve adjusted for investment management fees and the risk of credit defaults and migrations. These are estimated at 30 and
24 basis points, respectively. It also assumes per person administrative expenses of $40 per year and PBGC expenses per person of $69 in 2017, $74 in
2018, $80 in 2019 and indexed thereafter, plus PBGC variable rate premiums of 3.4% of unfunded vested benefits in 2017, 3.8% in 2018, 4.2% in 2019,
and indexed with inflation thereafter, capped at $517 per person in 2017 and indexed with inflation thereafter. Funded status for variable rate premium
assumed to be 85%.
8
WHO SHOULD DE-RISK?
Pension-heavy companies—Studies have shown pensions
weigh on the stock prices of pension-heavy companies by
increasing a company’s beta and cost of capital. This is
because a firm’s stock beta typically reflects the riskiness
of the company, including its pension plan.8 This risk has
manifested itself through plan contributions—S&P 500
companies have contributed approximately $300 billion to
their plans since year-end 2000, significantly constraining
their cash flow and financial flexibility.9 In times of crisis,
pension heavy stocks underperform the market, and during
these times, pension de-risking discussions often take
center stage on earnings calls and in corporate boardrooms.
However, in good economic times, pension discussions are
often relegated, and companies tend to focus on earnings
growth and cash return strategies. By implementing risk
management strategies in good times when they have the
means to do so, companies can build a strong defense so
they can prosper even during a downturn.
Cyclical companies—Certain companies are more
vulnerable to swings in the business cycle or the prices of
commodities, and tend to suffer when both the business
and the pension plan underperform simultaneously during
a downturn, impeding financial flexibility. As a result of their
sensitivity to economic forces outside of their control and
generally high degree of operating leverage, these sectors,
such as consumer discretionary and materials, tend to
possess high cash flow volatility relative to other areas of
the economy. Companies in these sectors become more
vulnerable if they sponsor a large pension plan, and tend to
significantly underperform compared to their less pension
heavy peers, as shown below.
Pension risk may have the greatest impact on the valuation of cyclical firms
Consumer Discretionary
$8
Materials
$8
$7.01
$6
Cumulative Returns
$4
$2
$1.51
Pension Heavy
$2
Pension Light
Pension Heavy
L ong, Bronsnick and Zwiebel, “How Corporate Pension Plans Impact Stock Prices,” Morgan Stanley, 2010. Jin, L., R. Merton, and Z. Bodie. “Do a Firm’s Equity
Returns Reflect the Risk of Its Pension Plan?” Journal of Financial Economics 81, No. 1 (July 2006): 1-26.
9
Bronsnick and Cost, "Plugging the Pension Cash Drain," Morgan Stanley, April 2017.
9
16
20
20
Pension Light
Note: Represents the value of $1 invested in each segment at the beginning of the period. A comparable percentage return can be obtained by subtracting 1
from the final number (i.e., 6.41 – 1 = 541% return). PBO ÷ Market Cap of companies are sorted annually by quartile to determine pension heavy and pension
light groupings. Calendar year total returns for each grouping are averaged annually. Firms in this study may migrate into or out of the pension heavy or pension
light groupings based on their annual pension overhang relative to the quartile thresholds.
8
14
12
20
10
20
08
20
06
20
04
20
02
20
00
98
19
16
20
20
14
12
20
10
20
08
20
06
20
04
20
02
20
00
20
98
$3.81
$4
$0
$0
19
$6
20
Cumulative Returns
$6.41
10
DE-RISK WHILE YOU HAVE THE MEANS TO DO SO
The current economic and regulatory landscape has produced desirable conditions for pension
de-risking. However, this environment could be short-lived. By implementing risk management
strategies while they have the means to do so, companies can build a strong defense now so they
can pursue growth initiatives even during a downturn.
11
pensionrisk.prudential.com
Rohit Mathur leads the Global Product and Market Solutions team
at Prudential Retirement that creates original research on the
corporate finance implications of pension risk management. He has
also helped structure and execute large pension risk transfer
transactions. Formerly, he worked at Moody’s and UBS on various
corporate finance, risk and pension related issues.
E: [email protected]
T: 973-367-8507
Scott Kaplan is the head of Prudential Retirement’s Pension Risk
Transfer business. He works with multiple teams of over 240 people
to deliver risk transfer solutions for pension plan sponsors that help
secure retiree benefits. Scott previously led the Global Product and
Market Solutions team, and was also a managing director in the
Treasurer’s Department. Scott is a CFA Charterholder and a CPA.
E: [email protected]
T: 973-367-8506
The analysis provided is a general communication that should not be construed as tax, legal or investment advice to any individual or entity.
Any individual or entity that has questions as to the tax and other legal implications of the matters discussed above based on its particular
circumstances should consult with and rely on its own advisors and legal counsel. This document does not constitute an offer or an agreement,
or a solicitation of an offer or an agreement, to enter into any transaction (including for the provision of any services). Prudential Financial,
its affiliates, and their financial professionals do not render tax or legal advice. Please consult with your tax and legal advisors regarding your
personal circumstances. Insurance and reinsurance products are issued by either Prudential Retirement Insurance and Annuity Company
(PRIAC), Hartford, CT, or The Prudential Insurance Company of America (PICA), Newark, NJ. Both are wholly owned subsidiaries of Prudential
Financial, Inc. Each company is solely responsible for its financial condition and contractual obligations.
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0306164-00001-00PRTWPRE2
06/2017