Corporations with defined-benefit pension plans are beginning to recognize that having a pension plan is just like having an insurance subsidiary. Increasingly, corporate boards are realizing that insurance subsidiaries are not core to their business, so they must decide either to run the pension plan like a life-insurance company or get an insurance company to run it for them.
The federal government does not regulate insurance companies, but in a strange twist, legislation passed in 2006 has made private-sector pension plans look more and more like insurance companies. Many corporate pension plans are shifting their asset allocations heavily toward fixed income to the point where the plans look more like the portfolios of an annuity provider. In some instances, the pension plan can loom so large that the pension liabilities can swamp the market cap of the corporation.
This can mean the company’s success is based on meeting and managing the annuity liabilities it has effectively insured, rather than on its success in its core business. Corporate boards are increasingly focused on this issue. And for some companies, where the size of the pension obligation is large compared with the size of the company, shareholders are asking, “Why do I want to invest in this manufacturing company when it is really in the insurance business?”
In a classic example of the law of unintended consequences, legislation that was designed to make pension plans safer has turned out to be their death knell. Corporations cannot handle the short-term volatility the law has imposed upon them — of course they can’t: they aren’t insurance companies. And for companies that cannot withstand this funding volatility, derisking has become imperative.
The Pension Protection Act (PPA) of 2006 requires that corporations value their pension liabilities each year using a measurement approximately equal to AA corporate-bond rates, which are at once-in-a-generation lows. One such measure, the Citigroup Pension Liability Index, has moved from 6.48% to 4.05% in the past five years. That means a liability valued at $1 billion five years ago could be as high as $1.5 billion today.
The PPA was supposed to protect pensions, but its short-term focus on a long term problem has forced corporate-plan sponsors into a classic liability mismatch. Short-term funding obligations based on a freeze-frame of current interest rates create volatility that a true long-term investor might choose to withstand. (A real insurance company would face less volatility because it would require more expensive premiums and higher funding levels.) But corporate sponsors cannot withstand that volatility in annual funding contributions, so they are freezing or terminating their plans.
Individuals will have less retirement security as a result of this legislation, but one can understand why a shareholder would say, “I want to invest in this company’s core competence, not in a midsize industrial corporation with a gigantic insurance company on the side.”
Recognizing that a pension plan is an annuity insurer leads to two essential options: run it more like an insurance company or pay an insurance company to do it for you.
Outsourcing the insurance subsidiary to a proper insurance company can eliminate the pension liability entirely. General Motors and Verizon took substantial steps, through mega-annuity purchases, to limit the risk they face in their pension plans by striking deals for Prudential to take them over entirely. Ford, GM, and NCR announced they would pay lump sums to certain pension participants, and numerous corporate-plan sponsors issued debt and used the proceeds to fund their pensions.
To operate the pension like an insurance company principally means increasing funding levels and buying high-grade bonds along with overlays. Funding contributions can be made out of cash flow, with company stock, up to a relatively low limit, or the corporation can issue debt and use the proceeds to fund the plan. Ford and Goodyear are among the companies that have recently issued debt to fund their plans.
Issuing debt can make sponsors uncomfortable that they are “crystallizing” debt that is contingent. But the pension is real debt. It is floating-rate debt that the corporation definitively owes. That is borne out by the fact that the ratings agencies regularly look upon these transactions as leverage-neutral while mitigating risk. Besides, if the idea is to run the insurance subsidiary more like an insurance subsidiary, remember that no insurance provider would be permitted to operate at the 75%-funded level that is currently typical in North America.
Other sponsors feel that funding up to a liability that is so high when interest rates are so low is too painful and they should wait. Also, if rates rise enough to make the plan overfunded, those funds cannot be recovered. However, most corporations can issue debt so cheaply in current markets that, combined with the tax deductibility of pension contributions, the effect can be net present value and cash-flow positive. Besides, who thought rates could go lower in 2009 . . . or 2010 . . . or 2011. . .?
In addition to increasing funding levels, corporations will likely continue changing their asset allocations such that they look more like an insurance company. In anticipation of a possible annuity purchase, many corporations are considering asset transitions that will make their portfolio more in sync with the portfolio an insurer would want in such a transaction.
Traditionally, the rule of thumb for corporate pensions’ asset allocations was 60% equities and 40% fixed income. Today it tends to more like 50/40/10, with the 10 being alternative investments. Many corporate plans have gone much further in derisking their portfolios. Ford has stated its intention to move to 80% fixed income, and NCR has stated a goal of 100% fixed income. If the goal is to invest like an insurance provider, a company would need a portfolio that was as high as 80% high-grade corporate bonds (and had much higher funding levels).
There are other ways to move in the direction of running the plan like an insurer that do not go quite so far. Plan sponsors can adopt a dynamic de-risking plan whereby their asset allocation becomes more conservative, but only in a step-wise manner as funded status changes. Or the plan can invest in certain kinds of bonds with cash flows designed to match the cash flow needs of the pension plan. And captive insurance can also provide potential solutions.
Plan sponsors can also take advantage of a 2012 change in law that makes lump-sum calculations more favorable than they had been in the past. More importantly, the GM transaction also made clear that lump sums may be used to pay people who are already retired and in pay status: a change in the pension landscape that makes lump sums a more attractive and more widely available option.
And, of course, plan sponsors can use a “buy-in” to immunize their plan or a buyout to completely eliminate it through an annuity purchase with an actual insurance company. Those transactions can be as complex as an M&A deal and can require many months and numerous work streams and negotiations: after all, it is essentially the “sale” of a subsidiary.
It would be better if the law made it easier for corporations to maintain their pensions intact: more working people would have more retirement security, and corporations would face less volatility in their required contributions. But as long as the law forces the short-term/long-term mismatch, more corporations will be asking, “What are our plans for our insurance subsidiary?”
Charles E.F. Millard is the head of Pension Relations at Citigroup. He was the director of the U.S. Pension Benefit Guaranty Corp. from 2007 to 2009. The views expressed are his own.