Risk Management

For Many CFOs, Pension Plans Are Millstones Around the Neck

The massive, high-risk debt weighing down so many defined benefit plans promises to accelerate the pace of pension-risk transfer undertakings.
David McCannDecember 13, 2019
For Many CFOs, Pension Plans Are Millstones Around the Neck

This is the first of two articles on pension risk transfer.

Defined benefit plans were originally instituted to reward Revolutionary War veterans for their service. Since then, they have come to represent a system belonging to a bygone era of graduation-to-retirement jobs held by lifetime employees who receive, in exchange for their service, a promise of guaranteed retirement income correlated to their length of employment at a company.

Where such plans are still offered, responsibility for honoring this promise rests wholly on the company’s shoulders. Employees need to take no action beyond agreeing to join the pension plan, which in most cases simply requires a small deduction from their wages.

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The promise of such a plan can remain valid for more than 60 years. That makes defined benefit pensions, whose aggregate value in the U.S. has risen to more than $6 trillion, a long game indeed.

While these pension plans are still a large part of the U.S. retirement ecosystem, the world of work has changed in such fundamental ways that many would argue they are archaic: labor has become more mobile; the “gig” economy claims more self-employed workers; and more parents are taking career breaks to raise children.

Overall, “lifetime employment” today bears little resemblance to the notion of that concept a few decades ago, when defined benefit pensions were the norm.

Radical changes have vastly affected the composition of the workforce — and by extension the population still served by defined benefit plans. Moreover, the economy experienced plummeting interest rates a decade or so ago. Amid the shifting environment, these funds now require much more principal to be invested in order to get the expected result at payout.

The maintenance and administration of old-school defined benefit plans has consequently become increasingly unsustainable for companies to manage.

Most employers both in the U.S. and the U.K. have of necessity switched from defined benefit to defined contribution plans. These offer much lower benefits and are far less expensive to keep up. The net result has been a shift in responsibility to the employee. These savings plans, such as 401(k)’s, first came into play in the United States in 1978. And so, most pension savers now have a “pot” rather than a promise.

This leaves a vast legacy issue for companies with carried-over defined benefit plans. In many cases, particularly for plans where shortfalls are projected, the challenge they present has divided the attention of CFOs who would otherwise be fully focused on optimizing the company’s present-day finances.

Carrying a defined benefit plan requires hard thinking about longevity trends, interest rates, and investments. With people living longer, pension liabilities rise, and required knowledge about the company’s specific employees and pensioners becomes increasingly complex.

Under a standard asset allocation (60% equities/40% fixed income), when interest rates fall, the company’s liabilities rise, due to lower discount rates and lower investment returns. A modern company’s legacy-defined benefit pension fund might be in surplus, but more often it’s in deficit. This means that without topping it up, a company can’t meet the promises its predecessors have signed up for.

What’s been left behind from these shifts is a mountain of defined benefit pension money that has been promised to employees, but which, to a CFO examining it from a liability viewpoint, has actually become high-risk debt. Many of these plans have increasing deficits.

Moreover, the company that originated the plan might not even still be in business. In fact, right now in the U.S., of the estimated $10.3 trillion worth of assets in country’s largest pension funds, there’s something on the order of $6.6 trillion in defined benefit pension plans.

That figure encompasses all defined benefit plans including public plans, such as state teachers’ pensions. Corporate plans, the focus of this article, comprise about 50% of this number.

Because of the tectonic shifts that have occurred since these plans were set in motion, we are now experiencing what’s probably a once-in-history moment: We estimate that only about 5% of corporate plans have been bought out to date, which means there exists significant opportunity for CFOs to transfer pension risk.

What this boils down to is that a company currently facing potential deficits in a given pension fund may choose to offload that risk to another party.

Pension risk transfer (PRT) thus represents an enormous two-way opportunity, with a lot of capacity to execute. (Full disclosure: we’re a 183-year-old insurance firm with billions in PRT deals currently in play in the U.S. and the U.K.)

Executing these transfers for very long-term success can take some ingenuity. So I’ll close with a story about one of the U.K.’s largest ever pension risk transfer deals, the £4.6 billion ($5.5 billion) Rolls-Royce deal — a transaction our firm completed recently.

At the same time, we had just forged a £4 billion ($5 billion) real estate investment deal with Oxford University, where we are funding the development of housing for post-graduate students and support staff, tech centers, and other income-producing assets.

How exactly are these deals related?

Because of the multifaceted financial structure we’ve built, it’s likely that 50% to 70% of the assets created by the Oxford real estate deal will eventually be funneled into the funding of bought-out pension plans.

In fact, it’s highly feasible that people who are doing post-graduate engineering at Oxford may soon be living and working in facilities that are also paying the pensions of their predecessors who went on to work at Rolls Royce.

Not every PRT deal is this neat or virtuous, but it’s worth pointing out that there are many ways to deliver on funding pensions.

Part 2 of this two-part series will look at who should consider pension risk transfer and different ways to optimize the transfer.

Nigel Wilson is group chief executive of Legal & General, a multinational U.K.-based financial services company. He was appointed to his post in 2012, after having joined the firm as group CFO in 2009.