Last week’s deal by Prudential Financial to take on $26 billion of the retirement liabilities of General Motors has reignited a part of the American insurance market that had been bouncing along the bottom in recent years.
But experts in the sector say GM’s splash was so big, there may be somewhat limited capacity for more mega-sized deals in the market for pension-risk transfers. Still, the market could be in the tens of billions over the next few years, they said.
A Reuters analysis of the pension obligations of the S&P 500 found that almost half of the companies with underfunded pensions have enough cash to spare to do a risk-transfer deal, including Rupert Murdoch’s News Corp. and agriculture giant Archer Daniels Midland Co., suggesting there could be a scramble ahead for that limited capacity.
Known as pension terminal funding, the concept is simple: an employer pays an upfront premium to an insurance company for an annuity that covers all the members of a pension plan.
The insurer becomes responsible, via the annuity, for all of the retirees’ pensions and the sponsor gets to wash its hands of the obligation.
“Starting about a year ago it was the chatter, the chatter picked up … in the last six months, even in the low interest rate environment, transactions are starting to happen,” said Mike Devlin, the head of the Boston office for BCG Terminal Funding, which matches plan sponsors with insurers.
For years, plan sponsors have held off on buying single-premium group annuities to transfer risk, hoping that interest rates would rise from historically low levels, boosting the value of their assets and potentially filling pension gaps without extra cash.
Hewitt Ennisknupp, an Aon unit, estimated there were about 200 single premium group annuity deals done last year, worth about $900 million — just one-third of what had been done even four years previously.
MARKET CATCHING UP
But with rates showing no signs of rising – and even declining further because of the euro zone crisis – the need to get the plans off corporate balance sheets has come to the fore.
These deals are quite similar to what Warren Buffett has successfully done with the asbestos market — insurers pay him a large upfront lump sum and he takes their asbestos liabilities off their hands, betting his ability to earn money on that upfront payment will outstrip the ultimate costs.
Up to now, the pension annuity market had been much more active in the UK, with estimates of just $3 billion in total transfer deals in the United States in the last three years, perhaps one-fifth the size of the British market. One of the executives responsible for the GM deal said that has now changed.
“With the GM transaction, in one fell swoop the (U.S.) pension de-risking market has caught up with where the UK is,” said Dylan Tyson, the Prudential senior vice president who runs the company’s pension risk transfer business. “We’re seeing more activity in this market now than we’ve seen in the last three to five years combined.”
Tyson said Prudential did its first pension transfer deal in 1928, with the public library system in Cleveland, and 84 years later it is still paying “six or seven” pensions as a result.
110 PCT OF LIABILITIES
All of that activity has a cost, though. Given the low interest rate environment, insurers have to charge more upfront (GM paid 110 percent of its liabilities) and then put the money into the highest-returning instruments available.
“Clearly when insurers are looking at entering these types of transactions they’re taking today’s rate environment into account when they’re pricing them,” said Ramy Tadros, head of the Americas insurance practice at Oliver Wyman, which consulted on the GM deal.
Tadros said the capacity for these kinds of deals will have to come from traditional participants, as regulators are unlikely to bless the private equity-backed, special-purpose insurers formed in Britain to take on these liabilities.
Such special purpose companies do not provide nearly the same degree of financial strength and stability U.S. regulators have sought.
“I think capacity in this particular area of terminal funding certainly is not limitless,” said Elaine Sarsynski, executive vice president of retirement services and chief executive of international business at MassMutual.
“There is definitely going to be risk-adjusted capital applied to this business,” she said. “It’s a question of making sure you underwrite with an appropriate return.”
Beyond the availability of capital, there are also questions about compliance with government standards for annuities and retirement plans. BCG’s Devlin said at most a half-dozen insurers comply fully with U.S. Department of Labor guidelines, which are intended to ensure plans are financially sound and safe for consumers.
U.S. regulators have good reason to be careful. The Labor Department’s rules were crafted following the demise of California insurer Executive Life in 1991. The company imploded after heavy investment in junk bonds that were ultimately too risky for such a large pension guarantor.
Sponsors of underfunded pension plans may have few alternatives to topping up their plans and then paying those higher transfer fees, given an environment in which 10-year U.S. Treasuries are yielding about 1.6 percent.
Accounting rules require companies to value estimated future liabilities based on the amount of money they would have to set aside now, minus the yield they could collect from investing in high quality bonds. Lower yields mean more money has to be set aside. And as this discount rate has pushed continually lower, the chance that rising rates will save underfunded pension plans has declined.
“I think you see less certainty that pension liabilities will be reduced by interest rates rising any time in the near future,” said Sean Brennan, a principal in the financial strategy group at Mercer. “Plan sponsors are exhausted at waiting for rates to rise.”
Some 94 percent of the biggest corporate pension plans in the U.S. are underfunded, according to the Reuters analysis. At the close of their 2011 financial years, 322 of 343 S&P companies that report their pension status indicated their plans didn’t have enough assets to meet future pension obligations, to the tune of $363 billion.
GM, with a huge cash pile after its government bailout, was in the unusual situation of having the ability to make up for the underfunding in its salaried workers plan plus pay for an annuity. The company said it was using $3.5 billion to $4.5 billion of cash in the deal.
But even GM might be hard pressed to annuitize its remaining U.S. obligations, which are underfunded by an estimated $12 billion to 13 billion, according to Stephen Brown, senior director at credit agency Fitch Ratings. “It’s a hefty up-front cost,” he said. “And many other companies with underfunded pensions wouldn’t have this much cash lying around.”
The best candidates for future termination deals would be plans closer to full funding that are run by companies with cash available to cover the premiums, Brown said.
The Reuters analysis looked for companies with at least twice the cash needed to do a deal similar to GM’s. The analysis turned up 150 companies with the flexibility to potentially conduct a pension transfer.
Software giant Oracle, semiconductor maker KLA-Tencor and gas producer EQT had among the highest ratios of available cash to the amount needed for a pension deal but all three have relatively tiny pension obligations. Companies with larger plans, like News Corp and Archer Daniels Midland, also made the cut.
“Almost any company could do what GM did,” said John Ehrhardt, principal at actuarial consulting firm Milliman in New York, who reviewed Reuters’ analysis. But because interest rates are at historic lows, pension liabilities are at historic highs, making a potential deal more costly. “That’s the balance the CFO has to make: even if you have the cash on hand, is it worth the hit to de-risk your portfolio?” he said.
KLA, News Corp., Oracle and ADM declined to comment, and EQT did not respond to request for comment.
To be sure, companies that did not make the list could terminate a portion of their pensions, as GM did. And not every company with enough cash to do a termination will do so. GM competitors Chrysler and Ford have both said in recent days that they prefer to use cash for other purposes.
(Additional reporting by Cezary Podkul in New York; Editing by Steve Orlofsky)
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