Pension Risk in a New Era

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In the wake of the global financial crisis, many finance executives are struggling to address risk and funding issues surrounding defined benefit (DB) pension plans.

This Towers Watson presentation discusses how leading organizations are approaching the risk and financial issues around their DB plans and share findings from our just completed 2010 Pension Risk Survey.

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Pension Risk in a New Era

  1. 1. Pension Risk in a New Era Towers Watson-Forbes 2010 Pension Risk Survey November 10, 2010 © 2010 Towers Watson. All rights reserved. Matt Herrmann, Leader – Retirement Risk Management Group Mark Ruloff, Director of Asset Allocation – Towers Watson Investment Services
  2. 2. 2towerswatson.com © 2010 Towers Watson. All rights reserved. Proprietary and Confidential. For Towers Watson and Towers Watson client use only. About the Pension Risk Survey Fielded from September 8, 2010 – October 8, 2010 Seeks to gain insight into how leading organizations are approaching DB plan risk and related financial issues Provides new insights about the current trends and practices of pension plans Includes responses more than 304 U.S. executives in charge of pension finance at large companies
  3. 3. 3towerswatson.com © 2010 Towers Watson. All rights reserved. Proprietary and Confidential. For Towers Watson and Towers Watson client use only. 9% 11% 12% 13% 16% 25% 26% 41% 47% 56% 0% 10% 20% 30% 40% 50% 60% Percentage of Respondents in the U.S. Companies are most concerned about the DB plan’s impact on cash flow over the next five years Top Concerns of DB plan sponsors over next five years Impact on our cash flow Conforming to regulatory requirements Impact on investors perception of our company Impact on our credit rating Orderly exit of older workers Lack of appreciation from employees Impact on attraction and retention of workers Impact on public perception of company Impact on our balance sheet Impact on our income statement
  4. 4. 4towerswatson.com © 2010 Towers Watson. All rights reserved. Proprietary and Confidential. For Towers Watson and Towers Watson client use only. Pension funded status has declined materially over the past 10 years with significant volatility along the path Towers Watson Pension Index 60 70 80 90 100 110 120 130 140 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 Rising discount rates and strong investment performance during September and October increased benchmark funded ratio by 8% since August lows 68.3 as of 10/31/10
  5. 5. 5towerswatson.com © 2010 Towers Watson. All rights reserved. Proprietary and Confidential. For Towers Watson and Towers Watson client use only. As financial conditions decline, ability to act decreases, yet desire to act increases 60% 65% 70% 75% 80% 85% 90% 95% 100% 105% Funded Status When funded status is low (typically following a period of poor market conditions), Desire to reduce pension risk is high, but cost to de-risk often results in Ability being low As funded status improves, so does the Ability to implement de-risking solutions. However, the memory of the “pain” has diminished, and Desire often falls Ability increases Desire increases
  6. 6. 6towerswatson.com © 2010 Towers Watson. All rights reserved. Proprietary and Confidential. For Towers Watson and Towers Watson client use only. 19% 22% 4% 5% 22% 42% 58% 61% 50% 13% 28% 57% 69% 34% 17% 16% 19% 41% 54% 4% 5% 7% 4% 5% 6% 11% 2% 5% 2% 2% 12% 5% 16% 33% 35% 1% 2% 2% 3% 7% 0% 20% 40% 60% 80% 100% Effect of Financial Crisis Financial crisis reduced sponsors’ commitment to DB plans, despite higher employee appreciation Strongly Negative Effect Slightly Negative Effect No Effect Slightly Positive Effect Strongly Positive Effect Impact of DB Plan on cash flow Impact of DB Plan on financial statements Investors’ concern about your DB plan Company’s long-term commitment to its DB plan Impact of DB Plan on ability to raise capital through debt or equity The financial strength of your company's DB plan Employee appreciation of the DB plan Retirement pattern of older workers
  7. 7. 7towerswatson.com © 2010 Towers Watson. All rights reserved. Proprietary and Confidential. For Towers Watson and Towers Watson client use only. Over half of plan sponsors expect to change the DB promise in the future 49% 47% 29% 16% 15% 22% 1% 7% 6% 8% 0% 20% 40% 60% 80% 100% Open Plans Closed Plans Percentage of Respondents in the U.S. Maintain DB, but Change Future Design No Changes Planned Seeking Alternatives to DB Seeking to Terminate the Plan Other Sponsors who have already taken the step to close the plan expect to seek alternatives to DB in the future Sponsors with plans that are currently open to new entrants as likely to change future DB design
  8. 8. 8towerswatson.com © 2010 Towers Watson. All rights reserved. Proprietary and Confidential. For Towers Watson and Towers Watson client use only. Hybrid regulations may also lead to further changes down the way The IRS released final and proposed Hybrid regulations in October Final regulations may provide another design opportunity for plan sponsors with traditional defined benefit plan designs In addition, sponsors of existing plans may review their Hybrid plans for compliance, especially around the interest crediting rate for cash balance plans related to the proposed regulations
  9. 9. 9towerswatson.com © 2010 Towers Watson. All rights reserved. Proprietary and Confidential. For Towers Watson and Towers Watson client use only. Sponsors’ cash flow concerns prompting some to change funding policy Contribute the amount that ensures the plan is fully funded Contribute enough to achieve explicit funding targets Contribute the maximum tax-deductible amount Make ad hoc decisions on pension funding without a formal funding policy Contribute the legal or negotiated minimum payment 0% 10% 20% 30% 40% Defined Benefit plan funding policy prior to the crisis and today Policy Today Policy Prior to Crisis
  10. 10. 10towerswatson.com © 2010 Towers Watson. All rights reserved. Proprietary and Confidential. For Towers Watson and Towers Watson client use only. Majority of companies focused on aligning plan assets with liabilities to reduce risk 26% 16% 8% 5% 22% 16% 15% 6% 21% 32% 26% 19% 17% 23% 30% 31% 6% 9% 14% 35% 8% 3% 6% 3% 0% 20% 40% 60% 80% 100% How likely is your company to use the following strategies to reduce risk in its DB plan over the next five years? Very Unlikely Somewhat Unlikely Equally Likely/ Unlikely Somewhat Likely Very Likely Don’t Know Capital market innovations (e.g., moving benefits to captive insurance vehicles) Governance structure redesign (e.g., more formal decision-making structures for the plan to enable better decision making) Greater focus on dynamism (e.g., to capture long-term investment opportunities when extreme market pricing moves in your favor) Better alignment of assets with liabilities (e.g., buy-ins, liability-driven investment)
  11. 11. 11towerswatson.com © 2010 Towers Watson. All rights reserved. Proprietary and Confidential. For Towers Watson and Towers Watson client use only. Asymmetric risk is driving plan sponsors to reduce risk as plans become better funded 100% LDI (100% DD) 90% LD I(100% D D ) 80% LD I(100% D D ) 70% LD I(100% D D ) 60% LD I(100% D D ) 50% LD I(100% D D ) 40% LD I(100% D D ) 30% LD I(100% D D ) 20% LD I(100% D D ) 10% LD I(100% D D ) 0% LD I(100% D D ) 100% LB 90% LB 80% LB 70% LB 60% LB 50% LB 40% LB 30% LB 20% LB 10% LB 100% AB 90% AB 80% AB 70% AB 60% AB 50% A B C urrent 30% A B 20% A B 10% A B 0% A B $0 $2,500 $5,000 $7,500 $10,000 $0 $25 $50 $75 $100 PV Contributions plus Deficits (PBO) ($M) 95th Percentile PVContributionsplusDeficits(PBO)($000) 50thPercentile Desirable Duration Matching strategies are attractive under this measure to manage both the expected and worse cases LDI portfolios 60% – 90% have no expected contributions (50th percentile) Well-Funded Frozen Plan
  12. 12. 12towerswatson.com © 2010 Towers Watson. All rights reserved. Proprietary and Confidential. For Towers Watson and Towers Watson client use only. Interest rate risk is the primary focus for companies who use financial instruments to manage risk Financial instruments used to manage risks in DB plans 14% 26% 30% 31% 39% 39% 0% 10% 20% 30% 40% 50% Option-based Strategies Interest-rate Futures Interest-rate Swaps Currency Forwards Mortality Swaps Credit Derivatives
  13. 13. 13towerswatson.com © 2010 Towers Watson. All rights reserved. Proprietary and Confidential. For Towers Watson and Towers Watson client use only. Explicit assumptions regarding future plan administration costs and taxes payable by plan on contributions and benefit payments Disaggregate components of cost Expanded disclosures to provide insight about nature of plan and risks Interest cost and expected return on plan assets replaced with net interest income/expense Immediate recognition of all changes in funded position Balance Sheet & Comprehensive Income Potential accounting changes may also impact behavior Comprehensive Income (P&L + OCI) Balance Sheet & P&L Financial Reporting & Disclosure
  14. 14. 14towerswatson.com © 2010 Towers Watson. All rights reserved. Proprietary and Confidential. For Towers Watson and Towers Watson client use only. Current accounting rules encourage risk taking and the proposed rules may not Desirable Current Proposed $125 $0 $25 $25 $75 ($50) $0 $50 $100 $150 $200 PV of Cumulative IAS 19 Pension Expense ($M) 95th Percentile PVofCumulativeLAS19PensionExpense($M) 50thPercentile 100% Equities 50% Equities/50% Long Bonds 100% Long Bonds 100% Equities 100% Long Bonds Asset/Liability Frontier – Year 2019
  15. 15. 15towerswatson.com © 2010 Towers Watson. All rights reserved. Proprietary and Confidential. For Towers Watson and Towers Watson client use only. Private equity is the most common alternative investment for pensions, but more companies are holding company stock 23% 26% 38% 43% 62% 0% 10% 20% 30% 40% 50% 60% 70% Percentage of Respondents in the U.S. Private Infrastructure Alpha-seeking strategies that utilize short-selling or derivatives Company stock Private Real-Estate Private-Equity Of the companies who reported holding Company Stock, almost 60% said they have contributed stock to the pension fund in lieu of cash
  16. 16. 16towerswatson.com © 2010 Towers Watson. All rights reserved. Proprietary and Confidential. For Towers Watson and Towers Watson client use only. Dynamic strategies are being considered to help organizations take action as funded status improves Funded Ratio Bond Allocation One-Way Dynamic Funded Ratio Bond Allocation Two-Way Dynamic Standard Approach Funded Ratio Bond Allocation
  17. 17. 17towerswatson.com © 2010 Towers Watson. All rights reserved. Proprietary and Confidential. For Towers Watson and Towers Watson client use only. Lump Sums / Dynamic Allocations Annuity Products / LDI Partial Settlement Termination/ Immunization Connecting funded status to market activity Funded Status > 80 % > 90% > 100% > 110% EOY 2007 95% 80% 53% 30% EOY 2008 31% 14% 6% 3% EOY 2009 47% 14% 6% 5% General Trends Connecting Funded Status to Market Activities Distribution of Funded Status of Large Plans by Year
  18. 18. 18towerswatson.com © 2010 Towers Watson. All rights reserved. Proprietary and Confidential. For Towers Watson and Towers Watson client use only. Prevalence of lump sums and annuity purchases expected to increase in the future How Likely Are You to Do the Following to Reduce Pension Obligations? 24% 42% 28% 28% 26% 31% 13% 13% 14% 21% 22% 26% 27% 26% 28% 25% 12% 22% 17% 20% 14% 6% 4% 15% 8% 6% 5% 8% 8% 8% 6% 8% 8% 16% 12% 14% 0% 20% 40% 60% 80% 100% Offer lump sum to terminated vested participants next year Add lump sum option for current active participants next 2 to 5 years Add lump sum option for current active participants next year Purchase annuities for pension plan next year Purchase annuities for pension plan next 2 to 5 years Offer lump sum to terminated vested participants next 2 to 5 years Very Unlikely Somewhat Unlikely Equally Likely/ Unlikely Somewhat Likely Very Likely Don’t Know
  19. 19. 19towerswatson.com © 2010 Towers Watson. All rights reserved. Proprietary and Confidential. For Towers Watson and Towers Watson client use only. The changing lump sum rules make transfer of the obligation to participants more attractive for most plans $0 ($1,000) ($1,000) Liability (Savings)/ Cost ($2,500) ($3,500) ($4,000) Additional Operational (Savings) $126,000 $83,000 $56,000 Historical Lump Sum Basis $109,000 $56,000 $32,000 PPA Lump Sum Costs (2012) $109,00060 $57,00050 $33,00040 Accounting Liability Age Illustrative lump sum values for $1,000 monthly benefit*: * Analysis shown above for deferred to 65 annuities, payable as a life option. Historically, lump sum pay-outs were based on 30-year Treasury bond rates Under PPA, interest rates for minimum lump sum value calculations are based on bonds rated from A to Aaa Savings also exist due to the elimination of future operating expenses but additional considerations (opportunity costs, accounting issues, PPA threshold issues, etc.) will have a significant influence on viability of approach
  20. 20. 20towerswatson.com © 2010 Towers Watson. All rights reserved. Proprietary and Confidential. For Towers Watson and Towers Watson client use only. Significant effort and planning will be required to act JOINT TEAM HR/LEGAL TEAM Q4 2010 – Q1 2011 Feasibility and Design Q1 – Q3 2011 Preparation Project Coordination Implementation Q4 2011 – 2012 Economic feasibility analysis: Cash funding requirements One-time and ongoing P&L costs Operational costs Investment strategy Operational Feasibility Assessment Administrative Feasibility Assessment Data Quality Assessment Process overview and steps Legal and Bargaining Assessment Design decisions on: Temporary vs. permanent provision Groups to include Early retirement subsidies Lump sum value basis FINANCIAL TEAM JOINT TEAM HR/LEGAL TEAM Desired timing/triggers Monitor economic conditions and plan funded status Interim investment strategy Participant communication strategy DC provider/rollover opportunities Confirm trustee interaction Data cleanup Missing participants Plan document/SPDs Election packets Calculation process FINANCIAL TEAM FINANCIAL TEAM JOINT TEAM HR/LEGAL TEAM Prepare and send calculations and election packets Process election forms Call center Participant follow-up Final determination of P&L impact Cash funding projections Liquidity and investment strategy implementation Plan amendments enacted Monitor acceptance rate and impact on plan funded status
  21. 21. 21towerswatson.com © 2010 Towers Watson. All rights reserved. Proprietary and Confidential. For Towers Watson and Towers Watson client use only. Towers Watson – Equity Analyst Survey How do Equity Analysts view Pension Risk?
  22. 22. 22towerswatson.com © 2010 Towers Watson. All rights reserved. Proprietary and Confidential. For Towers Watson and Towers Watson client use only. About the Analyst Survey 32% 2% 53% 5% 8% Domestic plans only International plans only Domestic and international plans None of the above Don't know 8%Don't know 25%More than $10 billion 10%$5 billion to $10 billion 39%$1 billion to $5 billion 18%Less than $1 billion 0%None Types of defined benefit pension plans Total amount of pension liabilities held by the company with the largest plan(s)
  23. 23. 23towerswatson.com © 2010 Towers Watson. All rights reserved. Proprietary and Confidential. For Towers Watson and Towers Watson client use only. Most important factors analysts consider in their performance assessments Notes: Respondents were asked to consider all companies they cover that sponsor defined benefit pension plans. Percentages indicate responses of “To a great extent” or “To a very great extent.” 49% 49% 38% 32% 28% 18% Size of pension deficit (surplus) relative to size of the organization Size of pension plan cash funding requirements Size of pension obligations relative to size of the organization Size of earnings impact from pension plans Volatility in pension plan cash funding requirements Volatility in earnings impact from pension plans
  24. 24. 24towerswatson.com © 2010 Towers Watson. All rights reserved. Proprietary and Confidential. For Towers Watson and Towers Watson client use only. 2% 6% 10% 10% 14% 27% 33% 45% 49% % %Changes to Pension Investment StrategyPension Risk Reduction Strategies None of the above Other Partial pension obligation settlement by transferring obligations to a third party (annuity option) Partial pension obligation settlement by transferring obligations to participants (lump sum option) Changing the pension investment strategy to better match pension obligations Complete wind-up of pension plan Freezing the plan for all employees Closing the plan to new hires Plan design changes, e.g., converting the pension plan to a hybrid (cash balance) plan 0%Other 16%Increasing equity exposure 18%Increasing fixed income exposure 24%None of the above 27%Using alternative investments (such as swaps) to better match the pension liability profile 39%Using alternative investments to improve diversification and/or lower the volatility of the equity profile 45%Extending the duration of fixed income assets to better match the pension liability profile Notes: Respondents were asked to consider the company they cover that has the largest defined benefit pension plan. Analysts’ view hybrid conversions and matching duration of assets to liability profile as top strategies to boost performance…
  25. 25. 25towerswatson.com © 2010 Towers Watson. All rights reserved. Proprietary and Confidential. For Towers Watson and Towers Watson client use only. Notes: Respondents were asked to consider the company they cover that has the largest defined benefit pension plan. Percentages indicate responses of “To a great extent” or “To a very great extent.” …although nearly two in five indicate that a full wind-up of the plan would boost the company’s valuation 38% 35% 16% 8% 100% from current level (full wind-up) 75% from current level 50% from current level 25% from current level
  26. 26. 26towerswatson.com © 2010 Towers Watson. All rights reserved. Proprietary and Confidential. For Towers Watson and Towers Watson client use only. Summary Survey results demonstrated that highest concerns for both plan sponsors and outside analysts are DB Plan funded status and cash flow Desire to take action to reduce risk is high today, but often ability is low Sponsors are re-evaluating funding policy, design and investment strategy in the near- term to manage risk Investment strategy decisions continue to shift towards a liability-focused risk reduction strategy Currently implemented through liability-hedging strategies and dynamic allocation strategies Anticipate this shift continuing as potential accounting changes may reduce the incentive for risk taking As plan funded status improves, more companies anticipate transferring the pension obligations to reduce the overall size and risk of the DB Plan These transfers will require significant up-front planning to implement when both economic conditions and sponsor ability align
  27. 27. 27towerswatson.com © 2010 Towers Watson. All rights reserved. Proprietary and Confidential. For Towers Watson and Towers Watson client use only. Contact Details Matt Herrmann matt.herrmann@towerswatson.com Mark Ruloff mark.ruloff@towerswatson.com
  28. 28. 28towerswatson.com © 2010 Towers Watson. All rights reserved. Proprietary and Confidential. For Towers Watson and Towers Watson client use only. Disclaimer The information included in this presentation is general information only and should not be relied upon without further review by the appropriate professional advisors. Towers Watson is not a law firm nor an accounting firm, and we are not providing legal, accounting or tax services or advice. Some of the information included in this presentation might involve the application of law; accordingly, we strongly recommend that audience members consult with and involve their legal counsel and other professional advisors as appropriate to ensure that they are fully advised concerning such matters. Additionally, material developments may occur subsequent to this presentation rendering it incomplete and inaccurate. Towers Watson assumes no obligation to advise you of any such developments or to update the presentation to reflect such developments

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