The Future of U.S. Pension Financing — Lessons From Europe


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This Towers Perrin presentation examines alternative risk financing techniques being implemented by companies in Europe with defined benefit (DB) pension plans. These techniques offer insights into the future of financing global pensions, both in the U.S. and elsewhere.

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The Future of U.S. Pension Financing — Lessons From Europe

  1. 1. The Future of U.S. Pension Financing Lessons From Europe April 2009 © 2009 Towers Perrin
  2. 2. Presenters Mitchell Cole Mitch is a Principal in Towers Perrin’s Retirement Risk Solutions (RRS) practice in Stamford, CT. He directs the firm’s work in Alternative Financing for Employee Benefits and Pensions, which is part of the RRS. RRS combines expertise in employee benefits and pensions with risk expertise and transaction execution capabilities to provide risk management and structured solutions worldwide. Travis Winkels Travis is a Principal in Towers Perrin’s RRS practice in St. Louis, MO. In his nine years of global employee benefit consulting experience, Travis has had the privilege of working with some of the largest and most recognizable companies in the world to mitigate their pension risk exposure through the implementation of alternative pension financing including the use of captive insurance companies, liability driven investments, and other cutting-edge financial products. 2 © 2009 Towers Perrin
  3. 3. Presenters Paul Kelly Paul Kelly is a Principal in Towers Perrin’s Global Consulting Group in London. Paul joined Towers Perrin in 2004, following a number of years as a global Director of Pensions. Prior to this, he worked for 20 years in international employee benefits consulting and has dealt with many mergers and acquisitions. James Staveley-Wadham James is a consultant in Towers Perrin’s Retirement group in London. One of his areas of expertise is in securing benefits arising from defined benefit arrangements, which he has been involved in for over seven years. This work covers full buyouts with the corresponding winding up of the pension plan through to buying in certain members’ benefits as part of an investment of the pension trust. 3 © 2009 Towers Perrin
  4. 4. Agenda Context for Emerging Solutions in Europe Case Studies U.K. Pension Buy-In Cross-Border Pension Pooling European Pension Captive Ideas for Action 4 © 2009 Towers Perrin
  5. 5. Recent surveys show a similarity between European and U.S. executives’ views on pension risk The Major Risks of a Pension Plan (as seen by corporate leadership) Europe (% respondents) Regulatory changes 48 Mortality assumptions 47 Inflation 36 Accounting changes 26 Source: The Economist Intelligence Unit 2008 and Towers Perrin U.S. (% respondents) Cash flow 38 Regulatory compliance 35 Income statement 27 Source: CFO Research Services in collaboration with Towers Perrin 5 © 2009 Towers Perrin
  6. 6. The economic crisis has adversely affected the funded status of plans in Europe and the U.S. PBO-Funded Ratio for Benchmark Plan 140% 140% Europe U.S. 130% 130% 120% 120% 77.9% as of 63.7% as of 110% 110% 3/31/2009 3/31/2009 100% 100% 90% 90% 80% 80% 70% 70% 60% 60% Dec 99 Dec 00 Dec 01 Dec 02 Dec 03 Dec 04 Dec 05 Dec 06 Dec 07 Dec 08 Dec 99 Dec 00 Dec 01 Dec 02 Dec 03 Dec 04 Dec 05 Dec 06 Dec 07 Dec 08 60/40 Average Duration Fixed Income (FI) 6 © 2009 Towers Perrin
  7. 7. Credit spreads introduce a new element of risk into the overall risk profile that is difficult to hedge using traditional financial market instruments (including derivatives) Key Bond Yields (at end of month) 9.00% 8.00% 7.00% 6.00% 5.00% 4.00% 3.00% 2.00% Spread Between Corporates (ML 10+) and 30-year T-bonds (bps) Dec 04 Dec 05 Dec 06 Dec 07 Dec 08 December 1998 – March 2009 30-Yr Swaps 30-Yr T-Bonds ML 10+ HiQ 4 Credit derivatives are 3.5 costly and volatile 3 Traditional LDI 2.5 strategies hedge 2 general interest-rate risk, but don’t capture 1.5 credit-spread risk 1 High-quality corporate 0.5 bonds are few in number and fairly illiquid 0 Dec 98 Dec 99 Dec 00 Dec 01 Dec 02 Dec 03 Dec 04 Dec 05 Dec 06 Dec 07 Dec 08 7 © 2009 Towers Perrin
  8. 8. Companies in the U.S. and Europe face identical challenges Mark-to-market accounting Matching pension obligations with fixed income is difficult: Limited availability of long-duration bonds Deviation in credit spreads Historically low yields on government issues Counterparty credit risk New accounting rules and pension regulations increase cost of DB plans 8 © 2009 Towers Perrin
  9. 9. The alternatives, which are largely customized, rely on insurance and reinsurance companies Why Alternatives …and Why Insurers Control Capacity Cost savings Credit risk management Cash flow Capability Annuity Traditional purchase asset High immunization Buy-ins Cashouts/ Custom other exercise insurance of options Interest- Cost rate overlay strategy Pension CAP* Cross-border Control pension pooling Traditional offering Low Alternative financing approaches Low High Degree of Risk Assumption *Patent pending in the U.S. 9 © 2009 Towers Perrin
  10. 10. European executives are turning to alternative financing, versus traditional, one-size-fits-all approaches Operational Risk Plan administration Plan governance Regulatory Risk Risk from regulatory changes by IRS, DOL, PBGC, FASB, IASB, etc. Asymmetric risk of surplus rules Demographic Risk Risk posed by participant longevity and embedded-design options (e.g., lump sums, early retirement subsidies) Spread Risk Risk posed by changes in spreads, yield-curve shapes and pension Investment Strategies Traditional Annuities asset/liability mismatch Interest-Rate Risk Risk posed by inflation-rate changes, changes in treasury yield-curve shapes Alternatives Market Risk Market risk posed by investments held in pension trust (equity volatility, credit risk, currency risk, etc.) 10 © 2009 Towers Perrin
  11. 11. Alternative 1: U.K. Pension Buy-In
  12. 12. Snapshot of the pension buy-in marketplace, 2007-2008 Name GBP m Insurer Date Type Telent 3,000 Pension Corporation Nov-07 UFB Thorn 1,200 Pension Corporation Jun-07 UFB Cable & Wireless 1,000 Prudential Sep-08 PPB P&O 800 Paternoster Dec-07 PPB Rank 700 Rothesay Life Feb-08 Full Delta 452 Pension Corporation Jun-08 PPB Powell Duffryn 400 Paternoster Mar-08 Full Friends Provident 350 Norwich Union May-08 PPB TI Group 259 Legal & General Mar-08 PPB Weir Group 240 Legal & General Dec-07 PPB Thomson Regional Newspaper 200 Citigroup Aug-07 UFB DRG Pension Fund 180 Legal & General Jan-07 PPB M-Real Corporation 180 Legal & General Mar-08 Full Electricity Association Services 170 Legal & General Nov-07 Full Emap 170 Paternoster Oct-07 Full Morgan Crucible 160 Lucida Mar-08 PPB Eni Lasmo 150 Paternoster Nov-07 Full Hunting 110 Paternoster Jan-07 PPB Threshers 100 Pension Corporation Jun-07 UFB Lonmin 78 Paternoster May-08 Full Book Club Associates 75 Legal & General Dec-07 Full Ravenmount (Swan Hill) 72 Pension Corporation May-08 Full Queens Moat Houses 60 Legal & General Dec-07 Full UFB: Uninsured Full Buyout, PPB: Partial Buyout, Full: Full Insured Buyout Source: Pension Week, May 26, 2008 plus addition of recent transactions 12 © 2009 Towers Perrin
  13. 13. What is a buy-in? What is a Bulk Annuity? What Makes a Successful Transaction? An insurance policy that addresses Trustees clear on what they want Investment risk Clarity and support from the company Inflation and interest-rate risks Effective process and project management Mortality risk Appointment of a project sponsor Policies can be owned by either the trustees — a “buy-in” — or by the individual — a “buyout” What is a Buyout? What is a Buy-In? Company and trustees transfer all An investment held by the pension trust of their responsibilities to a third-party Covers specific groups (e.g., retirees) insurer or insurers Future tranches could be secured Insurers deal directly with members with the insurer in the future, who will have their own Plan retains all administration individual policies Plan is exposed to counterparty risk Future benefit accrual cannot be bought out 13 © 2009 Towers Perrin
  14. 14. Example buyout and buy-in structures Buyout Buy-In Plan Plan Sponsor Sponsor Sponsor Annuity Annuity Premium Premium Pension Pension Pension Pension Insurer Insurer Plan Scheme Plan Scheme Monthly Payroll Benefit Benefit Payments Payments Plan Plan Participants Participants 14 © 2009 Towers Perrin
  15. 15. Case study: U.K. pension buy-in Context Objectives With liabilities of £1bn, Company Significantly reduce the level was concerned over pension risk of pension risk by transferring within its overall risk budget to a third party Trustees keen to “de-risk” pension Satisfy trustees’ concern over investments counterparty risk Issues to Consider Outcome Surrender provisions The first transaction in the U.K. to fully insure obligation within the plan while Mark-to-market accounting/valuation offering unique security features of the plan asset Surrender value payable, after certain Participant security and residual claim trigger points, equal to 98% of on pension fund statutory reserve value of insurer’s Counterparty risk outstanding liabilities Withholding of the premium, which could be returned to the trustees at 90% of the outstanding liabilities 15 © 2009 Towers Perrin
  16. 16. Advantages and considerations of buyout and buy-in in the U.S. Buyout Buy-In Advantages Advantages liabilities off balance sheet liabilities not removed, but “matched” no PBGC premiums may lower funding under PPA outsourced administration requirements Considerations may avoid accounting settlement hit accounting settlement charge Considerations under FAS 88 subject to PBGC premiums PPA funding implications continued administration — benefit restrictions counterparty risk — quarterly contributions terms for future plan windup — use of credit balance possible enhanced credit protection options (may increase cost relative to buyout) review by auditors and attorneys is recommended 16 © 2009 Towers Perrin
  17. 17. 2. Cross-Border Pension Pooling
  18. 18. Optimizing financial and operational effectiveness for pensions on a global basis Defined Benefit Defined Contribution Country A B C IMEs D E F G IMEs H employee group Local Local Local Local Local Local IME country country country country country country plan DC plan DC plan DB plan DB plan DB plan DB plan Cross-border Cross-border DC platform DB platform (e.g., IORP*) (e.g., CAP, IORP*) Optimizes financial and demographic Optimizes fiduciary, risks (in an enterprise compliance and plan context) governance risks Cross-border asset pooling vehicle (with subsections) Optimizes asset management arrangements (governance, cost, return) *Institution for Occupational Retirement Provision, under EU Directive 18 © 2009 Towers Perrin
  19. 19. Concept of cross-border IORP NL Multinational Employees in NL, U.K., IRL IORP located in B Regulated in B — single license B supervision, regulations, funding. For taxation, assets split based on liabilities. Single fund with sections. U.K. Section IRL Section NL Section Respects U.K. tax, Respects Irish tax, Respects NL tax, labor, social law labor, social law labor, social law 19 © 2009 Towers Perrin
  20. 20. Asset pooling vs. cross-border plan Without Pooling German French U.K. pension plan pension plan pension plan Asset Asset Asset Asset Asset Asset Asset Asset Asset class class class class class class class class class 1 2 3 1 2 3 1 2 3 Asset Pooling Cross-Border Plan German French U.K. pension plan pension plan pension plan Single pension plan Single Legal Entity Asset-Pooling Vehicle Asset Asset Asset Asset Asset Asset class class class class class class 1 2 3 1 2 3 20 © 2009 Towers Perrin
  21. 21. U.S. multinational case High-tech Fortune 500 Had legacy defined benefit and defined contribution issues for internationally mobile employees And needed future home for defined contribution Mostly related to EMEA countries 21 © 2009 Towers Perrin
  22. 22. Cross-border pension plan Ireland Section Deferred members Active members U.K. Section in Ireland Deferred members in Turkey U.K. and elsewhere Active members Active members in U.K. IORP in Ireland Poland section Egypt Active members Active members Russia Hungary section Active members Active members 22 © 2009 Towers Perrin
  23. 23. Summary of advantages and effort related to cross-border pension plans Advantages Effort Improved governance Setup of cross-border plan, including Improved risk management benefit design for each Improved reporting country section selection of plan domicile Reduced internal management time and cost selection of vendors understanding of social and Reduced administration labor law for each country and management cost understanding of tax Stronger sense of one firm requirements for each country among employees Establish a clear governance model for countries involved 23 © 2009 Towers Perrin
  24. 24. 3. European Pension Captive
  25. 25. How a captive works Benefit plan purchases premium Benefit Plan (or a single premium) for either Life, Disability, Medical or Pensions at a given cost (say Claims or Benefits the prevailing market cost from Annuity AA insurer) premium Insurer reinsures to captive Insurer and passes assets to captive Thus employer has control of assets and can liberate any emerging surplus Reinsurance Captive 25 © 2009 Towers Perrin
  26. 26. Captive reduces the net cost of windup by eliminating profit loads and providing access to emerging surplus How CAP Can Reduce the Cost of Windup CAP Reinsurance can be Potential Adverse terminated, transitioning Deviation Buy-in / Buy-out to traditional windup at Retail Price market prices Up-Front Savings from “no-load” annuity Wholesale Price Surplus recovery Realized return > through profit annuity technical rate distribution reduces net pension cost over time Cost Years 26 © 2009 Towers Perrin
  27. 27. Case study: European pension captive Context Objectives Centralize investment control Global company needed to externalize final-average-pay pension due to local Achieve long-term cost savings tax ceiling Maintain (or improve) participant Cost of externalization unacceptably security high Reduce cost of externalization Support global pension governance Issues to Consider Outcome Pension and reinsurance regulations Investment strategy controlled by Corporate Treasury function IFRS and the early involvement of the accountants Centralized decision-making authority Acceptable fronting capacity NPV cost reduction of €100M relative to traditional buyout Captive; domicile, license Participant security enhanced Capital Security 27 © 2009 Towers Perrin
  28. 28. Ideas for action 3. Set a timetable for 2. Assess whether 1. Determine how much risk achieving the refinancing is the company is able and refinancing, possibly necessary and how willing to assume using alternatives in combination Cost Cost Annuity Traditional purchase We should be asset immunization indifferent between x Interim financing million loss in the plan Buy-ins or in operating income Cashouts/ Custom other exercise insurance We would prefer to of options have losses of less Alternative financing Interest- than x in the plan approaches rate overlay strategy Pension CAP Windup Cross-border Control pension pooling Time in Months/Years Extent of Risk Aversion Degree of Risk Assumption Traditional offering Alternative financing approaches 28 © 2009 Towers Perrin
  29. 29. Following a proven process can deliver custom solutions that satisfy diverse needs Key Needs Risk assessment and gap analysis Identification and feasibility review of custom solutions Assessment of global partners available to deliver proposed solutions Execution and implementation Agile decision making and ongoing monitoring 29 © 2009 Towers Perrin
  30. 30. Questions ?
  31. 31. Presenters Mitchell Cole Ph: (203) 326-5431 Paul Kelly 44 (20) 7170-3693 Travis Winkels Ph: (314) 719-5920 James Staveley-Wadham Ph: 44 (20) 7170-3449 31 © 2009 Towers Perrin