Insurers Carving Out the Pension Turkey?

Canadian insurance companies are throwing a lifeline to businesses stressed out by looming pension obligations — for a price.

“It’s the extra-strength Tylenol to make this pension headache go away,” says Brent Simmons, senior managing director of defined benefits solutions at Sun Life Financial Inc. “We’re promising that things won’t get any worse.”

The problem for companies that promised to pay workers guaranteed amounts of money until their death is that Canadians are living longer. What’s more, interest rates are in a sustained trough and equity markets continue to be choppy, adding to the struggle to meet their long-term defined-benefit pension obligations and leaving many plans only about 75% to 90% funded.

The “transfer-of-risk” products marketed by insurers generally exchange a portion of a company’s pension obligations for an annuity.

Will let you read the entire article but it ends off by stating Canadian insurers are aggressively pushing into pension risk transfers:

Standard Life Assurance Co. of Canada says it is also active in the area, with 17% of the domestic 
market.

Manulife Financial Inc. is also dipping in a toe, and industry players say Great-West Life Assurance Co., Industrial Alliance Insurance and Financial Services Inc. and Desjardins are also interested in stepping up their participation.

Sue Reibel, senior vice-president of group retirement solutions at Manulife, cautions that while the insurer is keen on the business, the economics may not be there for all propositions. While insurers can help companies with heavy pension risk better balance their assets and long-term obligations, the transfer of risk doesn’t completely fill the hole in which some companies find themselves.

“It’s not perfect — perfect costs a lot of money,” she says.

In addition, industry players say, there is far too much risk in Canada’s system of defined-benefit pensions to be entirely absorbed by the “risk-transfer” solutions being marketed.

At the start of 2011, there were about 11,500 defined-benefit plans in Canada’s private sector and an additional 400 in the public sector.

Still, Nicolas Genois, Standard Life’s manager of product management for group savings and retirement, is bullish about the business.

“We expect the market to grow,” says Mr. Genois, adding that the evolution putting pension management in the hands of insurers makes sense because insurers are already in the business of weighing risks against expected actuarial outcomes such as life expectancy.

He adds that insurers are bound by strict solvency regulations, which make them a relatively safe bet for managing the risk of pension obligations.

Another benefit the insurers have is that they can pool the money they take in under annuity plans — which will vary from company to company based on specific plan risks and guarantees such as spousal survival benefits.

This means scale and a bigger selection of investments, potentially including private deals and asset classes such as real estate and infrastructure.

“We get access to investments that smaller pensions couldn’t get access to,” Mr. Simmons says.

I've already covered GM and Ford's pensions jubilee and why pension risk transfers are a boon to insurers. Seizing the opportunity, insurance companies are salivating at the prospect "aiding" companies offload their pension risk, for a price. Interestingly, top hedge funds were busy buying GM, Ford and insurers in Q3 2012.

A buddy of mine calls this "a free call option" for insurance companies. They can take on pension risk, pool assets, invest them across public and private markets, set annuity rates during a period of historic low rates, and wait for rates to rise along with the value of public and private assets, making windfall gains in the process. 

And what if the titanic battle against deflation is lost? What then? Are insurance companies screwed? Not necessarily. If things get really ugly, they can go bankrupt or ask for a bailout, compliments of taxpayers.

One thing is for sure, this "private sector solution" to pension deficits is fraught with potential pitfalls. We've long known about problems with annuities. Just look at what is going on in the UK where rising prices and lower annuities are preying on the elderly (common theme is workers and retirees get screwed!).

And even though it's true that insurance companies are bound by strict solvency regulations and can pool assets to invest across public and private markets, the reality is they can't compete with large, well-governed defined-benefit plans.

In other words, if we got the pooling of pension assets right from the beginning, we wouldn't have reached the point where companies struggling with their defined-benefit plans are contacting insurers to offload their pension risk.

Importantly, if we got the pooling of pension assets right, companies wouldn't have any pension risk whatsoever. They would help employees with pension contributions but the assets would be managed by large, well-governed pension plans like CPPIB and its peers.

Think about it. Insurance companies stand to make windfall gains with all these pension risk transfers. I'd rather it be CPPIB and other large public pension funds which make these gains, benefiting all Canadians, not just a few large insurance companies. No wonder shares of Sun Life Financial (SLF) and other insurance companies aggressively engaging in pension risk transfers are booming (click on image below):


But as the Sue Reibel of Manulife  said in the article above, these pension risk transfers are from from perfect. “It’s not perfect — perfect costs a lot of money,” she says.

Finally, pension risk transfers are now being examined in the United States for fiduciary reasons. Susan Mangiero and Nancy Ross wrote an excellent for CFO magazine, Applied to Pensions, Risk Is a Four-Letter Word:

Record pension deficits for U.S. corporate pension plans of more than $700 billion are sure to keep the CFOs of plan sponsors small and large, public and private, busier than ever.

Market volatility, low interest rates, and an explosion of Employee Retirement Income Security Act (ERISA) lawsuits are a few of the factors in the continued interest in a variety of approaches known as “pension de-risking.” The group of solutions made headlines in the United States and the United Kingdom, and General Motors, NCR, and Verizon are a few of the firms that have de-risked this year.

While there is no universal definition of “de-risking,” many experts use the term to refer to any type of transaction that: allows a company to transfer part or all of its pension obligations to a third party like an insurance company; settle up with plan participants by offering a lump sum payout; or embark on an investment strategy like liability-driven investing. The choices vary, as do the advantages and disadvantages. CFOs everywhere will need to do their homework about what makes the most sense for their pension plan participants.

If experts are right, more pension de-risking deals are on the way. While there are plenty of reasons that a company may want to consider restructuring one or more of its ERISA plans, a final decision must be based on a comprehensive assessment of costs versus benefits, as well as taking legal and governance considerations into account.

Fiduciary fatigue is likewise motivating companies to explore ways to partially or fully transfer the risk of pension plans to big financial institutions. To paraphrase the lament of one executive, “We don’t want to be in the pension business anymore.”

A company’s failure to show that its ERISA fiduciaries thoroughly considered the merits of all relevant choices — something jurists describe as “procedural prudence” — is an invitation to a lawsuit or enforcement action or both. Adding to the complexity of pension de-risking due diligence is the potential problem that arises when a CFO or other company insider serves as an ERISA fiduciary — yet makes a decision mostly based on enterprise value enhancement for shareholders.

Beyond the obvious number-crunching needed to vet what's often a large dollar transaction, the decision to de-risk should minimally include:

• A thorough evaluation of the financial, operational, and legal strength of the annuity provider as required by the U.S. Department of Labor Interpretative Bulletin 95-1.
• Independent pricing of any hard-to-value assets that will be contributed as part of a de-risking deal.
• Economic assessment of opportunity costs in a low interest rate environment and whether it is better to delay a transaction or close immediately.
• Review of vendor and counterparty contracts that may need to be unwound in the event of a full transfer of pension assets and liabilities to a third party.
• Review of direct and indirect fee amounts to be paid by a plan sponsor as the result of a de-risking transaction.
• Assessment of litigation risk associated with plan participants asserting that they've been unfairly treated as the result of a pension de-risking arrangement.
• Creation of a strategic communications action plan to ensure that plan participants, shareholders, and other relevant constituencies are provided with adequate information.

The increased trend by plan sponsors to transfer responsibility for pension risk to external parties raises myriad legal considerations. To ensure compliance with the spirit and letter of ERISA, fiduciaries must show that any pension de-risking considered — and possibly accepted — would be mainly in the best interest of participants, not shareholders. In the event of a lawsuit, the threshold analysis will be whether the company was acting as a fiduciary under ERISA in offloading its pension risk.

ERISA defines a “fiduciary” as one who exercises discretionary authority or control over the management of plan assets. Often, the courts find that the answer requires a factual analysis of the specific acts performed. This can unfortunately preclude early dismissal of litigation maintaining a fiduciary breach. Certain acts concerning benefit plans, such as establishing, amending, or terminating a plan, do not invoke ERISA’s fiduciary obligations, however.

Because the transfer of pension liabilities constitutes a termination, or partial termination, of a benefit plan, ERISA’s fiduciary responsibilities may not be implicated. But the law is unsettled, and to the extent the transfer of pension liabilities is deemed to involve the management of plan assets, ERISA’s dual standard of prudence and loyalty to plan participants will be triggered.

For those pension de-risking transactions that require the hiring of an annuity vendor, affected parties may be tempted to file a claim if there is any concern that a "safest available" provider has not been selected. To defend such claims, companies, to the extent they are deemed fiduciaries, must be able to show that they acted as a reasonable person in like circumstances would have done.

Some prudence challenges may focus on the amount paid to the annuity provider. Participants may assert that the future liabilities were undervalued or calculated at too high an interest rate, causing the company to provide inadequate funds to the annuity provider at the time of transfer.

Challenges asserting a breach of fiduciary loyalty will likely contend that the company offloaded its pension liability to benefit the company and its shareholders, at the expense of the participants. The low interest rate environment fuels such claims, as participants may view the company as de-risking to avoid increased funding requirements, as well as the higher insurance premiums that must be paid to the Pension Benefit Guaranty Corporation. 

The Pension Rights Center (PRC) has already called for a moratorium on de-risking transactions until policymakers can evaluate their effect on retirement security. Among other concerns, the PRC claims that such transactions leave retirees without the usual protection of insurance by the Pension Benefit Guaranty Corporation against pension underfunding or delinquency. Instead, the PRC contends that the pension annuities fall under the lesser protection provided by State Guarantee Associations.

While participants may find the transfer of responsibility for their pension entitlement unsettling, the risk of litigation should not be a deterrent to plan fiduciaries. Lawsuits by the participants involve significant cost and resources, and will likely not succeed without proof of harm. Litigation to stop the transaction may well be deemed premature and speculative as to damages.

Only in the clearest of situations that a transfer will result in harm is a court likely to direct it to be stopped. Notwithstanding the risk of challenge, pension transfers, if done carefully, can beneficially provide retirement security to retirees and financial strength and growth to the company.

That last paragraph sounds too benign. Pension transfers are good for companies and insurance companies but will likely turn out to be toxic for retirees because annuities may be set at historic low rates and they aren't insured against pension underfunding or delinquency.

Below, Prudential wants companies to offload their pension risk so they can "focus on their core business" (sounds familiar!). That's why I dedicate this US Thanksgiving to workers and retirees getting squeezed from all sides as companies and insurers carve out the pension turkey. Stick a fork in their pensions, they're done.