The investment banking community is sniffing out a business opportunity in the growing risk and volatility surrounding defined-benefit plans: whether they can assume the liability, manage the assets more effectively than plan sponsors yet more aggressively than insurance companies, and make the price attractive to companies.
The concept already is trickling into the market in the United Kingdom, where insurer Aegon has teamed up with UBS Global Asset Management to establish a staged-annuity product that may be a little more appealing to a pension plan sponsor than a traditional, high-cost annuity contract. Pension experts say the U.S. investment banking community is abuzz with ideas on how it can bring some comparable offering to the U.S. market as well.
The concept may become more appealing as companies navigate new accounting and funding rules for defined-benefit pensions that generally increase the cost of maintaining the plans, the visibility of the pension assets and liabilities on the balance sheet, and the volatility that flows through to earnings.
Defined benefits have become the target of regulatory activity in recent years, as it has become apparent that many corporate plans are badly underfunded. Congress passed the Pension Protection Act last year to increase funding and protect the Pension Benefit Guaranty Corp. from a crushing onslaught of failed plans. Separately, the Financial Accounting Standards Board adopted Financial Accounting Standard No. 158, Accounting for Defined Benefit Pension and Other Postretirement Plans, to report plans’ funded status on the face of the balance sheet; FAS 158 is only the first step in a promised overhaul of pension accounting rules.
Waite
Companies are looking for new ways to manage their pension plans in light of the new risk of rising near-term costs and earnings volatility. Those methods include freezing plans to new entrants and pursuing new investment strategies to better align the plans with the long-term liability, says Jon Waite, chief actuary with asset management firm SEI. In the most extreme method of offloading pension risk, companies would simply buy an annuity through an insurance company, Waite said, but the upfront cost typically is high—as much as 20 percent of the liability in the plan.
That’s where proposals like the Aegon/UBS might fill a gap in the market. Richard Priestly, head of annuity and protection development for Aegon in Great Britain, says the investment banking community is starting to look for ways it can help companies manage their pension liabilities, especially for closed or frozen plans, because the upfront cost of an annuity is too much to swallow. “A lot of companies don’t want a buyout at day one, so they’re looking for a staged buyout,” he said.
“Transfer The Risk Completely”
The Aegon/UBS proposal would allow a company to buy an annuity in stages over five to seven years, Priestly explains. As companies reach various funding triggers, Aegon would buy portions of the liability and hand them over to UBS for asset management. The partnership “combines the guaranteed longevity that an insurance company can provide with the investment management that a bank can provide,” he says. “What makes our proposition different is as soon as a company enters into a plan, the longevity basis is guaranteed.”
Meder
The two firms are hawking their proposal, but expect a long lead time to sign up an initial buyer because of the analysis necessary to determine if the strategy fits the circumstances. They started in Great Britain because the market is “ripe for these types of solutions,” says Aaron Meder, UBS head of asset liability investment solutions for the Americas. “If you look at the percentage of plans that are frozen, the U.K. has a much larger percentage than the U.S. Once you close or freeze a plan, the next question is `What do I do with this liability?'”
“We’ve seen in the marketplace a need, or a desire, to transfer the risk completely. Companies are asking, ‘How can I get rid of this risk completely?’ ”
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Aaron Meder,
Head Of Asset Liability Investment Solutions For The Americas,
UBS
Meder says UBS formed its asset liability investment solutions team when it became clear there would be a growing demand for what to do about growing pension risk, but the initial focus has been on how to help plan sponsors continue managing their plans more efficiently.
“We've seen in the marketplace a need, or a desire, to transfer the risk completely,” he says. “Companies are asking, ‘How can I get rid of this risk completely?’ ”
Meder says the staged transfer of liability helps companies buy the annuity, but more affordably. “It gives time to let the capital markets help pay for some of that cost,” he says.
Pension experts say the U.S. market is exploring ways to develop some kind of parallel offering, but there may be steep regulatory hurdles to overcome. The Department of Labor, which enforces rules assuring the protection of plan assets, would certainly have an interest in any new models to address risk, Waite says, as would the PBGC and the Internal Revenue Service.
Meder says those are issues to address before anything comparable appears on the market in the United States. ”We haven’t done the due diligence in the U.S. to see if it can work, but there are more parallels than difference,” he says.
Still Many Unanswered Questions
Aglira
Bob Aglira, a partner with Mercer Human Resource Consulting, says the “planned transfer business” remains in formative stages only in the United States right now. He says he’s aware of proposals that would involve privately funded organizations—not insurance companies—as the guarantors of the liability. They would essentially buy the pension plan from the corporate sponsor, enabling the company to transfer the pension entirely off the balance sheet.
“These will be private organizations that will be privately funded—call them private equity firms—and they will assume sponsorship of frozen pension plans,” he says. “This is significant because if the business model becomes a reality, essentially the sponsor can transfer the assets and liabilities and all of the fiduciary responsibility of the plan going forward much the same as if it had terminated the plan and purchased an annuity.”
Aglira said investment banks would secure the private equity, help establish the private organizations, and assist with managing the pension assets probably more effectively than companies can manage the assets themselves. That would in theory lead to a greater return, which would reduce the company’s cost of fully offloading the plan compared with the cost of an annuity.
While the role of an investment bank might include securing funding and helping manage assets, it likely would not assume the liability directly, Aglira says. “The investment banks are really at the core of forming the private equity company. They’re necessary to raise the capital from private investors, and the capital will have to be adequate for securing the obligations of the plans that they take on,” he says.
Much remains undetermined about how such a business model might take shape, Aglira adds—which might explain why investment banks generally did not respond to Compliance Week’s requests for information.
For example, it’s not clear how the private organizations could earn and declare a profit when the assets it would manage are held in protected, defined-benefit plans, Aglira says. It’s also not clear how a private organization that is not an insurance company can legally guarantee the liability without becoming the target for insurance industry regulation. The legal, guaranteed transfer of the liability is key to the value proposition for companies because they don’t gain a great deal in the transaction if they can’t fully offload the risk, Aglira says.
Verlautz
James Verlautz, chairman of the Pension Committee for the American Academy of Actuaries, says insurance companies are required to maintain a certain level of solvency to ensure that plan assets are protected, so they’re sure to take an interest in any competitive product offering that wouldn’t be subject to the same requirements.
“Investment bankers can probably invest more aggressively than an insurance company can, and they can offer a better price,” he says. “There's a risk and a reward for aggressive banking, so what happens when they don’t earn enough to cover the liability?”
Another question, Verlautz says, is whether parties with an interest in bringing a competitive product to market would navigate the prospective regulatory hurdles in advance, or pen a transaction and force it into the market. “It depends on whether an organization doing it tries to get every ‘I’ dotted and every ‘T’ crossed beforehand, or if it says,
‘We'll try it and deal with the shrapnel as it proceeds,’” he says.
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