Written By: Darren Morris – Corporate Finance
Defined-benefit pension plans are in turmoil for many reasons: increase in longevity, ageing populations, inflation and protracted low interest rates are causing funding gaps to pension funds and their sponsors. To add to these macroeconomic and financial evolutions, International Financial Reporting Standards (IFRS) principles, which oblige companies to evaluate their pension-fund engagement at market value, have caused the balance sheets of companies to experience heavy fluctuations. To hedge their balance sheets against market fluctuations is not simple and can be costly for companies. And to match the duration of their assets with that of their liabilities is also not easy, especially for some industrial companies with short-term inventories and no long-term assets.
The IMF’s (International Monetary Fund’s) last Global Financial Stability report (Chapter 2 on pension funds and insurance) suggests that transferring the management or at least financial risk of those funds to insurers would be an interesting idea.
Companies could benefit from transferring their pension plans to insurers in several ways.
First, in terms of pooling risks induced by assets and liabilities, insurers are better placed with many types of death and non-life products to mitigate the pension-plan risks (provided that pooling is permitted in the country by regulation). Indeed, life insurers that have written term insurance (where benefits are payable only if death occurs in a specified time period) benefit if their policyholders live longer than expected. So a certain complementarity exists between the risks derived from the death-insurance business of insurers and that derived from pension funds. In addition, insurers may be more specialized in risk-monitoring of such long-term gaps between assets and liabilities.
But costs are also an important reason for pension funds to transfer their risks. The Clear Path Analysis study “Pension Plan De-Risking, Europe” (April 2017) explains that in the United Kingdom, transferring to insurers is by far the most efficient solution because pension funds cost around 2 percent per annum of assets in administrative expenses alone, while insurance would cost less than 0.5 percent of liabilities for most companies. The costs in the risk-pooling and risk-sharing environment for pension funds are lower than their direct management on markets.
But today, different types of difficulties arise while transferring.
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First, before transferring, recapitalizing the plans to close funding gaps is deemed necessary by the IMF, but should not induce buying unnecessary assets by the companies. Pension-risk transfers should only represent a market-efficient arrangement under which non-financial firms close out defined-benefit plans and sell them to insurers at actuarially fair prices.
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Regulators will question whether the transfer is transparent enough and fair for workers. In 2016, the FCA (Financial Conduct Authority), Britain’s financial watchdog, strongly criticised the way some life-insurance firms treated long-standing customers with pensions. The FCA reviewed 11 insurer practices to make sure that workers had transparent and complete information of the nature of the transfers and the choices available.
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In some countries, such as the United States, the nature of guarantees offered to workers can differ according to whether the retirement plan is held by a pension fund or by an insurer. The Pension Benefit Guaranty Corporation, the federal agency that insures most private pension plans, no longer insures transferred pensions. Instead, insurance annuities are covered by the State Guaranty Associations, which provide some protection in the event that insurance companies fail. The trouble is that the new guarantee limits differ by state and are generally limited to amounts varying from $100,000 to $250,000 or $300,000. This results in possible claims for the excess in insolvency proceedings against the estate of the liquidated company, if the pension expected is over this limit.
Regulators are highly conscious of some new risks arising from transfers.
The IMF has stated that regulation could play an important role in this area by facilitating such transfers. According to the Dutch Central Bank report on “Longevity Risk Transfer Activities by European Insurers and Pension Funds”, the following scheme illustrates all the different types of arrangements that could exist for defined-benefit pension plans.
Their study reveals that the UK and the Netherlands show by far the largest amounts of longevity-risk transfer deals, respectively EUR 52.7 billion and EUR 25.4 billion in 2014. These countries have a large market share in the European pensions market, as together they represent the majority of the total European pension market for defined-benefit schemes. And the Dutch regulator has also warned that if transferring can be a good solution for defined-benefit holders, attention should be given as to where the longevity risk is transferred. And as deals involve banks, corporates and insurers, increased interconnectedness could bring new contagion risks.
Defined-benefit pensions are definitely in search of solutions to enable them to meet their future obligations. Transferring fully or partially their risks to insurers makes sense, but taking into account the amounts at stake, these transfers will be long and not-so-smooth processes—guaranteed to attract strong regulator involvement.