Now is the Time for Pension Liability Risk Transfer!

I know, I know: I apologize. That must be the most click-baity headline you’ve seen today. But stay with me because, with a little financial engineering, every blue-chip company out there that still has underfunded pension liabilities now has the opportunity of a generation.

With a phone call to their favorite investment banker they can eliminate the unfunded status of their pension liability and shed all responsibility for it going forward.

It’s a two step process:

  1. Have your investment banker raise a bond offering for you in the same amount as your unfunded pension liability.
  2. Take the proceeds from the bond, plus your existing pension fund assets, and give them to someone like Prudential. In exchange, Prudential will pay and administer the retirement benefits owed to the retirees and beneficiaries going forward.

This two step process assumes the company has already frozen its pension for existing workers and doesn’t offer it to new employees.

Underfunded Pension Liabilities

If you have no idea why I’m suggesting the above then you haven’t been reading the footnotes to the financials. There are tons of public and private companies that still have pension obligations accumulating on their books. The “unfunded pension liability” portion comes from a mismatch between the amount of plan assets and the actuarially calculated net present value of future payouts. When the value of the assets are lower than the net present value of future payouts you end up with an unfunded pension liability.

These unfunded pensions occur because of the following:

  1. The company did not contribute enough money to the investment pool and/or didn’t take out enough money from the employee’s paycheck; or
  2. The investments underperformed expectations. This can be due to unrealistic expectations, poor investment selection, or high fees. Often it’s a combination.

Anyone with a bit of common sense can see that it’s simple to solve the issues that cause an underfunded pension. Unfortunately, “moral hazard” typically keeps a solution from ever being implemented.

Painful Underfunded Pension Liability Solutions

One solution to solve an underfunded pension liability is to contribute more money to the investment pool. But most companies don’t want to boost contributions because it reduces the cash flow available to pay executives, repurchase stock, issue dividends, or reinvest in the business (usually in that order). It’s also hard to dip further into employees’ paychecks for fatter contributions because a lot of the outstanding pensions these days are owed to union workers who already feel they’ve paid their pound of flesh.

If you can’t contribute more money to the investment pool, then the alternative is to try to boost investment returns. A lot of investment managers of pension funds have added allocations to alternative investments such as hedge funds and private equity to boost their returns, but even with that allocation you can easily do the math to see that they’re going to fall short.

Disconnected Reality: An Underfunded Pension Example

Take a look at the footnotes to YRC Worldwide’s most recent 10-K. Starting on page 58, let’s look at their plan obligations and assets:

YRCW Pension Status

The table shows that there is a $198MM shortfall between the NPV of future benefits and the fair value of the assets held in the fund. You can also see that the company is only contributing $15.2MM per year to try to help close the gap.

The next fun table from the 10-K shows their assumptions for the discount rate and the expected rate of return on the assets held in the plan:

YRCW Plan Assumptions

The Discount rate refers to the interest rate used to discount the estimated future benefit payments to their present value. The discount rate allows YRCW to estimate what it would cost to settle the pension obligations as of the measurement date.

Where it gets a bit disconnected from reality is the 7.0 percent expected rate of return on assets. But to understand why 7 percent is a bit crazy you must look at the breakdown of how their pension assets are invested:

YRCW Plan Assets

And then the “Investments measured at NAV” is in a separate table because, let’s not make it easy:

YRCW NAV Pension Assets.png

[Check out the footnotes in that table! I would have loved to have listened to the pitch for those royalty payments…]

If you do the math on the two tables that list the plan assets you come up with the following allocation:

  • 17.3% Equities
  • 47.6% Fixed Income
  • 22.7% Private Equity
  • 12.4% Absolute Return

What’s interesting is that they show their target allocation on page 60, and they seem to be classifying things differently than I am:

YRCW Target Allocations.png

Regardless, the next step is to reverse engineer the returns you need to get to that 7 percent annual return given the above asset allocation. Start with the easiest returns to forecast then solve for the other asset classes:

  • Since fixed income is the easiest to solve for (just use the current yield), we’ll plug in AGG’s yield of 2.66 percent.
  • Equities are a bit more tough (obviously), so we’ll be lazy and use Research Affiliates global expected real return of 2.9 percent and tack on 2.0 percent inflation to get our total return.
  • I’ll be generous to private equity and assume past performance can continue. Note: this is the only time you’ll ever hear me utter this statement without a bunch of asterisks and caveats. Using the analysis from the 2018 AIC Public Pension Study I’ll plug in 8.6 percent.
  • Absolute Return is anyone’s guess so using the above estimates for future results let’s go ahead and solve for this asset class. If you’re following along in your own spreadsheet you’ll see we need a 23.7 percent return to hit the 7 percent overall return mark.

Obviously a 23.7 percent return for the pension’s Absolute Return investments is ridiculous. And you can play around with the non-fixed income numbers, say by being optimistic and setting each to 10 percent, but even then, you still end up with a return for the portfolio of only 6.5 percent. That’s because the fixed income segment accounts for almost half of plan assets but is only going to yield two or three percent over the next six of seven years given the heavy allocation to government debt. The only way they get better returns out of fixed income is if the yield on government debt hits 0 percent and they keep rolling the maturity.

Just to be clear, I’m not picking on YRC Worldwide’s accounting; almost every pension plan out there uses similar assumptions and similar investments. It’s just one specific example among many of the disconnect between how pension plan assets are invested and the returns a company assumes for the plan’s assets going forward.

High Plan Asset Values + Super Low Interest Rate = Transfer Pension Liability

Since the value of pension assets have benefited from a 10-year bull market and companies can borrow money at super low interest rates, it makes all the sense in the world to transfer a company’s pension liability risk to anyone who’s willing to take it.

The reality is that you are starting to see some companies take advantage of the situation. Lockheed Martin announced that in December 2018 they used $2.6B of pension trust assets to purchase group annuity contracts from Prudential. “As a result of this transaction, the insurance company is now required to pay and administer the retirement benefits owed to these retirees and beneficiaries.” Lockheed didn’t borrow any money for this transaction, but they could have if they wanted to.

My contention is that if you have an underfunded pension liability and the ability to borrow cheaply from the capital markets, you’re way better off in the long run borrowing money now to close the underfunded pension gap in order to get the liability off your books. Doing this makes sense because I’d wager that pension plans are going to be a lot more expensive than the current assumptions indicate.

Just beware of the companies that agree to assume the risk.

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