Rising Insurance Premiums: A New Impetus for Voluntary Funding of Corporate Defined Benefit Plans

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1 Featured Solution December 2014 Your Global Investment Authority Rising Insurance Premiums: A New Impetus for Voluntary Funding of Corporate Defined Benefit Plans It is not quite a perfect storm, the simultaneous drop in equity markets and decrease in interest rates that torpedoed the funding levels of corporate defined benefit (DB) plans in and But to many plan sponsors, it sure feels like one. Markus Aakko, CFA Executive Vice President Account Manager Rene Martel, FSA, CFA Executive Vice President Product Manager Kate Tan, FSA, CFA Senior Product Associate Consider that despite the rally in equities, declining bond yields (and thus liability discount rates) have kept funding ratios low. The return potential on stocks and bonds may seem unattractive. Plan demographics limit inflows of fresh injections of cash and shorten investment horizons. And, if that is not enough, another gust is coming: Next year, and again in 2016, the premiums charged by the Pension Benefit Guaranty Corporation (PBGC) on unfunded liabilities are set to jump. Given these conditions, we believe plan sponsors should evaluate whether the time is ripe to reduce or eliminate a funding deficit by issuing debt to boost funding levels and invest in strategies that may help reduce surplus volatility. With some advanced techniques, plans also may be able to mitigate their concerns about rising rates. Of course, many plans have already been considering de-risking through immunization or annuity buyouts risk transfers of part or all of a liability to an insurance company. In the near term, we believe that immunization through bond purchases will be significantly less expensive and therefore the more common path for sponsors that choose to fully fund their plans.

2 FIGURE 1: MARKET CONDITIONS IMPLY LOWER PROSPECTIVE ASSET RETURNS 10-year Bond Yield and 2-30 Yr Slope 10-year variation range and current value (%) yr Yield Curve Slope CAPE Shiller CAPE 10-year variation range and current value Source: PIMCO, Bloomberg and Robert Shiller as of 28 November 2014 Interesting math of the PBGC variable-rate premium The hike in PBGC premiums is quite interesting from a corporate finance perspective. In 2015, variable-rate premiums will be assessed on the underfunded portion of the liability at a rate of $24 per $1,000 of underfunding (increasing to at least $29 in 2016). Over the long run, a pension liability should grow at an annual rate that is more or less in line with its discount rate, which is derived from high quality corporate bonds (rated A to AAA under the rules of the Pension Protection Act (PPA) of 2006). Underfunding a plan is therefore economically similar to borrowing at the average PPA discount rate of the plan. By 2016, the PBGC variable-rate premium effectively raises the cost of carrying underfunded balances to 290 basis points (bps) above the plan s PPA discount rate. As can be seen in Figure 2, for a 10-year maturity this would imply a financing cost of 6.78% using today s PPA segment rates as a proxy. Given current corporate spread levels, it is difficult to find any investment-grade-rated firms that would have to pay similar rates on newly issued debt. In fact, more than 99% of the constituent firms in the Barclays Investment Grade Index have a lower yield on their debt of any maturity. (For the Barclays Investment Grade Index, only 10 bonds out of 5,212 had a yield greater than 6.78% as of 28 November 2014.) FIGURE 2: BORROWING MAY BE LESS EXPENSIVE THAN PBGC PREMIUMS Yield (%) Dec-14 Dec-19 Dec-24 Dec-29 Dec-34 Dec-39 Dec-44 Maturity date YTW for Barclays US IG index constituents PBGC Liability discount rate¹ + 290bps 1 The PBGC liability discount rate is based on the November 2014 spot segment rates (standard election for PBGC liability calculation purposes). Source: PIMCO and Barclays as of 28 November 2014 In addition, it should be noted that the yield curve continues to be steep and pension liabilities typically have cash flows extending decades into the future. Therefore, the average liability yield is heavily driven by the long end of that steep curve. In contrast, most corporations could borrow at five- or 10-year maturities, providing an attractive yield advantage (funds could be borrowed at DECEMBER 2014 FEATURED SOLUTION 2

3 five- or 10-year rates, beneath the rate at which liabilities are growing). Therefore, it appears that issuing debt to finance the deficit and investing proceeds into a liabilitymatching asset (immunizing the liability) could make sense 1. To be sure, PBGC variable-rate premiums will be capped at $500 per participant (including terminated vested and retired participants) in Thus, depending on plan circumstances the variable-rate premiums may apply only to part of the unfunded liability. As a hypothetical example, if a plan has a liability of $750 million and 10,000 participants, the PBGC variable-rate premium would be limited to $5 million (10,000 x $500). This would correspond to a $172 million or 23% pension deficit (2.90% x $172 million = $5 million). In other words, if the plan in our example were more than 77% funded, the entire underfunding would be assessed the 290-bp premium (and if the plan were less than 77% funded, the premium would be assessed only on the first 23% of underfunding). Plans with lower per-participant balances would be worse off in this respect, in that the cap would not apply unless greater levels of underfunding existed. (Generally speaking, frozen plans with long-tenured employees will have the highest per-participant balances.) Immunization portfolio Fully funding a plan with borrowed funds may provide shelter from the coming PBGC rate hikes. However, that protection may prove temporary unless it is done in conjunction with significant risk reduction. In other words, plan sponsors should take advantage of an inflow of fresh money into the plan to improve the match between assets and liabilities and reduce overall plan risk. Many investors consider current yields on fixed income securities unattractive and may be tempted to wait for 1 Note that de-risking the plan arguably delevers the balance sheet. The corporation could use that flexibility to relever toward the initial level by effectively buying equity outside the plan. By focusing on buying back the firm s own equity, the corporation may enhance shareholders value. fairer weather and higher yields to deploy a de-risking strategy. However, several arguments support moreimmediate de-risking for plans to achieve full funding through borrowing, including: There would be lesser need for excess returns if the plan were fully funded. Excess funding cannot easily be used for other purposes by a sponsor; therefore, the allocation of return-seeking assets should be reduced as the plan achieves full funding. A steep yield curve means that sponsors hiding in shorter-duration instruments in anticipation of higher interest rates would incur a significant carry disadvantage relative to their liabilities. (For example, holding cash instead of 10-year bonds would translate into an annual yield shortfall of 250 bps coincidentally, a cost similar to the PBGC variable rate premium!) Corporate spreads at the long end of the curve continue to be wider than pre-crisis historical averages, suggesting that the long credit market is not necessarily overstretched. Hence, considering long duration corporate credit, potentially with an added interest rate hedge, could be a fair compromise. Lastly, fixed income investments within the pension trust would be tax exempt, whereas bonds issued to finance voluntary contributions would be tax deductible. This differential would also enhance the economic value of the pension plan and accrue benefits to the financial statements on an after-tax basis. Seeking shelter In summary, the overall strategy to consider is the following: Issue bonds to finance the pension deficit. Interest expense is tax deductible. Make a voluntary contribution to the plan to cover part or all of the underfunding. Part or all of the contribution will also provide tax deductibility benefits. If you believe that interest rates will rise in the short run, DECEMBER 2014 FEATURED SOLUTION 3

4 consider investing proceeds of the debt issuance in longdated credit bonds while hedging their interest rate risk exposure (for now) using swaps or futures. (Bear in mind that hedging the rate exposure on the asset side is a speculative move as rates could stay low for a longer time than anticipated or even fall further.) If you want to try something even more advanced, consider selling payer swaptions on top of the swaps or futures used to shorten duration. This way you could collect income until rates rise and more or less automate your transition back into pure long credit bond exposure as rates rise. Given the confluence of factors described in this note, we expect many plans to consider funding through voluntary contributions. We believe it is important to consider appropriate investment strategies now, before any decisions on funding are made, to be able to execute effectively. While significant uncertainty remains for plan sponsors in the current environment, a well-thought-out investment strategy tailored for both the pension plan and its sponsor can significantly increase the likelihood of weathering the storm. DECEMBER 2014 FEATURED SOLUTION 4

5 Biographies Mr. Aakko is an executive vice president and account manager in the Newport Beach office, servicing institutional clients. Prior to joining PIMCO in 2010, he was a managing director and portfolio manager in Global Portfolio Solutions within Goldman Sachs Asset Management (GSAM). His prior experience with GSAM includes roles as head of risk management and head of fixed income for manager selection. Before joining GSAM, Mr. Aakko worked with the International Finance Corporation at the World Bank. He has 16 years of investment experience and holds master's and bachelor's degrees in finance from Helsinki School of Economics. Mr. Martel is an executive vice president and product manager in the Newport Beach office. He focuses on liability-driven investments and is also a member of PIMCO's investment solutions team. Prior to joining PIMCO in 2006, he was responsible for conducting assetliability modeling and recommending risk management strategies for pension plan sponsors at Mercer Investment Consulting. He also advised institutional clients on asset allocation, investment policy and investment manager selection. Previously, Mr. Martel was in the actuarial practice of Mercer, advising pension plan sponsors on funding, accounting and plan design matters. He has 13 years of investment experience and holds an undergraduate degree in actuarial science from Laval University. Mr. Martel also holds the Fellow of the Society of Actuaries (FSA) designation. Ms. Tan is a senior product associate in the liability-driven investment and investment solutions groups in the Newport Beach office. Prior to joining PIMCO in 2012, she was a pension consulting actuary at Towers Watson. She holds a master's degree in financial mathematics from Stanford University and she received a bachelor's degree from the University of Waterloo in Canada. Ms. Tan also holds the Enrolled Actuary (EA) and Fellow of the Society of Actuaries (FSA) designations. Past performance is not a guarantee or a reliable indicator of future results. Investing in the bond market is subject to risks, including market, interest rate, issuer, credit, inflation risk, and liquidity risk. The value of most bonds and bond strategies are impacted by changes in interest rates. Bonds and bond strategies with longer durations tend to be more sensitive and volatile than those with shorter durations; bond prices generally fall as interest rates rise, and the current low interest rate environment increases this risk. Current reductions in bond counterparty capacity may contribute to decreased market liquidity and increased price volatility. 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