the future of u.s. pension financing — lessons from europe

April 2009

© 2009 Towers Perrin

The Future of U.S. Pension Financing

Lessons From Europe

© 2009 Towers Perrin 2

Presenters

Mitchell ColeMitch is a Principal in Towers Perrin’s Retirement Risk Solutions (RRS) practice in Stamford, CT. He directs the firm’s work in Alternative Financing for Employee Benefits and Pensions, which is part of the RRS. RRS combines expertise in employee benefits and pensions with risk expertise and transaction execution capabilities to provide risk management and structured solutions worldwide.

Travis WinkelsTravis is a Principal in Towers Perrin’s RRS practice in St. Louis, MO. In his nine years of global employee benefit consulting experience, Travis has had the privilege of working with some of the largest and most recognizable companies in the world to mitigate their pension risk exposure through the implementation of alternative pension financing including the use of captive insurance companies, liability driven investments, and other cutting-edge financial products.


Presenters

Paul KellyPaul Kelly is a Principal in Towers Perrin’s Global Consulting Group in London. Paul joined Towers Perrin in 2004, following a number of years as a global Director of Pensions. Prior to this, he worked for 20 years in international employee benefits consulting and has dealt with many mergers and acquisitions.

James Staveley-WadhamJames is a consultant in Towers Perrin’s Retirement group in London. One of his areas of expertise is in securing benefits arising from defined benefit arrangements, which he has been involved in for over seven years. This work covers full buyouts with the corresponding winding up of the pension plan through to buying in certain members’ benefits as part of an investment of the pension trust.


Agenda

Context for Emerging Solutions in Europe

Case StudiesU.K. Pension Buy-InCross-Border Pension PoolingEuropean Pension Captive

Ideas for Action

Recent surveys show a similarity between European and U.S. executives’ views on pension risk

The Major Risks of a Pension Plan (as seen by corporate leadership)

Source: The Economist Intelligence Unit 2008 and Towers Perrin

(% respondents)

47Mortality assumptions

48Regulatory changes

Inflation 36

Europe

Cash flow 38

Regulatory compliance 35

Income statement 27

Accounting changes 26

Source: CFO Research Services in collaboration with Towers Perrin

(% respondents)U.S.



The economic crisis has adversely affected the funded status of plans in Europe and the U.S.

PBO-Funded Ratio for Benchmark Plan

60/40 Average Duration Fixed Income (FI)

U.S.

60%

70%

80%

90%

100%

110%

120%

130%

140%

Dec 99 Dec 00 Dec 01 Dec 02 Dec 03 Dec 04 Dec 05 Dec 06 Dec 07 Dec 0860%

70%

80%

90%

100%

110%

120%

140%

Dec 99 Dec 00 Dec 01 Dec 02 Dec 03 Dec 04 Dec 05 Dec 06 Dec 07 Dec 08

77.9% as of 3/31/2009

63.7% as of 3/31/2009

Europe130%


Credit spreads introduce a new element of risk into the overall risk profile that is difficult to hedge using traditional financial market instruments (including derivatives)

Spread Between Corporates (ML 10+) and 30-year T-bonds (bps)December 1998 – March 2009ML 10+ HiQ 30-Yr Swaps 30-Yr T-Bonds

Credit derivatives are costly and volatileTraditional LDI strategies hedge general interest-rate risk, but don’t capture credit-spread riskHigh-quality corporate bonds are few in number and fairly illiquid

Key Bond Yields (at end of month)

2.00%

3.00%

4.00%

7.00%

8.00%

9.00%

Dec 04 Dec 05 Dec 06 Dec 07 Dec 08

6.00%

5.00%

0

0.5

1

1.5

2

2.5

3

3.5

4

Dec 98 Dec 99 Dec 00 Dec 01 Dec 02 Dec 03 Dec 04 Dec 05 Dec 06 Dec 07 Dec 08


Companies in the U.S. and Europe face identical challenges

Mark-to-market accounting

Matching pension obligations with fixed income is difficult:

Limited availability of long-duration bondsDeviation in credit spreads Historically low yields on government issues

Counterparty credit risk

New accounting rules and pension regulations increase cost of DB plans


The alternatives, which are largely customized, rely on insurance and reinsurance companies

*Patent pending in the U.S.

ControlCost savingsCash flow

…and Why InsurersWhy Alternatives

Traditional offering

Alternative financing approaches

Control

Degree of Risk Assumption

Cost

PensionCAP*

Traditionalasset

immunization

Cashouts/other exercise

of optionsInterest-

rate overlaystrategy

Custominsurance

Cross-borderpension pooling

Buy-ins

Annuitypurchase

High

Low

Low High

CapacityCredit risk managementCapability

European executives are turning to alternative financing, versus traditional, one-size-fits-all approaches

Risk from regulatory changes by IRS, DOL, PBGC, FASB, IASB, etc.Asymmetric risk of surplus rules

Regulatory Risk

Risk posed by participant longevity and embedded-design options (e.g., lump sums, early retirement subsidies)

Demographic Risk

Risk posed by inflation-rate changes, changes in treasury yield-curve shapes

Interest-Rate Risk

Market risk posed by investments held in pension trust (equity volatility, credit risk, currency risk, etc.)

Market Risk

Risk posed by changes in spreads, yield-curve shapes and pension asset/liability mismatch

Spread Risk

Plan administrationPlan governance

Operational Risk

Inve

stm

ent S

trat

egie

s

Trad

ition

al A

nnui

ties

Alte

rnat

ives


Alternative 1: U.K. Pension Buy-In


Snapshot of the pension buy-in marketplace, 2007-2008

UFBJun-07Pension Corporation1,200Thorn

FullMay-08Pension Corporation72Ravenmount (Swan Hill)

PPBJun-08Pension Corporation452Delta

Source: Pension Week, May 26, 2008 plus addition of recent transactions

UFB: Uninsured Full Buyout, PPB: Partial Buyout, Full: Full Insured Buyout

Dec-07

Dec-07May-08Jun-07Jan-07Nov-07Mar-08Oct-07Nov-07Mar-08Jan-07Aug-07Dec-07Mar-08May-08Mar-08

Feb-08Dec-07Sep-08

Nov-07

Date

FullLegal & General60Queens Moat Houses

FullLegal & General75Book Club AssociatesFullPaternoster78LonminUFBPension Corporation100ThreshersPPBPaternoster110HuntingFullPaternoster150Eni LasmoPPBLucida160Morgan CrucibleFullPaternoster170EmapFullLegal & General170Electricity Association ServicesFullLegal & General180M-Real CorporationPPBLegal & General180DRG Pension FundUFBCitigroup200Thomson Regional NewspaperPPBLegal & General240Weir GroupPPBLegal & General259TI GroupPPBNorwich Union350Friends ProvidentFullPaternoster400Powell Duffryn

FullRothesay Life700RankPPBPaternoster800P&OPPBPrudential1,000Cable & Wireless

UFBPension Corporation3,000Telent

TypeInsurerGBP mName


What is a buy-in?

An investment held by the pension trustCovers specific groups (e.g., retirees)Future tranches could be secured with the insurerPlan retains all administrationPlan is exposed to counterparty risk

Company and trustees transfer all of their responsibilities to a third-party insurer or insurersInsurers deal directly with members in the future, who will have their own individual policiesFuture benefit accrual cannot be bought out

What is a Buy-In?What is a Buyout?

Trustees clear on what they wantClarity and support from the companyEffective process and project managementAppointment of a project sponsor

An insurance policy that addressesInvestment riskInflation and interest-rate risksMortality riskPolicies can be owned by either the trustees — a “buy-in” — or by the individual — a “buyout”

What Makes a Successful Transaction?What is a Bulk Annuity?


Example buyout and buy-in structures

Pension Scheme

Sponsor

Pension Scheme

Plan Sponsor

Pension Plan

PlanParticipants

Insurer

Benefit Payments

Annuity Premium

PlanSponsor

PensionPlan

Plan Participants

Insurer

BenefitPayments

AnnuityPremium

MonthlyPayroll

Buyout Buy-In


Case study: U.K. pension buy-in

The first transaction in the U.K. to fully insure obligation within the plan while offering unique security featuresSurrender value payable, after certain trigger points, equal to 98% of statutory reserve value of insurer’s outstanding liabilitiesWithholding of the premium, which could be returned to the trustees at 90% of the outstanding liabilities

Surrender provisionsMark-to-market accounting/valuation of the plan assetParticipant security and residual claim on pension fundCounterparty risk

OutcomeIssues to Consider

Significantly reduce the level of pension risk by transferring to a third partySatisfy trustees’ concern over counterparty risk

With liabilities of £1bn, Company was concerned over pension risk within its overall risk budgetTrustees keen to “de-risk” pension investments

ObjectivesContext


Advantages and considerations of buyout and buy-in in the U.S.

Advantagesliabilities off balance sheetno PBGC premiumsoutsourced administration

Considerationsaccounting settlement charge under FAS 88PPA funding implications— benefit restrictions— quarterly contributions— use of credit balance

Advantagesliabilities not removed, but “matched”may lower funding under PPA requirementsmay avoid accounting settlement hit

Considerationssubject to PBGC premiumscontinued administrationcounterparty riskterms for future plan winduppossible enhanced credit protection options (may increase cost relative to buyout)review by auditors and attorneys is recommended

Buyout Buy-In

2. Cross-Border Pension Pooling


Optimizing financial and operational effectiveness for pensions on a global basis

Country employee

groupIMEsA B E F G HIMEsC D

Local country DC plan

Local country DC plan

Local country DB plan




IME plan

Cross-border DC platform (e.g., IORP*)

Cross-border DB platform

(e.g., CAP, IORP*)

Cross-border asset pooling vehicle (with subsections)

Optimizes financial and demographic

risks (in an enterprise context)

Optimizes asset management arrangements (governance, cost, return)

Optimizes fiduciary, compliance and plan

governance risks

Defined Contribution Defined Benefit

*Institution for Occupational Retirement Provision, under EU Directive


NL MultinationalEmployees in NL, U.K., IRL

IORP located in BRegulated in B — single license

B supervision, regulations, funding.For taxation, assets split based on liabilities.

Single fund with sections.

Respects NL tax, labor, social law

Respects Irish tax, labor, social law

Respects U.K. tax, labor, social law

Concept of cross-border IORP

NL Section IRL SectionU.K. Section


Asset pooling vs. cross-border plan

Without Pooling

Germanpension plan

Assetclass

1

Assetclass

2

Assetclass

3

Frenchpension plan

Assetclass

1

Assetclass

2

Assetclass

3

U.K.pension plan

Assetclass

1

Assetclass

2

Assetclass

3

Asset-Pooling Vehicle

Asset Pooling

Germanpension plan

Frenchpension plan

U.K.pension plan

Assetclass

1

Assetclass

2

Assetclass

3

Single Legal Entity

Cross-Border Plan

Single pension plan

Assetclass

1

Assetclass

2

Assetclass

3


U.S. multinational case

High-tech Fortune 500

Had legacy defined benefit and defined contribution issues for internationally mobile employees

And needed future home for defined contribution

Mostly related to EMEA countries


Cross-border pension plan

TurkeyActive members

EgyptActive members

RussiaActive members

Hungary sectionActive members

Poland sectionActive members

U.K. SectionDeferred members inU.K. and elsewhere

Active membersin U.K.

Ireland SectionDeferred membersActive members

in Ireland

IORP in Ireland


Summary of advantages and effort related to cross-border pension plans

Improved governance

Improved risk management

Improved reporting

Reduced internal management time and cost

Reduced administration and management cost

Stronger sense of one firm among employees

Setup of cross-border plan, including

benefit design for each country sectionselection of plan domicileselection of vendors understanding of social and labor law for each countryunderstanding of tax requirements for each country

Establish a clear governance model for countries involved

Advantages Effort

3. European Pension Captive


How a captive works

Captive

Benefit Plan

Insurer

Annuity premium

Claims or Benefits

Reinsurance

Benefit plan purchases premium (or a single premium) for either Life, Disability, Medical or Pensions at a given cost (say the prevailing market cost from AA insurer)

Insurer reinsures to captive and passes assets to captive

Thus employer has control of assets and can liberate any emerging surplus


Captive reduces the net cost of windup by eliminating profit loads and providing access to emerging surplus

Reinsurance can be terminated, transitioning to traditional windup at market prices

Realized return > annuity technical rate reduces net pension cost over time

Wholesale Price

Retail Price

How CAP Can Reduce the Cost of Windup

Up-Front Savings from “no-load” annuity

Surplus recovery through profit

distribution

Buy-in / Buy-out

CAP

Potential Adverse Deviation

Years

Cost


Case study: European pension captive

Investment strategy controlled by Corporate Treasury functionCentralized decision-making authorityNPV cost reduction of €100M relative to traditional buyoutParticipant security enhanced

Pension and reinsurance regulationsIFRS and the early involvement of the accountantsAcceptable fronting capacityCaptive; domicile, license CapitalSecurity

OutcomeIssues to Consider

Centralize investment controlAchieve long-term cost savingsMaintain (or improve) participant securityReduce cost of externalizationSupport global pension governance

Global company needed to externalize final-average-pay pension due to local tax ceiling Cost of externalization unacceptably high

ObjectivesContext


Ideas for action

Cost

Extent of Risk Aversion

We should be indifferent between x million loss in the plan or in operating income

We would prefer to have losses of less than x in the plan

Time in Months/Years

Control

Degree of Risk Assumption

Cost

Traditionalasset

immunization

Cashouts/other exercise

of options

Interest-rate overlay

strategy

Custominsurance

Buy-ins

Traditional offering


Annuitypurchase

Interim financing


Windup

PensionCAP

Cross-borderpension pooling

1. Determine how much risk the company is able and willing to assume

2. Assess whether refinancing is necessary and how

3. Set a timetable for achieving the refinancing, possibly using alternatives in combination


Following a proven process can deliver custom solutions that satisfy diverse needs

Key NeedsRisk assessment and gap analysisIdentification and feasibility review of custom solutionsAssessment of global partners available to deliver proposed solutionsExecution and implementationAgile decision making and ongoing monitoring

Questions ?


Presenters

Mitchell [email protected]: (203) 326-5431

Paul [email protected] (20) 7170-3693

Travis [email protected]: (314) 719-5920

James [email protected]: 44 (20) 7170-3449

the future of u.s. pension financing — lessons from europe

Economy & Finance

pension risk exposure

risk expertise

towers perrinu

pension plan

pension trust

towers perrins rrs practice

pension financing lessons

new element of risk