(January 16, 2013) – Verizon Communications Inc. shrunk its pension liabilities by $9.5 billion in December, and two days later, Moody’s issued a credit opinion on the company.
The telecom giant received a stable A3 on long-term debt, and a P-2 for commercial paper—precisely the same ratings as before the risk transfer.
This may seem like something of a disconnect: a major corporation takes volatility and risk off its books, yet rating agencies give the firm an identical bill of health. But to anyone who had read Moody’s August report, Pension Terminations: No Free Lunch, this would have been no surprise: “We believe corporate pension termination transactions, similar to the General Motors Company transaction, will in most cases be credit neutral events. While our response will depend on the specifics of each transaction, we expect that the costs and liquidity reductions or increase in leverage involved in executing the transactions will likely balance out the benefits.”
Of course, a more favorable credit rating may not be one of a corporation’s primary reasons for considering a buyout—but it never hurts. The Moody’s report got a few portfolio managers at St. Louis-based NISA Investment Advisors thinking: Is annuitization the answer?
“What we thought was missing from the dialogue were traditional de-risking strategies, like hiking allocations to fixed income,” David Eichhorn, a managing director at NISA, told aiCIO. “With these, you can achieve almost all of the benefit of an annuity purchase without giving up the liquidity. If you just de-risk the pension but leave it in place, we believe it should be rating positive.”
Eichhorn and his colleagues at NISA, which specializes in risk control and liability-driven investing, built a model to test pension risk-transfer against conventional de-risking. “Ratings are a tough thing,” Eichhorn acknowledged. “Agencies use a lot of different metrics to arrive at a rating. We really stepped away from that, and chose to rely on the intuitive link between firm volatility and default probability. We use a ‘distance-to-default’ model,” he explained. “It’s based on option theory: Given a certain amount of equity and enterprise volatility, what’s the likelihood of burning through equity?”
The traditional approach—reallocating the model portfolio’s assets into less risky buckets—brought down the fund’s volatility by 79%, while the buyout alternative erased pension volatility all together. When it came to the sample corporation’s firm-wide volatility, the method of de-risking made little material difference. Reallocating pension assets reduced it by 31%, whereas a full pension buyout cut volatility by 33%. Both de-risking strategies caused the firm’s one-year likelihood of default to drop from 3.6% to 0.5%, according to NISA’s paper.
“The credit rating impact of lower pension risk can be quantified using a distance-to default model,” the authors wrote, “which estimates changes in default risk based on changes in firm volatility. This change in default risk can then be mapped to implied credit rating changes.” For the portfolio used in the study (which happened to be US Steel’s), NISA claims the reduced default risk implied a rating hike of two full notches, from BB to BBB-.
According to Moody’s report, the cost of substantially reducing firm-wide default risk with a pension buyout would likely cancel out the credit positives. Shuffling assets from equities and other return-seeking classes into fixed income would be far less capital-intensive off the bat, but de-risking by either method now means taking on serious interest rate exposure. Various industry insiders have questioned the prudence of locking-in liability values with discount rates at historic lows.
“Whether you go 100% fixed income or 100% annuity, you’re effectively buying 100% bonds at today’s rates,” Eichhorn said. “In that sense, traditional de-risking and annuitization are identical, and that is what makes this an apples-to-apples comparison.”
Despite their critiques of pension risk-transfer, NISA and Moody’s papers present it as an option that will be appropriate for some, and considered by many. They advise corporations to be cautious about the capital/liquidity demands of an annuity purchase, and the permanence of it. In other words, that even with buyouts all the rage, firms shouldn’t be too quick to throw the pension out with the bath water.
“If you’re thinking about annuitization, the closest in-house solution is a 100% fixed income portfolio with investment grade bonds that really mirror your liabilities,” Eichhorn said. “We would argue that corporations, particularly those with large pensions relative to market cap, undertaking these sorts of large de-risking actions for their pension funds would be justified in having ratings adjustments. Whether or not the rating agencies agree, that’s up to them.”
Read NISA’s whole paper, “The Credit Rating Impact of Pension De-Risking,” here.