Twelve months ago, automotive parts manufacturer TRW was watching the ink dry on four of the most important contracts it might have signed in its history. The first was a bulk annuity for its Canadian pension plan; the second, a similar contract for its US plan; the third, a partial buyout of its UK pension; and, finally, an acquisition document to become the latest subsidiary of German ZF Group.
While a small army of accountants, lawyers, and bankers would have been working with the company executive on the last item on that list, the first three were being dealt with by a small human resources and pensions team that spanned the Atlantic.
The hub of the operation was in Livonia, Michigan, where many of the operational decisions were made, but the big money deal was done in a large town in the UK’s West Midlands.
The £2.5 billion ($3.8 billion) buyout of part of TRW’s UK pension, the largest in the country to date, was also one of the “most complex,” according to Mercer, an advisor for the deal. It was designed, managed, and executed in Solihull, near Birmingham, by a team of three, with input from the Michigan headquarters.
But while the size of the deal was groundbreaking—in the UK at least—that a small team began de-risking all three pensions at once was the most impressive part.
“There is no cut-and-paste option to take what you do with one to the other,” says Jon Exley, partner in pensions investment advisory at KPMG in London and a de-risking expert. He worked on the TRW project and, like the company staff, is not permitted to talk about it.
Despite the three nations sharing broadly similar accounting and legal systems and similar defined benefit (DB) pension legacies, once in the weeds of the issue, they are each very different.
“In the US, corporations have the most influence on the management of a pension scheme,” says Frank Oldham, global head of DB risk at Mercer. “In the UK, it is more the trustees who take control. In Canada, it is different again due to the large public sector and multi-employer plans dominating the landscape.”
So let’s get in to the very weeds that TRW would have had to dig into.
Art by JooHee YoonThe first, and most important thing to consider is
inflation. Or at least it is if you manage a pension fund in the UK.
“Thanks to the Pensions Act passed in 1995, all pension liabilities in the UK are inflation-linked [since 1997],” says Charlie Finch, partner at consulting and actuarial firm Lane Clark & Peacock. “This is good news for our parents, but it is also one of the major reasons UK pensions are closing.”
Unlike their transatlantic cousins, UK pensions—both private and public sector—have to factor in potential inflation increases to their investment decisions. Conversely, benefits do not drop in line with deflation—much to the chagrin of many CIOs.
As central bank economists have found out in recent years, inflation is exceptionally hard to predict and even harder to control. Therefore, UK investors either have to cover their exposure through swaps or take on assets they hope will track the rise in prices as closely as possible.
Additionally, inflation compounds longevity risk.
In the US, a pension fund member could be scheduled to live for 20 years but hang around an extra two years and it would make a difference to what was needed, says Finch. But add in inflation and longevity risk becomes a much more important issue. It is telling that longevity swaps have only occurred once on the western side of the Atlantic, whereas they are more common to the east.
In the UK, £7.5 billion ($11.4 billion) in longevity swaps have transacted this year, with potentially more to follow. In 2014, some $38 billion in longevity risk was swapped out of UK pensions, fuelled by a $25 billion transfer by the BT fund. By comparison, in March, the Bell Canada Pension Plan carried out a C$5 billion ($3.7 billion) swap with Sun Life Financial—the only one in North America so far.
It is not that people in the UK outlive their Canadian or US counterparts—it’s just more costly for their pension funds when they do. Canadian pensions do actually have the option to increase members’ benefits in line with inflation—but it’s an opportunity few have taken.
An added complication for TRW was the inflation measure trustees had chosen to use. In the UK, there are two main options: the retail prices index (RPI) and consumer price index (CPI). Both monitor the increase (or fall) of the price of a certain basket of goods. RPI is by far the most commonly used index—in finance generally, not just in the pension arena—and has traditionally been higher than CPI.
The TRW trustee board, however, had chosen CPI, which left the pensions team with a problem: practically no insurers would take on their inflation risk. There just isn’t a market to swap it out, and to take it on would mean some hefty—and expensive—derivative use.
Instead, the TRW team got around the CPI problem by using a pension increase exchange (PIE), which promised members a set level of benefit that was higher than their original promised amount but not tied to inflation. Through the exchange they may win, they may lose—only time would tell. But they would be assured of a set income, the insurer would take them on—and the CPI problem would disappear.
The PIE is a tool created for the UK market to deal with a specific national problem and around 40% of the TRW members who were offered the exchange took it. A study from Towers Watson last year showed the average take up is around 20%, so TRW had managed the exercise very successfully.
It enabled the employer to afford to include in the buyout the rest of the members who either did not want or were not offered the PIE.
So that’s inflation linkage: compulsory in the UK, optional in Canada, not a problem in the US.
The next difference is the impetus to insure or de-risk a pension.
Plans in the UK are not badly funded (despite some outlier examples), according to Finch at LCP, which means de-risking or buying out to relieve a business of the hassle of a legacy pension is within reach for many.
The influence of trustees, who are often pension members looking out for their peers, compels companies to remove the risk of them not being paid what they have been promised.
And finally, partially due to the influence of longevity, but also just plain old generosity, corporate pensions’ assets and liabilities often dwarf the size of the company to which they are attached. Consider International Airlines Group—the parent company of British Airways—which in August had pension liabilities more than double its market value.
Shareholders are likely to stand beside pension fund members in wanting the risk taken off the company balance sheets—albeit for different reasons.
By comparison, US pensions are not as well funded, according to Mercer’s Oldham, but the size of sponsoring corporations often far outweighs the magnitude of the deficit. Thus, the impetus to de-risk is less strong than across the pond.
Additionally, the person holding the checkbook for a sponsoring employer of a corporate plan is the one with the most influence, says Oldham. And this makes a whole world of difference in the sponsor’s outlook.
“US companies can offset pension charges to profits,” says Oldham. “For example, if you invest $100 million in equities, you can say you expect a 6% yield. Whereas if you invest in better-matching bonds, which yield 3%, you will see a reduction in what can be taken as pension costs.”
If the pension deficit is not causing concern to the company—and in some US cases, it could prove to be a boon—there may be little compelling bosses to de-risk.
Indeed, a report from Prudential Financial in October showed the UK had seen $180 billion in de-risking transactions since 2007, while the US—which dwarfs the UK for pension liabilities—had only seen $67 billion.
If the pension deficit is not causing concern to the company—and in some US cases, it could prove to be a boon—there may be little compelling bosses to de-risk.The groundbreaking GM $26 billion mega-deal in 2012, which made up more than a third of the US historic total, is not likely to become a common occurrence in the short term, according to Oldham.
“Companies look at what their shareholders expect and the relative value of the pension liabilities,” says Oldham. “Also if they have the resources—and will—to spend on managing the pension.”
TRW’s business circumstances may have pushed the company to de-risk. According to a statement from Fitch Ratings in 2014, the US plan was 90% funded, the company had a stable cash flow, and it had been executing share buybacks. It might have made sense to use any ‘spare’ cash to rid itself of pension risks—including levy increases from the Pension Benefit Guaranty Corporation.
For a multinational company operating in a constantly changing sector, removing unnecessary risks could be seen as a good move by shareholders.
MetLife issued
a bulk annuity for TRW’s US pension—which was worth just under $700 million in
March 2014, according to Fitch—and took on responsibility for paying members’
benefits ad infinitum.
With just a few hundred million dollars in assets and liabilities, the smallest piece in the TRW puzzle was the Canadian plan.
And if transferring or insuring pension assets and liabilities has not taken a tight grip in the US, in Canada, it is yet further back down the road with just $16 billion transacted since 2007, according to Prudential.
That is not to say Canadian pensions are not thinking about risk, according to Janet Rabovsky, a director at Towers Watson in Toronto. “Corporate plans are de-risking for the same reasons as everywhere else,” she says. “These are usually corporate reasons.”
The Canadian retirement landscape is dominated by large corporate or multi-employer plans—which also dominate many asset classes and markets.
This has meant that corporate pension funds have looked to employers for contributions to help with funding and are looking for ways to match liabilities outside the bond market.
“Some corporate plans are well funded and are just biding their time. It is a waiting game.”Additionally, there is a slightly uneven playing field in the Great White North as corporate funds have five years to achieve solvency while public plans are allowed 15 years and are looked at on a ‘going concern’ basis.
“If corporate plans can afford to buy bonds and match their liabilities, they will,” says Rabovsky, “unless there is a larger multinational parent company that can afford to take the risk away. Many are not in this position though, so are looking for ways to capitalize when interest rates rise.”
Canada, unlike the UK and US, was not delivered too many hammer blows in the financial crisis and its pension funds did not suffer as extremely.
“Some corporate plans are well funded and are just biding their time,” says Rabovsky. “It is a waiting game, but there hasn’t been a wholesale movement here as there has been in other countries.”
A hurdle for Canada’s plans looking to buy out is that a member’s liability must be bought out in full, rather than insuring cents on the dollar. This has meant providers tweaking their offerings to allow for what can and cannot happen. Things might be in line for further change too, as Canada’s 10 provincial governments are addressing the nation’s pension issue at a local level.
The current situation may soon start to shift further afield too, according to Finch at LCP. “More US companies will start to transfer their risk and the market is not there,” he says.
Despite MetLife, Prudential, and new entrant Legal & General making the first deals, once the momentum grows in the US, their capacity will not be enough.
“The US will draw away some of the capacity we have in the UK now,” says Finch, highlighting the eight or so major providers, and two new market entrants this year.
The number of providers is one of the factors that keep buyout prices reasonable. With a potential new, much larger market on the horizon, might we see a flip in the numbers being transacted?
For now, the figures remain stable. According to TRW’s regulatory filing a year ago, the de-risking was predicted to result in a pre-tax charge of $875 million to $925 million, with an additional $225 million to $250 million being made to top up the pensions. The majority of this was dedicated to the UK buyout.
Today, TRW—a year into its new ownership under ZF—is working to close down its remaining pension risks around the world, bolster its defined contribution offering, and get on with what it was meant to do: making parts for autos. Much of it may still be via conference call.