Pension Buyouts: The Best Use of Corporate Capital?
Faced with the rising cost of defined benefit (DB) pension provision; driven by rising longevity, a more demanding regulatory environment and the combination of falling equity prices and lower interest rates, an increasing number of sponsoring companies are seeking to de-risk. In seeking this finality, some sponsoring companies have turned towards benefit re-design while an increasing number are closing their schemes completely. However, closing a scheme does not end a company’s obligation to pay its previously accrued liabilities, which means that the risk management burden remains.
Certainly, there are serious implications of unmanaged DB pension risk, which can impact the sponsoring company’s core business and financial performance, with significant knock-on effects for shareholders and scheme members. Recently, pension risk has even affected a company’s ability to borrow, as lenders become more cautious following high-profile insolvency cases where pension schemes have been given ‘super-priority’, requiring pension liabilities to be paid prior to any other debts.
In this respect a full buyout, involving the transfer of all pension liabilities to an insurance company, offers the most complete solution. However, it is fair to say that the buyout market has, to date, failed to take off. It has attracted only £25bn of business, and this figure includes buy-ins. To put this into context, it represents only 2.5% of the total value of DB liabilities sitting alongside the balance sheets of UK corporates.
Yet there are signs the landscape is changing, and there have already been several large buyout deals this year, as the rationale for full buyout becomes better understood by financial directors (FDs) and company board members, as well as by analysts and shareholders. Furthermore with companies’ cash flow growing by 40% since the depths of the financial crisis, many corporations are looking for opportunities to put shareholders’ funds to good use.
Whether it makes sense to use this excess cash to transact on a pension buyout depends very much on the individual company and its alternative use of capital. That said, innovative new approaches to pension buyouts may increase the appeal from a corporate finance perspective, with positive accounting implications to boot.
Addressing the Corporate Finance Implications
To address whether a conventional pension buyout represents good use of a company’s capital, we must first consider the economics of the transaction in more detail. Buyouts have commonly been priced at about 140% of the valuation of a scheme’s liabilities on an International Accounting Standard (IAS) 19 basis – made up of the insurer’s best estimate of the value of the liability (around 120% of the IAS19 liability) plus an additional 20% that represents the insurer’s profit. That 20% of profit counts towards the capital the insurer is required by the regulatory authorities to provide to back its liabilities. Then, roughly speaking, the insurer itself is required to put up a further 20% of capital as equity, making a total of 40% of capital to back the 120% liability.
Typically the insurance profit component of the buyout premium is calculated by targeting a return on capital (ROC) of 12-15% per annum, which is what the insurer’s shareholders expect to earn. To put it simply, in a conventional buyout pension scheme sponsors are implicitly renting capital at 12-15%. Whether it makes sense or not to do so depends entirely on the company’s alternative use of its capital.
In this respect, companies have four main options as an alternative:
With a return of cash to shareholders suggesting a lack of strong corporate leadership on the best way forward, and with equity markets relatively strong in comparison to expectations for the economy, most companies either opt to re-invest in their day-to-day business operations or just sit on it, earning very low returns.
Compared to re-investment in the business, if the company’s ROC is equal to or exceeds 12-15%, then entering into a conventional buyout to remove all of its DB exposures would, in fact, prove a more economically attractive option. However, if the ROC of the business is lower, a conventional buyout may represent a significant transfer of value from the company’s shareholders to those of the insurer.
Analysing the decision in this way raises an important question: if the buyout premium contributes half of the insurer’s regulatory capital, why not consider making an equity investment to recapture all of the insurance profit? After all, this approach mirrors the captive solutions used by many large companies to manage other risks, such as property and casualty. This approach, which has been adopted by the insurer and pension pot specialist, Long Acre Life, reduces the eventual cost of buyout as it allows the retention of some or all of the profit, at a 12-15% ROC, which would typically be paid to an insurance company. As long as there is an appropriate proportion of external capital, the pension scheme should not need to be consolidated on the company balance sheet, helping corporate treasurers.
From an accounting perspective, this structure involves an initial hit to the profit and loss (P&L) account similar in value to a conventional buyout. However, the key point here is that the equity investment, which can be up to 20% of the total value, will be recognised as an asset on the company’s balance sheet. Without going too deep into the technicalities, regardless of whether a sponsor accounts for its investments on a fair-value or equity accounting basis, it can expect an immediate increase in the value of its initial investment with this increase recognised as a profit in its income statement at the time of buyout. This profit will partially offset the buyout loss recognised in the sponsors’ financial statements and may reduce the final buyout cost from 140% to around 120% of the value of IAS19 liabilities.
Falling Barriers to Buyout
Many of the barriers that have previously hindered a buyout transaction are now being removed. Past impediments have included an inability to measure schemes’ funding position on a continuous basis, an incomplete understanding about the exact nature of the risk schemes faced, a lack of board-level incentive to transact, and, of course, expensive buyout premiums . The impending implementation of new IAS19 accounting standards may also remove some of the P&L benefit that certain companies currently enjoy from holding riskier assets in their pension schemes, and may therefore make risk-transfer activity more attractive for such companies.
However, while performing a buyout using a structure that allows the scheme to recapture some of the insurance profit may ultimately reduce the relative price of buyouts, the absolute price is intrinsically linked to the individual scheme’s current funding measure and therefore linked to its position with respect to volatile investment markets. Given global long-term economic uncertainty and the resulting reduction in pension scheme assets, as well as record-low interest rates that mean large pension liabilities as they are discounted using this value, the general consensus among scheme managers is that it may be preferable to wait for favourable conditions to return before transacting. The theory is that this will allow schemes to avoid locking in to a transaction when funding levels are low.
However, while pension scheme funding levels may compare unfavourably to those before the financial crisis, or even the start of last year, companies may have to accept that better conditions continue to recede into the future. Indeed, interest rates have been at record lows for three years, with little indication this will change any time soon. Add to this the fact many pension schemes have already completed interest rate swaps, mitigating their risk but also reducing their upside benefit from interest rate swings, as well as moving the valuation of liabilities closer to that of an insurer, one could argue that there may be no better time than now to prepare to remove pension liabilities from the balance sheet. But only as long as the economics make sense.