Longevity Derivatives Seem Poised For Further Growth

If this photo of senior ski fans is representative of the upward global trend in longevity, creators of derivatives could be on to something big. Deal count suggests that 2013 will be described as a banner year for banks and others types of financial companies as their respective corporate clients, in search of protection against the greying of their plan participants, took the plunge to get rid of risks they find difficult to manage. Financial News reports a December deal for 2.5 GBP between AstraZeneca and Deutsche Bank that "will cover the drug company against the risk that 10,000 of its former employees will live longer than expected." This follows a 1 billion GBP swap between Carillion and Deutsche Bank and a second transaction between BAE Systems and Legal & General, also in December 2013. See "A shot in the arm for longevity swaps" by Mark Cobley (January 6, 2014) for more details.

Certainly the topic is gaining importance in policy-making circles and at an international level. In December 2013, the Bank For International Settlements ("BIS") released an updated version of a study about longevity risk transfer markets. The product of the Joint Forum on longevity risk transfer ("LRT") markets, the report strongly encourages those with regulatory authority to carefully track the nature of deals being done and by which organizations as a way to gauge capacity to handle risks being transferred to the financial sector. Longevity risk exposures should be properly measured and attention should be paid to the extent to which "longevity swaps may expose the banking sector to longevity tail risk, possibly leading to risk transfer chain breakdowns." The study likewise notes the importance of supervisors to be able to evaluate whether those in possession of longevity risk have the "appropriate knowledge, skills, expertise and information to manage it."

These words of caution make sense, especially given the large amounts at stake. In its December 20, 2013 press release, the BIS cites estimates of the aggregate "global amount of annuity- and pension-related longevity risk exposure" as ranging between $15 and $25 trillion. Based on World Bank data, U.S. Gross Domestic Product for 2012 was $16.2 trillion. It was reported at $8.2 trillion for China and $5.9 trillion for Japan. The implication is clear. Get it wrong and it could mean big losses for a delicate global financial system that has had its share of risk management twists and turns. Click to access "Longevity risk transfer markets: market structure, growth drivers and impediments, and potential risks" (Basel Committee on Banking Supervision Joint Forum, December 2013).

As at least one major bank moves forward to develop a longevity derivative instrument that is meant to be traded, expect more news from insurance company and banking regulators about capacity, internal controls, assessment of risk, posting of capital and adequate disclosure about the transfer of large amount of longevity risks to financial intermediaries. Risk Magazine author, Tom Osborn, describes some of the impediments to a full-scale launch of the longevity transfer market, including limited disclosure about how transactions are priced, absence of a liquid index that would facilitate cost-effective hedging and avoid capital adequacy-related basis risk problems and questions about how exposures should be accurately modeled. Click to read "Longevity: Opportunity or flop?" (September 20, 2013).

De-Risking, HR Strategy and the Bottom Line

In case you missed our December 10, 2013 presentation about pension de-risking, sponsored by Continuing Legal Education ("CLE") provider, Strafford Publications, click to download slides for "Pension De-Risking for Employee Benefit Sponsors." It was a lively and informative discussion about the reasons to consider some type of pension risk management, considerations for doing a deal and the role of the independent fiduciary. The transaction and governance commentary was then followed with a detailed look at ERISA litigation that involves questions about Liability Driven Investing ("LDI"), lump sum distributions and annuity purchases.

Some of the issues I mentioned that are encouraging sponsors to quit their defined benefit plans in some way include, but are not limited to, the following:

  • Equity performance "catch up" from the credit crisis years and the related impact on funding levels, leading some plans to report a deficit;
  • Need for cash to make required contributions;
  • Low interest rates which, for some firms, has ballooned their IOUs;
  • Increased regulation;
  • Higher PBGC premiums;
  • Rise in ERISA fiduciary breach lawsuits;
  • Desire to avoid a failed merger, acquisition, spin-off, carve-out, security issuance or other type of corporate finance deal that, if not achieved, could lessen available cash that is needed to finance growth; and
  • Difficulty in fully managing longevity risk that is pushing benefit costs upward as people live longer.

While true that numerous executives have fiduciary fatigue and want to spend their time and energies on something other than benefits management, it is not always a given that restructuring or extinguishing a defined benefit plan is the right way to go. Indeed, some sponsors have reinstated their pension offerings in order to retain and attract talented individuals who select employers on the basis of what benefits are offered.

Given what some predict as a worrisome shortage of talented and skilled workers, the links among HR strategy, employee satisfaction and the bottom line cannot be ignored. For those companies that depend on highly trained employees to design, produce, market and distribute products, the potential costs of losing clients to better staffed competitors is a real problem. According to the "2013 Talent Shortage Survey," conducted by the Manpower Group, "Business performance is most likely to be impacted by talent shortages in terms of reduced client service capability and reduced competitiveness..." A report about the findings states that "Of the 38,618 employers who participated in the 2013 survey, more than one in three reported difficulty filling positions as a result of a lack of suitable candidates; the 35% who report shortages represents the highest proportion since 2007, just prior to the global recession."

As relates to the well-documented shift by companies and governments to a defined contribution plan(s), I recently spoke to a senior ERISA attorney who suggested a possible re-thinking of the DB-DC array, based on discussions with his clients. The conclusion is that a 401(k) plan is sometimes much more expensive to offer than anticipated. For employees who lost money in 2008 and beyond and cannot afford to retire, they will keep working. The longer they stay with their respective employer, the more money that employer has to pay in the form of administration, matching contributions, etc.

A plan sponsor has a lot to consider when deciding what benefits to offer, keep, substitute or augment. Dollars spent on benefits could reap rewards in the form of a productive and complete labor force. With full attribution to the seven fellas in Disney Studio's Snow White, will your employees be singing "Heigh-ho, heigh-ho, it's off to work we go" or will they instead bemoan their stingy boss and search for a new work home, with better economic lollipops, thereby leaving a business deprived of precious human capital?

Pension De-Risking for Employee Benefit Sponsors: Minimizing Risks and Ensuring ERISA Compliance When Transferring Pension Obligations to Other Parties

Click to register for a January 16, 2013 webinar entitled "Pension De-Risking for Employee Benefit Sponsors: Minimizing Risks and Ensuring ERISA Compliance When Transferring Pension Obligations to Other Parties." Sponsored by Strafford Publications, this Continuing Legal Education ("CLE") webinar will provide benefits counsel with a review of pension de-risking approaches used by companies to reduce some of the risks involved with employee retirement benefits. The panel will offer best practices for leveraging the precautions to prevent ERISA fiduciary law violations when making transfers.

Description

As U.S. pension plans face record deficits, options for transferring some or all of a sponsor's plan risk make sense for many companies. General Motors, NCR and Verizon are a few companies that have chosen de-risking options in 2012.

De-risking transactions take many forms, from transferring company obligations to third parties, to offering payouts to plan participants, to undertaking liability-driven investing and other strategies. Counsel and companies must tread carefully to avoid ERISA-based litigation or enforcement actions.

Prudent de-risking requires thorough financial analysis and clear demonstrations that fiduciary standards under ERISA are met. Counsel should guide companies on how to establish the reasonableness of decisions and prepare to defend against possible court challenges.

Listen as our panel of experienced employee benefit practitioners provides guidance on precautions for companies undertaking transfers of pension plan obligations to third parties or other de-risking options. The panel will outline best practices for assembling a thorough financial review, complying with ERISA requirements, and responding to potential legal challenges from plan participants.

Outline

  1. De-risking overview
    1. Current trends
    2. Different approaches
      1. Transfers to third parties
      2. Lump sum payouts for participants
      3. Investment strategies
  2. Procedural prudence
    1. Financials
    2. Government filings and participant notifications
    3. Meeting ERISA fiduciary requirements
      1. Prudence
      2. Care
      3. Loyalty
  3. Potential challenges from plan participants
    1. Grounds for challenges
    2. Likelihood of success

Benefits

The panel will review these and other key questions:

  • What kind of financial reviews are needed to support a de-risking transaction?
  • How can pension providers demonstrate they have met their ERISA standards of prudence, care and loyalty to plan participants?
  • What steps should be taken in preparation for termination of a pension plan?

Following the speaker presentations, you'll have an opportunity to get answers to your specific questions during the interactive Q&A.

Faculty

Susan Mangiero, Managing Director
Fiduciary Leadership, LLC, New York Metropolitan Area
 

She has provided testimony before the ERISA Advisory Council, the OECD and the International Organization of Pension Supervisors as well as offered expert testimony and behind-the-scenes forensic analysis, calculation of damages and rebuttal report commentary for various investment governance, investment performance, fiduciary breach, prudence, risk and valuation matters.

Nancy G. Ross, Partner
McDermott Will & Emery, Chicago

She focuses her practice primarily on the area of employee benefits class action litigation and counseling under ERISA. She has extensive experience in counseling and representing employers, boards of directors, plan fiduciaries, and trustees in matters concerning pension and welfare benefit plans. Her experience includes representation of pension plans, ESOPs, trustees and employers.

Anthony A. Dreyspool, Senior Managing Director
Brock Fiduciary Services, New York

He specializes in the investment of assets of ERISA-covered employee benefit plans and all aspects of ERISA fiduciary law compliance.  He has more than 30 years of experience with respect to ERISA matters and has substantial knowledge in the structuring and formation of private real estate and equity funds for the institutional investment market.

CFO Magazine Article About Pension De-Risking

In case you missed the launch of "Applied to Pensions, Risk is a Four-Letter Word" by Dr. Susan Mangiero and ERISA attorney Nancy Ross (CFO Magazine, November 8, 2012), experts conclude that Chief Financial Officers need to do their homework before entering into a particular deal. "Beyond the obvious number-crunching needed to vet what's often a large dollar transaction, the decision to de-risk should minimally include:

  • A thorough evaluation of the financial, operational, and legal strength of the annuity provider as required by the U.S. Department of Labor Interpretative Bulletin 95-1.
  • Independent pricing of any hard-to-value assets that will be contributed as part of a de-risking deal.
  • Economic assessment of opportunity costs in a low interest rate environment and whether it is better to delay a transaction or close immediately.
  • Review of vendor and counterparty contracts that may need to be unwound in the event of a full transfer of pension assets and liabilities to a third party.
  • Review of direct and indirect fee amounts to be paid by a plan sponsor as the result of a de-risking transaction.
  • Assessment of litigation risk associated with plan participants asserting that they've been unfairly treated as the result of a pension de-risking arrangement.
  • Creation of a strategic communications action plan to ensure that plan participants, shareholders, and other relevant constituencies are provided with adequate information."

In a related commentary, ERISA Stephen Rosenberg describes the chaos in the defined benefit plan market that continues to give plan sponsors pause about staying with the status quo. Click to read "On Getting Out of the Pension Business."

Old Age Can Be a Bonus With a Price Tag

Enjoy this interview about longevity and pension risk management with Dr. David Blake, Director of the Pensions Institute. Professor Blake explains why understanding life expectancy trends across age, gender and socioeconomic groupings is so critical. He comments on new valuation rules that relate to financial statement transparency and share prices of plan sponsors. He differentiates between pension buy outs from pension buy ins and offers reasons why longevity swaps can be beneficial.

Click here to read "Longevity and Pension Risk Management," an interview with Professor David Blake, May 2010.

For other articles about longevity and pension risk management, visit http://portal.fiduciaryx.com/register/ for a complimentary subscription to best practices website, FiduciaryX.com.

Tontines - Way Out of a Pension Jam?



In a pension jam? Think tontines, not saltines, according to a newly published article about what to do as the benefits landscape quickly changes. Defined as a type of investment pool, tontines pay dividends only to survivors. Similar to an annuity "in that it provides a life income to a participant," a tontine could help millions of individuals who want retirement security without too much involvement (selecting and managing investments, forecasting post-employment spending and so on).

According to Ralph Goldsticker, author of "A Mutual Fund to Yield Annuity-Like Benefits" (Financial Analysts Journal, January/February 2007), making modern versions of the tontine a reality comes in the knick of time. Hundreds of companies are jettisoning traditional defined benefit plans as fast as you can say "senior citizen."

One version - a mutual fund/tontine hybrid - has the advantage of arguably lower default risk in contrast to a purchased annuity. Upon creation of an age- and gender-specific mutual fund/tontine structure, contributed monies are invested in a "diversified portfolio of high-grade fixed-income securities." A downside is the fact that heirs do not participate, forcing breadwinners to think about financial planning on a family-wide basis (not a bad thing to do anyhow).

Allegedly the brainchild of banker Lorenzo de Tonti, this 350-year old invention may deserve a fresh look.

Editor's Note:
Thanks to Hank Stern, Life Underwriter Training Council Fellow (LUTCF) and contributor to InsureBlog, for alerting me to the news about tontines. Winner of the 2005 Weblog Award, InsureBlog focuses on life and health insurance issues, with an emphasis on Consumer Driven Health Care.