What DB Plans Can Learn From Insurance Companies

Insurance companies take on pension risk, so why wouldn’t DB plan sponsors take lessons from insurer’s investment strategies?

John Simone, managing director and head of Voya’s Insurance Investment Solutions business in Chicago, says old ideas for insurance companies are new ideas for defined benefit (DB) plans.

Just as DB plans are challenged by low interest rates and the late credit cycle, so are insurance companies; they have to meet long-term obligations too. And, as Brett Cornwell, fixed income client portfolio manager at Voya Investment Management in Atlanta, Georgia, points out, it is insurance companies that DB plan sponsors turn to when transferring the risk of their plans.

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According to Cornwell, DB plans, in the last 10 or 15 years, have been adding more fixed income instruments that match the duration of their liabilities, such as long-duration bonds. They have also been moving out of growth-seeking assets. “DB plans are discounted with the AA corporate bond yield, so intuitively, plan sponsors are using more long-duration bonds to match the discount rate,” he says.

But fixed income has grown to 60% or as much as 80% to 90% of DB plans’ portfolios. Cornwell says that’s largely worked, but now it is a risk factor that corporate bond exposure is so high. “LDI 2.0 is more about now diversifying portfolios so they don’t have too much in a corporate bond name or sector,” he says.

When diversifying, some DB plan sponsors take on a lot of risk with non-fixed income assets, Simone says, but insurance company investment ideas do not necessarily dial up risk.

Diversifying from long-duration bonds

A Cerulli Associates survey shows U.S. insurance companies view the late stage of the credit cycle as “very concerning.” In response, nearly two-thirds (64%) plan to increase their allocations to private debt and half expect to add to structured or securitized debt during the next 12 months. Among alternatives investments, which are limited in insurers’ general account investment portfolios due to regulatory capital constraints, a majority of insurers plan to add to infrastructure investments (75%), alternative fixed-income strategies (63%), and private equity (55%).

Cornwell says insurance companies use a variety of securitized sectors—fixed income sectors not as narrowly defined as what DB plans use. He believes DB plans should take a more diversified approach.

For example, insurance companies use investment-grade private placements, which he says is a direct extension of what DB plans are already doing—adding corporate credit. A private placement is a sale of stock shares or bonds to pre-selected investors and institutions rather than on the open market. It is for an investor seeking to raise capital.

Cornwell explains that private placement can offer covenant packages—an investor may be asking for capital to fund a business, so a DB plan loans the investor money. Private placements have “make whole provisions.” Such provisions allow parties to agree in advance on a measure of damages for prepayment of the loan. Lenders use make-wholes to lock in a guaranteed rate of return on their investment at the time they agree to provide the financing, while borrowers may benefit by obtaining lower interest rates or fees than they would otherwise. Cornwell says private placements are credit-oriented instruments that come with protections from downgrades, defaults and credit-rating migrations.

NYC-based Tas Hasan, partner and investment committee member at Deerpath Capital Management, a direct lender to the lower-middle market, says for DB plans, there are elevated leverage levels in direct lending, while generating a low yield. “Pension funds need to generate yield, but in the late credit cycle, they are thinking more about safety,” he explains. “When pushed to take increased risk, the upper-middle market is overheated, so they can move into the lower-middle market. We don’t see an erosion of the quality of loans with an elevated level of risk in the lower-middle market.”

Direct lending is a form of corporate debt provision in which lenders other than banks make loans to companies without intermediaries such as an investment bank, a broker or a private equity firm. The lower-middle market consists of companies with less than $50 million of earnings before interest, tax, depreciation and amortization (EBITDA).

According to Hasan, the reason for direct lending in the lower-middle market is that a lot of capital has been raised in direct lending, but most has concentrated on lending to companies with more than $100 million in enterprise value. More than 80% of those loans are now “covenant-lite,” meaning they lack traditional requirements for companies to maintain certain financial benchmarks that protect the investors who pay for them. In the lower-middle market, there are still protections and covenants in place to mitigate risk.

A sustainable, long-term approach

Mike Anderson, vice president and portfolio manager for asset and liability management (ALM) strategies at Securian Asset Management, based in St. Paul, Minnesota, says, “In my role working with ALM strategies for [insurer’s] general accounts, I look at each liability and work to manage assets against those liabilities, taking a sustainable, long-term approach.”

He says securitized assets help with that. When the overall general account is in investment-grade fixed income, commercial mortgage loans are a good percentage of the portfolio. In addition, fixed income investments include asset-backed securities and corporate credit.

Anderson says regular feedback of liability and longevity information from actuaries helps to improve the ALM process as far as security selection and pricing, especially when thinking of credit risk and liquidity needs.

Jeremy Gogos, vice president and portfolio manager of quantitative strategies at Securian, based in St. Paul, Minnesota, says pension plan sponsors have the advantage of a good projection of liquidity needs. They have the ability to allocate into commercial whole loans and private placements variations, taking on a liquidity premium above that of the insurance market.

According to Cornwell, there are some securitized assets not available to DB plans, but there is still a wide array they can use. He adds that long duration collateralized mortgage obligations (CMOs) have structural protection and collateral that is government-backed. A CMO refers to a type of mortgage-backed security that contains a pool of mortgages bundled together and sold as an investment. Organized by maturity and level of risk, CMOs receive cash flows as borrowers repay the mortgages that act as collateral on these securities.

Some key things for DB plan sponsors to consider, according to Cornwell, is that DB plans and insurance companies work under different regulatory environments and DB plan liabilities are valued differently than insurance valuations. Also, DB plans are governed by the Employee Retirement Income Security Act (ERISA), so plan sponsors should consider what is and is not allowable. He adds that there’s some ambiguity about whether DB plan sponsors governed by ERISA can invest in below investment-grade securitized assets, but he believes most would say it is not allowed.

Still, Cornwell says, “We advocate for DB plan sponsors to take investing lessons from insurance companies to the extent it works for their plans.”

Pension Risk Transfer Appetite Is Unabated

They are trying other strategies, but DB plan sponsors are concluding that they and their employees would be better served by shifting risks to life insurers.

Legal & General Retirement America’s Pension Risk Transfer Monitor shows the U.S. pension risk transfer (PRT) market has remained very active throughout the first three quarters of 2019.

Relative to the same period in 2018, this year has seen a 12% increase in total deal count. According to the report, the total premium paid only increased by 1%, largely due to an “outlier transaction” in the second quarter of 2018, when FedEx entered into a $6 billion PRT transaction. Excluding the FedEx transaction, the total premium increase is nearly 53%.

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The analysis shows plan terminations accounted for just under $4 billion of sales in the first half of this year, nearly surpassing total plan termination sales in 2018.

Legal & General Retirement America projects that this year’s final deal volume will approach, but not reach, the record level set in 2012. Looking back, 2013 saw far less PRT activity than 2012, but each year since 2013, the PRT transaction total has increased or remained essentially flat, as was the case between 2015 and 2016.

The research points to a variety of causes for the trend of increased PRT transactions. Insurance premiums paid to the Pension Benefit Guaranty Corporation (PBGC) continue to increase, and at the same time, the Internal Revenue Service (IRS) is instituting updated mortality tables, which reflect a longevity measurement more in sync with insurance carrier assumptions.

Employers that sponsor defined benefit (DB) plans are increasingly recognizing the value of PRT annuities as they look to accomplish multiple goals, says Neil Drzewiecki, head of pension risk transfer for MassMutual. He says annuities help employers shift pension risks off their balance sheets, reduce their long-term financial liabilities and costs, and maintain long-term financial security and service for plan participants.

As detailed in a new MassMutual white paper on the topic, PRT effectively represents the only way to eliminate pension obligations under current law. This is another core reason why pension buy-out transactions have steadily gained traction during the past several years, growing from $3.84 billion in 2013 to $26.4 billion in 2018. The paper notes PBGC premiums for single-employer plans have more than doubled in the past 10 years, rising to $80 per participant in 2019.

“There are several different risk strategies for employers to contemplate when managing pension risks over both the short- and long-term,” Drzewiecki says. “More employers are concluding that transferring those risks to a life insurer is in the best interests of the company and its employees.”

He points to several short-term and long-term strategies for managing pension risks. First is to address “hibernating risks.” When plans are in “hibernation,” they have been closed to any new entrants and have stopped accruals for participants. While hibernating a DB plan protects against the risk of benefit increases, such plans are still exposed to many other risks, especially interest-rate risk, Drzewiecki says.

Next, in order to manage market risk, some plan sponsors elect to reallocate investments according to a funded stats-based schedule to hedge the exposure of their plan’s liabilities. With this approach, plan investments are increasingly allocated toward fixed income as the plan’s funded status improves. Doing so helps diminish the risk-reward tradeoff associated with equities, while fixed-income assets helps provide a hedging effect as interest rates rise or fall.

Another consideration for plans is whether/how to hedge equity market risk. Often, hedging reduces investment risks but does not eliminate them entirely. According to MassMutual, while it’s impossible to hedge every risk, hedging can help lower risk and create less volatility in some cases.

MassMutual’s analysis concludes that, as the management of pensions becomes more complex, employers are concluding that they and their employees would be better served by shifting defined benefit obligations, liabilities and risks to life insurers, which focus on risk management as their primary purpose. Insurers are also well-equipped to offer administrative services to large groups of plan participants.

“Many companies have considerable experience administering annuities for pension plans that have previously purchased annuities as well as other insurance-oriented lines of business that are similar to pensions,” the white paper concludes. “Life insurers, with their experience managing tail risks that can extend decades, are professional risk managers and are, therefore, best equipped to handle such risks.”

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