Companies are increasingly becoming more sophisticated in how they communicate pension costs to the market. A small but increasing number of plan sponsors are now beginning to strip out the non-cash impact of pension earnings and reporting an “adjusted EPS” result in the belief that these numbers are more important to investors. In almost every case, this departure from U.S. GAAP reporting has been well received by investors due to increased transparency and a more coherent view on sources and quality of corporate earnings.
There is growing acceptance among investors of the common view that a pension fund is not a good place to spend shareholders’ risk capital. We have already seen a gradual reduction in risk and a greater desire to manage the underlying economics across many corporations.
The options available for de-risking have expanded. On the buyout side, the high capitalization levels in the U.S. life insurance industry allow life insurers to invest heavily around areas such as product development to help corporations achieve cost-effective risk transfer while minimizing counterparty credit risk. Investment platforms also exist that facilitate a glide path to de-risking for pension plans via dynamic asset allocation.
“Due, in part, to current favourable conditions in the life insurance market and the strategic options available to them, we believe that companies willing to quickly undertake a thorough diagnostic followed by the enactment of a plan for pension risk reduction may be able to create substantial shareholder value in the long term,” said Ramy Tadros, partner and head of Oliver Wyman’s North America insurance practice.
While some believe the current market conditions are an odd time to pursue a de-risking strategy, the report’s authors argue that because the funding situation of a plan is highly volatile, it leaves organizations with few relative openings to lock in the surplus. Conversely, establishing a proper de-risking strategy for a plan is complex and requires months of preparation, and firms that are not ready to execute a strategy or even recognize the ability to do so are unlikely to pull it off successfully.
What should plan sponsors do?
• Start with a thorough understanding of the underlying economics of pension funding. Specifically, every sponsor should have a preferred strategy that would be implemented in the absence of any accounting constraints.
• Understand how the market currently treats or values pension exposure. This is different for different companies — some companies have more latitude to change than they believe. As the likelihood of convergence between U.S. and International GAAP approaches, companies need to be prepared for pension management in an environment of transparency.
• Consider managing the tension between risk reduction and reported earnings impact by executing a dynamic de-risking strategy. This approach is attractive as it provides a plan for managing downside economic risks as well as a means to communicate the impact to the market gradually.
• Consider complete risk transfer now. We believe that, ultimately, the amount of risk capital that insurance companies will have available for termination or close-out business is limited. As a result, there could be a pronounced early-mover advantage for those who annuitize liabilities.
View the joint Oliver Wyman and Mercer report here.
