UNLOCKING SHAREHOLDER VALUE THROUGH PENSION …...paper, we discuss the principal means to achieving...

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UNLOCKING SHAREHOLDER VALUE THROUGH PENSION RISK TRANSFERSA FRAMEWORK FOR CORPORATE PENSION PLAN SPONSORS

Technical Document

AUTHOR

Michael Moloney, Partner

1. INTRODUCTION TO FRAMEWORK 3

2. APPROACH 6

3. PART I – A HOLISTIC BALANCE SHEET VIEW OF THE FIRM 7

4. PART II – WHEN SHOULD CORPORATES FUND PENSION LIABILITIES? 9

• The funding condition 9

• Threshold credit spreads by interest rate environment 10

• Value created by accelerating funding 11

• Value creation for S&P 500 companies 14

5. VALUE CREATION 16

• The combined framework 16

• Economic cost of delivery 17

• Cost of risk transfer 22

• The value assessment framework for risk transfers 25

6. CONCLUSIONS 28

7. APPENDIX – THE OPTIONS BASED FRAMEWORK 30

CONTENTS

1. INTRODUCTION TO FRAMEWORK

This paper sets out an integrated model which we suggest investors should use to evaluate

the impact of potential defined benefit pension risk transfer actions by US companies.

We apply this framework to show that significant value can be unlocked for shareholders

if high quality US corporates transfer pension risk off of their balance sheets. In this

paper, we discuss the principal means to achieving this while focusing on the interests of

shareholders – not debt-holders, whose interests can vary.

We categorize S&P 500 companies into three groups:

1. Category A: Those our model would suggest immediately derisk and transfer

risk – facilitated, as necessary, by corporate borrowing

2. Category B: Those that should derisk but seek to minimize funding

3. Category C: A minority that should seek to minimize funding and maximize

investment volatility

For the first of these groups, we calculate the magnitude of the potential enhancement

to shareholder value from the actions we are suggesting. Additionally, we highlight

the current US GAAP treatment of these actions is unhelpful in appreciating the actual

underlying economics.

A majority of large US corporates are on an exit trajectory from the business of providing

and investing for defined benefit (DB) pension plans. A full third of S&P 500 companies have

no DB liabilities at all. Of US plan sponsors that have a DB plan, Mercer survey data shows

that 60% have either closed or frozen their plans. As a result, many sponsors are thinking

carefully about what the eventual ‘endgame’ will look like for their plan(s). Some are aiming

for a fully funded plan run off over the long-term using a low volatility investment approach.

Many, however, are expressing interest in more fundamental strategies to shrink liabilities

through a combination of insurance company annuitization and voluntary lump sum

payments to plan participants.

The potential flows involved are very large and are receiving a lot of attention from banks,

insurers and asset managers as these flows represent both an opportunity and a threat to

current business models. We estimate that overall single employer-sponsored corporate DB

pension plan liabilities on a US GAAP basis total in the region of $2 TN. As Exhibit 1 shows,

approximately $1 TN of these liabilities relate to current pensioners and $280 BN to former

employees who retain a right to a benefit from retirement (so called ‘terminated vested’

plan participants).

Copyright © 2012 Oliver Wyman 3

EXHIBIT 1: SEGMENTATION OF US DB PENSION PLAN LIABILITIES

Closed30%

Terminated vested14%

Open40%

Retiree50%

Frozen30%

RETIREE LIABILITIES IN SINGLE EMPLOYER SPONSORED CORPORATE DB PLANS ACCOUNT FOR APPROXIMATELY $1 TN

THE TREND TOWARD CLOSING AND FREEZING PLANS FORCES AN ‘ENDGAME’ FOCUS

Active36%

Total$2 TN

Source: DOL 5500s, Schedule S-Bs for 2009 plan years, Mercer estimates

The pie chart on the right-hand side of Exhibit 1 categorizes plans into three classes:

1. Open plans where sponsors are providing defined benefit pensions to all

active employees

2. Closed plans where future accrual to new employees was stopped at a point in time

3. Frozen plans where no future pension benefits are accruing

It is not always obvious into which category a particular company falls, and it is indeed

possible to have multiple plans across the different categories. With very few exceptions,

however, sponsors of closed or frozen plans are on the road to derisking these plans and

it is more a question of when and in what form rather than if. We have summarized the US

rules around use of pension plan surpluses in the appendix, but the key point is that surplus

very quickly becomes uneconomic. The idea, therefore, that it makes sense to continue to

take risk indefinitely in search of return is no longer valid. As a result, we will see sponsors of

frozen plans lead the derisking and pension risk transfer trend since they will be pushed to

full funding by Pension Protection Act rules and will have the least use for surplus given their

lack of ongoing accrual of liabilities.

For corporates wishing to shrink their DB exposures, it is relatively straightforward (subject

to acceptable pricing and sufficient available capacity) to transfer retiree liabilities to an

insurer and also reasonably simple to offer terminated vested and retired participants the

choice to take their benefit by way of a lump sum payment from the plan.


Many CFOs find such risk transfer approaches attractive in concept. A very early question

though is whether the economics are beneficial for shareholders or not and what the

accounting and cash consequences of any potential actions might be. In a previous paper1,

we commented on the challenges posed by US GAAP to derisking actions in general and

particularly on the impact on earnings of investment derisking. For the purposes of this

paper, we have ignored potential loss of ‘funny money’ expected return on asset earnings,

though we acknowledge that impact needs to be communicated carefully with the

investor community.

In the remainder of this paper, we provide a framework for assessing pension risk transfer

economics and illustrate that apparent US GAAP cost of risk transfer should be ignored or,

in many cases, heavily discounted by investors. Our motivation in doing so is to promote

investor awareness and understanding to help reduce what we think is a major barrier to

more efficient capital structure management for many of our clients.

1 Funny Money – The increasing irrelevance of pensions earnings, August 2010.


2. APPROACH

We introduce our framework in two parts:

• Part I establishes a Holistic Balance Sheet view of the firm, allowing directly for its stake in

the pension fund and thereby allowing us to think more deeply about the two opposing

forces that determine shareholder value – a corporate’s share in pension fund surpluses

versus the cost of funding future deficits.

• Part II sets out an approach for thinking about funding policy and looks at when it is tax

advantageous to fund pension liabilities.

We use this framework to:

• Identify conditions under which a company should fund its liabilities and those under

which funding should be minimized

• Conclude that for many high credit quality companies, it is cheaper to borrow outside

the pension fund, so pension provision should be thought of in terms of its ‘risk-free’ or

economic cost

We combine Parts I and II to identify conditions under which pension fund investment risk-

taking might add shareholder value but conclude that these circumstances are relatively

limited and, in most cases, corporates maximize shareholder value by hedging liabilities

irrespective of current market conditions.

The theoretical foundation for our two-part framework is well established2 and, as a result,

we have avoided a ‘back to basics’ exposition. Instead, we have focused on the mechanics

of applying the approach and its implications in what we hope is a relatively straightforward

way. Our experience has been that while the concepts are well set out in the existing

literature, the application is not as well expounded with the result that clients and some

practitioners are often unclear about practical application and consequences.

2 See, for example, W.F. Sharpe, “Corporate Pension Funding Policy”, Journal of Financial Economics, June 1976; I. Tepper, “Taxation and

Corporate Pension Policy”, Journal of Finance, Vol XXXVI, No. 1, March 1981; F. Black, “The Tax Consequences of Long Run Pension

Policy”, Financial Analysts Journal, July – August 1980; C. Exley, S. Mehta, A. Smith, “The Financial Theory of Defined Benefit Pension

Schemes”, British Actuarial Journal, Vol 3, Part IV, No 14, October 1997.


3. PART I – A HOLISTIC BALANCE SHEET VIEW OF THE FIRM

For the purposes of our analysis, we have used what we refer to as a ‘Holistic Balance Sheet’

for the firm3 which is shown below in stylized form. The approach augments the firm’s direct

assets (A), liabilities (L) and owners’ equity (E) as follows:

• We add the value of a call option on pension fund surplus to corporate assets. This call

option values the employer’s share of any potential future surplus which, for example,

may arise in the pension fund as a result of mismatching between assets and liabilities less

an allowance for any leakage that may occur by way of benefit increases or excise tax.

• We also add the value of a ‘put option’ to liabilities equivalent to the potential additional

funding the employer might be required to contribute to the plan as a result of current or

future deficits, less an allowance for the probability of default given bankruptcy.

EXHIBIT 2: THE INTEGRATED FIRM – FUND BALANCE SHEET

ASSETS LIABILITIES & OWNERS’ EQUITY

Conventional Corporate Assets

A Conventional Corporate Debt

D

Corporate Share of Pension Call

(1-j)C Firm Guarantee of Pension (1-l)P

Shareholder Equity E

Where:

• C = call option value

• P = put option value

•• j•= the proportion of surplus expected to accrue to members e.g. through discretionary

benefit increases

•• l•= an allowance for the employer’s ability to default on pension liabilities in bankruptcy.

C and P are struck at the value of liabilities discounted at risk-free interest rates and also

allowing for the addition of capitalized operating expenses. The ‘underlying’ on the options

is the value of the plan’s assets and option volatility is the expected annual standard

deviation in surplus (i.e. [asset – liability] volatility).

3 This approach was originally proposed by William Sharpe (1976). Please see the appendix for a more detailed explanation.


In order to maximize the value of the firm, we should be trying to maximize the value of the

difference between the call (the company’s share in any future surplus) and the put (the

requirement to fund any future deficits less the corporate’s ability to default in bankruptcy).

We should maximize:

We can restructure this expression as follows4:

This is just the existing surplus/deficit in the plan

So the key is maximizing the value of this put option to the company

Exhibit 3 summarizes four possible combinations for behavior of the second term in the

equation above which, as we note, drives how pension funding and investment policy

impact shareholder value.

EXHIBIT 3

CONDITION/SITUATION IMPLICATION

The firm will never default, all surplus accrues to the sponsor with no leakage:

l•=•j•=•0

The equation collapses to the current surplus/deficit in the pension fund measured on a risk-free basis and allowing for capitalized operating costs. Contribution and investment policy have no impact on corporate value.

lP has negative value As we will see in the next section, this condition arises when it is cheaper for the company to borrow from financial markets rather than from plan participants. j is at best 0, so in this case value is maximized by fully funding the plan and reducing the option value to zero by adopting a fully hedged investment strategy*.

lP•has positive value but value is less than jP

It is cheaper to borrow from participants than from markets but surplus leakage risk means that the best position is to minimize funding (i.e. maximize borrowing from participants) while hedging investment risk.

lP has positive value but value which is greater than jP

Borrowing is more cheaply available from participants than from markets and policy should be to maximize put option value by adopting as risky/unmatched an investment policy as possible in the pension fund.

* The parameters for the option value are the value of pension assets, the value of liabilities, the term of the option, the risk-free

interest rate and volatility. Volatility here refers to the standard deviation of the potential movement in surplus/deficit. Reducing

or eliminating volatility is achieved by fully hedging liabilities either through so called Liability Driven Investment strategies

(reduction) or through pension risk transfer approaches (elimination)

4 See appendix.


4. PART II – WHEN SHOULD A CORPORATE FUND PENSION LIABILITIES?

THE FUNDING CONDITION

When a company underfunds pension liabilities, it is borrowing from plan participants.

The obvious question from a shareholder value perspective is whether it is cheaper on an

after-tax basis to borrow instead from debt markets. The answer depends on the relative

net cost of debt from both sources. We set out the condition below that determines when it

is cheaper and therefore better, in terms of maximizing firm value, to borrow from markets.

When we talk about borrowing cost, by extension we are referring to the opportunity cost for

any funds the corporate already has at its disposal, such as cash on the balance sheet, which

could be used for pension funding purposes.

It is tax efficient to borrow to fund when the after-tax cost of borrowing is less than the

prevailing (risk-free) rate of return on the assets in the pension plan:

Where:

• rc is the corporate borrowing rate

• rf is the risk-free rate (i.e. the equivalent Treasury yield of appropriate term)

• T is the company’s marginal income tax rate

• VRP is the PBGC Variable Rate Premium

• IPPA<1 an indicator for when underfunding is attracting this premium

It is informative to think of the implications of this equation in terms of corporate debt being

a bundle of a risk-free debt which the company has sold and an option to default which the

company has simultaneously bought from the debt holders. If the equation above holds then

the default option on corporate borrowing is more cheaply available outside of the pension

fund due to the tax deduction.

Ignoring the VRP component, the equation above can be restated as:

where CS is the credit spread on marginal corporate borrowing.


In other words, provided a corporate’s credit spread is inside a threshold defined by

prevailing risk-free interest rates, borrowing to fund pension deficits is value additive.

The threshold spread increases as interest rates increase.

THRESHOLD CREDIT SPREADS BY INTEREST RATE ENVIRONMENT

Exhibit 4 shows the level that risk-free rates need to exceed to make borrowing a sensible

action based on a marginal tax rate of 35%.

EXHIBIT 4: THRESHOLD CREDIT SPREADS BY RATE ENVIRONMENT FOR PBGC AND NON-PBGC VRP ELIGIBLE DEFICITS

CORPORATE CREDIT SPREAD (BPS) ON BORROWING

RISK-FREE RATE AT WHICH DEFICIT SHOULD BE FUNDED

PBGC VRP DEFICIT ADDITIONAL DEFICIT

50 0 93

75 0 139

100 0 186

125 0 232

150 21 279

175 68 325

200 114 371

250 207 464

300 300 557

350 393 650

400 486 743

450 579 836

500 671 929

So, for example, for a corporate able to borrow at 200bps over risk-free, it makes sense to

borrow to fund a pension deficit when the risk-free rate is at or above 114bps for deficits

subject to the PBGC VRP or 371bps for other deficits.

Thresholds will vary, therefore, as risk-free rates vary. Exhibit 5 shows the threshold credit

spread implied by 20-year Treasury rates for both PBGC VRP and other deficits. When

corporate spreads were below the levels shown, companies should have borrowed to fund

pension deficits assuming a marginal tax saving of 35%. Recent declines in long-term rates

have obviously reduced the attractiveness of borrowing to fund though it is still economically

sensible for many as we will show.


EXHIBIT 5: HISTORY OF CREDIT SPREAD THRESHOLDS IMPLIED BY 20-YEAR TREASURY RATES (1995 – 2011)

1.0

1.5

2.0

2.5

3.0

3.5

4.0

4.5

1995 1998 2001 2004 2007 2010

PBGC

Non-PBGC

VALUE CREATED BY ACCELERATING FUNDING

Our discussion so far has set out the condition for determining when value is created by funding

pension liabilities but does not identify the amount of additional value in play. We do this now by

comparing the amount of cash required to fund a pension liability immediately with the amount

required if funding is deferred. For this purpose, we accumulate the amount required to pay later

in line with the risk-free rate of return and discount at the after-tax borrowing cost. This assumes

that the corporate has sufficient taxable earnings against which to offset interest.

The amount of cash required to pay a deficit now is as follows:

Where P is the amount being funded now and T is the marginal corporate tax rate.

The equivalent amount of cash required to fund this amount in n years’ time is:

where rf is the risk-free interest rate over n years (so the current n-year Treasury yield) and rc

is the corporate n-year borrowing cost.

The value created by borrowing to fund as a percentage of the amount borrowed is therefore:


So, value created by accelerating pension funding (either by borrowing to fund or use of

surplus cash in the business) increases as the risk-free rate and marginal tax rates increase

and decreases as the credit spread increases. Provided the expression is positive, value also

increases with n (i.e. the most value is created by accelerating contributions which would

otherwise only be made in the distant future).

We have considered two separate potential funding elements – deficits attracting PBGC

variable rate premiums (VRPs) and other potential funding. For the former, we allow for

90bps of VRP charge and assume that funding is required over seven years (in line with

regulatory funding requirements ignoring any smoothing effects). Exhibit 6 shows the value

created by immediately funding eligible deficits for a range of corporate credit spreads and

risk-free interest rates.

Figures in Exhibit 6 allow for 90bps VRP as an addition to the risk-free rate of interest and

assume that deficits would otherwise be funded over seven years. Obviously if the PBGC

VRP increases, as is suggested by changes currently being considered by Congress as part of

deficit reduction plans, then the risk-free interest rates in the table will drop – borrowing to

fund deficits subject to the VRP will become attractive at higher corporate credit spreads.

EXHIBIT 6: VALUE CREATED BY IMMEDIATE FUNDING AS % OF NET BORROWING REQUIREMENT WHERE DEFICITIS SUBJECT TO PBGC VARIABLE RATE PREMIUM

RISK-FREE INTEREST RATE

CREDIT SPREAD 3% 4% 5% 6%

3% 4% 5% 6%

0.50% 6.3% 7.6% 8.8% 10.1%

1.00% 5.0% 6.3% 7.5% 8.8%

1.50% 3.7% 5.0% 6.3% 7.5%

2.00% 2.5% 3.7% 5.0% 6.2%

2.50% 1.2% 2.5% 3.8% 5.0%

3.00% 0.0% 1.3% 2.5% 3.8%

So, for example, a company borrowing at 1% above risk-free when rates are at 5% saves 4.1%

of the amount of any deficit attracting the PBGC VRP by borrowing to accelerate funding.

Exhibit 7 shows value created as a percentage of amount funded for deficits that do not

attract VRPs for a range of risk-free interest rates.


EXHIBIT 7: VALUE CREATED BY IMMEDIATE FUNDING AS % OF NET BORROWING REQUIREMENT; NO VRP ON DEFICIT

RISK FREE RATE = 3% RISK FREE RATE = 4%

TERM

SPREAD 1 3 5 7 10 15 20

0.5% 0.7% 2.1% 3.6% 5.1% 7.3% 11.2% 15.2%

1.0% 0.4% 1.2% 2.0% 2.8% 4.0% 6.0% 8.1%

1.5% 0.1% 0.2% 0.4% 0.5% 0.7% 1.1% 1.5%

2.0% - - - - - - -

2.5% - - - - - - -

3.0% - - - - - - -

3.5% - - - - - - -

TERM

SPREAD 1 3 5 7 10 15 20

0.5% 1.0% 3.2% 5.3% 7.5% 10.9% 16.9% 23.1%

1.0% 0.7% 2.2% 3.7% 5.2%* 7.5% 11.5% 15.6%

1.5% 0.4% 1.2% 2.1% 2.9% 4.2% 6.3% 8.5%

2.0% 0.1% 0.3% 0.5% 0.7% 1.0% 1.5% 1.9%

2.5% - - - - - - -

3.0% - - - - - - -

3.5% - - - - - - -

* E.g. a tax-paying corporate which can borrow at 1% over risk free will save 5.2% by pre-funding a pension contribution that would otherwise be payable in seven years’ time.

RISK FREE RATE = 5% RISK FREE RATE = 6%

TERM

SPREAD 1 3 5 7 10 15 20

0.5% 1.4% 4.2% 7.1% 10.0% 14.6% 22.7% 31.4%

1.0% 1.1% 3.2% 5.4% 7.7% 11.1% 17.1% 23.4%

1.5% 0.7% 2.2% 3.8% 5.3% 7.7% 11.8% 16.0%

2.0% 0.4% 1.3% 2.2% 3.1% 4.4% 6.7% 9.0%

2.5% 0.1% 0.4% 0.6% 0.8% 1.2% 1.8% 2.4%

3.0% - - - - - - -

3.5% - - - - - - -

TERM

SPREAD 1 3 5 7 10 15 20

0.5% 1.7% 5.2% 8.8% 12.5% 18.4% 28.8% 40.2%

1.0% 1.4% 4.2% 7.1% 10.1% 14.8% 22.9% 31.7%

1.5% 1.1% 3.3% 5.5% 7.8% 11.3% 17.4% 23.8%

2.0% 0.8% 2.3% 3.9% 5.4% 7.9% 12.0% 16.4%

2.5% 0.5% 1.4% 2.3% 3.2% 4.6% 7.0% 9.4%

3.0% 0.1% 0.4% 0.7% 1.0% 1.4% 2.1% 2.9%

3.5% - - - - - - -

Overall, a reasonable ‘rule of thumb’ is to assume that accelerating funding is worth exploring further when credit

spread on borrowing is about half or less of the risk-free borrowing rate (over the relevant term).


VALUE CREATION FOR S&P 500 COMPANIES

To make this framework more tangible, we have applied it to the S&P 500 universe. To do this, we have calculated

representative credit spreads on traded corporate bonds for S&P 500 constituents by looking at average option-

adjusted spreads for bonds constituted within the Barclays Capital US investment grade and high yield universes as

of October 2011. We have divided companies into those in a ‘green zone’ who should borrow to fund now (based

on prevailing risk-free rates and our thresholds above) and those in an ‘orange zone’ where the strategy would make

sense with some reasonable uptick in rates and who should therefore monitor rates closely. Exhibit 8 shows the

breakdown of the S&P universe by category. In all cases we have assumed that corporates pay a corporate tax of 35%

at the margin, which is obviously a simplification.

EXHIBIT 8

NUMBER OF COMPANIES

AGGREGATE MARKET CAP (3/31/2011)

MARKET CAP AS % OF TOTAL

PENSION LIABILITIES (PBO)

PENSION LIABILITIES AS % OF INDEX TOTAL

No DB Liabilities 166 $3,592 BN 29% NA NA

WITH US DB LIABILITIES

Green Zone 100 $4,454 BN 36% $755 BN 48% v Should borrow to fund now

Orange Zone 101 $2,344 BN 19% $456 BN 29% v Should borrow to fund if rates increase by 1% or less

Remaining Investment Grade

58 $1,098 BN 9% $147 BN 9% v

v

Includes unrated corporates, those designated as high yield and investment grade corporates with no traded US debt

High Yield 75 $1,023 BN 8% $211 BN 13%

TOTAL 500 $12,511 BN 100% $1,569 BN 100%

Source: CapitalIQ; Mercer; BarclaysPOINT

Note: Pension liabilities as of 2010 year end, Market capitalizations as of 3/31/2011, credit spreads as of 11/1/2011

In Exhibit 9, we show illustrative figures for the value created by borrowing to fund US pensions for the top ‘green

zone’ companies by amount of US pension liabilities. These are only illustrative given the approximate nature of our

approach – we have assumed that borrowing to fund the US GAAP deficit shown could be executed at prevailing

credit spreads which may not be the case.


EXHIBIT 9

US GAAP PENSION LIABILITY (PBO)

US PENSION ASSETS

US GAAP DEFICIT

AVERAGE CREDIT SPREAD

VALUE CREATED BY BORROWING TO FUND US GAAP LIABILITY: % OF PRINCIPAL AND $ AMOUNT BY RISK- FREE INTEREST RATE SCENARIO

COMPANY NAME $MM $MM $MM BPS

3% 4% 5%

% $MM % $MM % $MM

Boeing 59,106 49,252 -9,854 96 4% 415 8% 764 11% 1,120

IBM 51,293 50,259 -1,034 82 5% 54 9% 91 12% 128

Lockheed Martin 35,773 25,345 -10,428 148 1% 92 4% 452 8% 818

Northrop Grumman 25,263 23,265 -1,998 135 2% 34 5% 103 9% 174

UTC 24,445 22,384 -2,061 122 3% 52 6% 124 10% 197

Du Pont 23,924 18,403 -5,521 86 5% 272 8% 469 12% 669

UPS 21,342 20,092 -1,250 86 5% 61 8% 106 12% 151

Raytheon 18,407 14,502 -3,905 124 2% 93 6% 230 9% 369

ExxonMobil 15,007 10,835 -4,172 63 6% 269 10% 419 14% 573

Note: Credit spreads shown are averages as of October 2011 for OAS on traded debt by corporate in the Barclays Capital US Investment Grade and High Yield

indices. Averages are taken across issues and not weighted

For example, assuming a risk-free rate of 3% and a credit spread of 0.82%, IBM would save 5% by issuing debt to

advance fund a pension contribution otherwise due in 10 years’ time.


5. VALUE CREATION

THE COMBINED FRAMEWORK

We bring Parts I and II together in Exhibit 10 below and use conditions to identify three

separate categories of companies according to the funding and investment policy actions

they should take to maximize shareholder value. For the remainder of this paper, we focus on

Category A. We plan to publish a separate paper that will look at categories B and C.

EXHIBIT 10

CATEGORY PART I CONDITION PART II CONDITION FUNDING POLICY INVESTMENT POLICY

Al•=•0

Maximize funding subject to recoverability, borrow if needed

Fully hedge

Bl•≤•j

Underfund Fully hedge

Cl•>•j

Underfund Maximize risk

Category A companies can borrow more cheaply outside the pension fund than from participants

(our Part I condition). As a result, as described earlier, it is not economically sensible for them to

buy a default option from participants. By extension, the cost of providing pension benefits needs

to be thought of in terms of future cash flows discounted by risk-free rates.

For Category A companies we will examine the following:

• What is being disclosed under US GAAP as the pension liability

• What the adjusted liability figure would be if we:

− Changed to risk-free discounting from AA

− Added capitalized plan operating expenses which are not included under US GAAP

We call the resulting number the Economic Cost of Delivery.


Then, we will take an educated guess at what cost risk transfer could be achieved at

assuming that the plan is terminated and:

• Insurance company annuities are bought for current retirees/pensioners

• Terminated vested and active participants are offered a choice between:

− an immediate cash lump sum; or

− a deferred annuity again secured from an insurer

We call this number the estimated Cost of Risk Transfer.

Once we have worked through this logic, it will become clear that in almost all cases, the

Cost of Risk Transfer is less than the Economic Cost of Delivery which will lead us to conclude

that despite US GAAP suggesting otherwise, transferring pension risk is value-additive for

shareholders to the tune of the difference between the Economic Cost of Delivery and the

Cost of Risk Transfer.

ECONOMIC COST OF DELIVERY

US GAAP pension liabilities are calculated as follows:

EXHIBIT 11: US GAAP LIABILITY CALCULATION

Projected futurebenefit payments

+

Expenses+

PBGC Premiums

Risk free yield curve (Treasury or swap)

(Cost of delivery/strike price on options)

Projected futurebenefit payments AA-curve Accounting Liability

Using publicly available information we want to adjust this calculation as follows:

The US GAAP pension liability figure does not include capitalized operating expenses for the plan and future PBGC premiums

By discounting using a AA yield curve, the US GAAP liability is implicitly offsetting the value of a default option against the pension liabilities consistent with an average level for AA-rated corporates. For Category A companies, we have determined that this default option from the fund is not relevant so we need to move back to risk-free discounting.

ADJUSTMENT 1

ADJUSTMENT 2

ADJUSTMENT 3


ADJUSTMENT 1 – PLAN OPERATING EXPENSES

US corporate pension plans are required to disclose expenses paid from plan assets annually

(so-called Form 5500s which are submitted to the Department of Labor). We have examined

5500 data for 2,328 non-union plans with assets greater than $40 MM and expenses greater

than zero for the 2009 plan year and calculated the ratio of total administrative expenses to

estimated liability values. These figures are shown in Exhibit 12.

EXHIBIT 12: 2009 OPERATING EXPENSES AS A % OF ASSETS

EXPENSE CATEGORYAMOUNT $MM

AMOUNT/ ASSETS BASIS POINTS

Contract Administration 512 4 Contract administrator for performing administrative services for the plan.

Management 1,902 13 Fees paid for advice to the plan relating to its investment portfolio.

Professional 844 6 Outside accounting, actuarial, legal, trustee and valuation/appraisal services including fees for the annual audit of the plan.

Other 1,629 11 Other expenses which may include plan expenditures such as salaries and other compensation and allowances expenses for office supplies and equipment, cars, telephone, postage, rent, expenses associated with the ownership of a building used in the operation of the plan, and all miscellaneous expenses.

Total Expenses 4,887 34

Assets 1,511,011

Source: 2009 Form 5500 filings

As expected, operating expenses tend to decline as plan size increases which we have shown

in Exhibit 13.

EXHIBIT 13: ANNUAL PENSION PLAN OPERATING EXPENSES AS % OF ASSETS

SIZE OF PLAN ASSETS

0.49% 0.49%

0.34% 0.31% 0.34%

0.15%

0.0%

0.2%

0.4%

0.6%

0.8%

1.0%

1.2%

1.4%

$50 - $250 MM

$250 MM - $1BN

$1 - $2.5 BN

$2.5 - $5 BN

$5 - $10 BN

$10 BN+

90th - 95th

75th - 90th

50th - 75th

25th - 50th

10th - 25th

5th - 10th

Min - 5th

Median



ADJUSTMENT 2 – PBGC COSTS

From the pension fund’s perspective, the PBGC is providing insurance against default by

the employer. In theory, this might mean that the PBGC premium is offsetting the value of

the employer’s default option (lP) which would then mean that the PBGC was charging

each employer for its default option in respect of benefits for which the PBGC would then be

liable. If this was the case, then all employers should calculate the economic cost of pension

benefit delivery at the risk-free rate. In fact, this is not the case currently since not all pension

benefits are covered by the PBGC and premiums are not charged to reflect default risk

directly. Exhibit 14 summarizes current premiums and protections and also highlights recent

proposals to increase fixed rate premiums and allow the PBGC to set variable rate amounts

directly (premiums are currently set by Congress).

EXHIBIT 14

CURRENT PROPOSED

Flat rate premium $35 per participant Rate to increase to $44 per participant in 2014 and then ratchet up annually to a rate of $70 per participant from 2020 which would be indexed thereafter in line with national wages

Variable rate premium 0.9% of any unfunded vested benefits (determined under PPA rules)

Power to be devolved from Congress to the PBGC to set premiums with guidance that the premiums should reflect investment policy and corporate credit risk.

Maximum guaranteed benefit (2011)

$55,841 (2012) for workers retiring at age 65 (lower for those retiring before that age)

Exhibit 15 shows the total amount of annual flat rate premium for the plans in our 5500

universe. Total PBGC flat rate premium collections in 2009 were $1.2 BN, 70% of which is

covered by our sample. Given that we are focusing directly on Category A companies, we will

make the assumption that variable rate premiums are not being paid. That said, PBGC statistics

for 1998-2008 show the percentage of plans paying variable rate premiums fluctuating from

a low of 25% to a high of 50% and on average the amount of variable rate premium collected

over that period was approximately 50% of the corresponding flat amount.

EXHIBIT 15: PBGC FLAT RATE PREMIUM COST

CATEGORYNUMBER OF PARTICIPANTS (THOUSANDS)

TOTAL PBGC FLAT RATE PREMIUM $MM

$35/PARTICIPANT $44/PARTICIPANT $70/PARTICIPANT

Actives 9,496 332 418 665

Terminated vested

7,172 251 316 502

Retiree/in pay 6,804 238 299 476

Total 23,472 822 1,033 1,643

Premium as % of assets

6 bps 8 bps 12 bps


ADJUSTMENT 3 – DISCOUNT RATE

US GAAP discounts pension liabilities using a high quality corporate bond yield which is

typically interpreted as meaning a AA-corporate curve. To adjust liabilities to reflect risk-free

discounting, we will look at the typical AA-spread implied by companies’ published pension

discount rates and adjust accordingly. Exhibit 16 shows the distribution of discount rates

used by those S&P 500 companies with US pension plan liabilities at FYE2010. The most

typical discount rate in use was 5.5%.

EXHIBIT 16: DISCOUNT RATES USED FOR FYE 2010 US PBO

0

100

60

80

40

20

48

30

58

90

44

15

<4.50% 4.75% 5.00% 5.25% 5.50% 5.75% 6.00%

Exhibit 17 shows representative points on the term structure below for both Treasury spot

rates and those from a AA-discount curve calculated by Mercer and in use by clients for

disclosure purposes.

EXHIBIT 17: REPRESENTATIVE AA SPREADS; 12/31/2010

TERM TREASURY SPOT YIELD MERCER SPOT YIELD CURVE IMPLIED AA CREDIT SPREAD

1 0.27% 1.21% 0.94%

5 2.06% 3.67% 1.61%

10 3.56% 5.35% 1.78%

15 4.02% 6.18% 2.16%

20 4.57% 6.46% 1.89%

30 4.69% 5.80% 1.11%

A 5.5% discount rate would suggest liabilities between 10 and 15 years in duration and a AA-

spread between 1.78% and 2.16%. To be conservative in our estimates of savings on pension

risk transfer, we have used a 2% spread and 10 year duration.


ILLUSTRATIVE ADJUSTED ECONOMIC DELIVERY COSTS – TOP 20 COMPANIES BY US GAAP LIABILITIES

We have applied Adjustments 1 – 3 for the top 20 companies by US GAAP liabilities as shown

in Exhibit 18.

EXHIBIT 18

ADJUSTMENT CALCULATIONRESULTING ADJUSTMENT TO US GAAP PBO NOTES

1 Capitalized Operating Expenses

0.15% x 10 +1.5% Median operating expense for $10 BN+ plans times our assumed duration for a mature pension plan

2 Capitalized PBGC Premiums

0.06% x 10 +0.6% Average PBGC premium as a % of liabilities by mature plan duration

3 AA- to Treasury curve discounting

2% x 10 +20% Average AA-spread implied by FYE2010 disclosures times mature plan duration

Overall adjustment +22.1% Total approximated adjustment to GAAP liabilities

We have illustrated the application of these adjustments to published US GAAP results in

Exhibit 19 for the top 20 US plan sponsors in the S&P 500 group, ordered by size of liabilities.

Resulting figures are obviously approximate and, while we think they are useful, are

intended only to show broad order of magnitude/directional adjustments.

In all cases, Economic Cost of pension delivery is substantially above the disclosed US

GAAP liability.


EXHIBIT 19

Latest FYE

deficit under

US GAAP

s

Capitalized expense

estimate at 0.15% pa

s

Adjustment from US GAAP discount rate to Treasury at 2.00% spread

s

Resulting economic

deficit

s

COMPANY NAME

AVERAGE CREDIT SPREAD


US PENSION ASSETS

US GAAP DEFICIT

CAPITALIZED EXPENSES + PBGC COSTS

TRANSLATION TO RISK FREE DISCOUNTING

ECONOMIC COST

ECONOMIC DEFICIT

GAAP VS ECONOMIC DIFFERENCE

$MM $MM $MM $MM $MM $MM $MM $MM $MM

Boeing 96 59,106 49,252 -9,854 887 11,821 71,814 -22,562 -12,708

IBM 82 51,293 50,259 -1,034 769 10,259 62,321 -12,062 -11,028

Lockheed Martin

148 35,773 25,345 -10,428 537 7,155 43,464 -18,119 -7,691

Northrop Grumman

135 25,263 23,265 -1,998 379 5,053 30,695 -7,430 -5,432

UTC 122 24,445 22,384 -2,061 367 4,889 29,701 -7,317 -5,256

Du Pont 86 23,924 18,403 -5,521 359 4,785 29,068 -10,665 -5,144

UPS 86 21,342 20,092 -1,250 320 4,268 25,931 -5,839 -4,589

Raytheon 124 18,407 14,502 -3,905 276 3,681 22,365 -7,863 -3,958

Exxon Mobil 63 15,007 10,835 -4,172 225 3,001 18,234 -7,399 -3,227

Johnson & Johnson

53 14,993 13,433 -1,560 225 2,999 18,216 -4,783 -3,223

Honeywell 83 14,990 12,181 -2,809 225 2,998 18,213 -6,032 -3,223

Pfizer 97 14,436 10,596 -3,840 217 2,887 17,540 -6,944 -3,104

Caterpillar 97 13,024 10,760 -2,264 195 2,605 15,824 -5,064 -2,800

Exelon 150 12,524 8,859 -3,665 188 2,505 15,217 -6,358 -2,693

3M 62 12,319 11,575 -744 185 2,464 14,968 -3,393 -2,649

PG & E 131 12,071 10,250 -1,821 181 2,414 14,666 -4,416 -2,595

Consolidated Edison

122 10,307 7,721 -2,586 155 2,061 12,523 -4,802 -2,216

Chevron 52 10,271 8,579 -1,692 154 2,054 12,479 -3,900 -2,208

Deere & Company

79 10,197 9,504 -693 153 2,039 12,389 -2,885 -2,192

Pepsico 80 9,851 8,870 -981 148 1,970 11,969 -3,099 -2,118

Source: Oliver Wyman Analysis

COST OF RISK TRANSFER

We now want to look at the alternative cost involved in transferring pension risk by way of either annuitizing with a

qualified life insurance company or offering direct, optional lump sums to participants. We describe below how we have

estimated the cost of each of these approaches in turn.


ANNUITIZATION

When pricing annuities, a life insurer:

• Projects liability cash flows in much the same way as a pension fund actuary will do for

accounting and funding purposes (though perhaps taking a more conservative view of

projected longevity improvements given the one time nature of the premium payment

involved and the downside of getting this wrong);

• Adds a margin for projected administration and other operating expenses (much as we

have done above)

• Discounts these projected amounts using a curve based on the largely high quality

corporate bond portfolio the insurer expects to hold to back liabilities; and

• Adds a margin for the cost of the capital required to back this business

EXHIBIT 20: INSURER ANNUITY PRICING

Benefit payments+

Expenses+

Cost of capital

Corporate based yield curve Buyout cost

While individual insurers do not disclose pricing bases, Mercer conducts a monthly pricing

survey for a representative set of retiree and terminated vested liabilities. Prices received are

averaged and then translated into an equivalent discount rate which can be compared to the

prevailing 10-year Treasury yield. Exhibit 21 shows the spread between the corresponding

imputed discount rate and the 10-year Treasury rate compared to the option-adjusted credit

spread (OAS) on the Barclays US AA Corporate Index.

EXHIBIT 21: RETIREE ANNUITY PRICING – SURVEY COMPOSITE

0%

1%

2%

3%

4%

5%

6%

2003 2004 2005 2005 2006 2006 2007 2008 2008 2009 2009 2010 2010 2011

Retiree annuity pricing spread to 10-year Treasury

US Corporate AA spread

Source: Mercer


It is clear that there is a strong relationship between credit spreads and insurer pricing and

that insurers’ pricing bases (as expected) are passing through an allowance for a credit risk

premium and pricing overall at a rate cheaper than risk-free.

The line showing ‘Spread to 10-year Treasury rate’ gives an indication of the level of savings

available versus the sponsor’s risk-free liability. The average for the period shown is 0.75%.

The average spread between AA and retiree annuity pricing is 0.5%. Based on these averages

and assuming a typical eight year duration for a set of retiree liabilities, the implication

is that, on average, pricing for retiree annuitization would have been broadly 104% of

a corresponding US GAAP number and 94% of a corresponding Treasury or Economic

Cost figure.

LUMP SUMS

Terminated vested participants can be given the option to take their benefit in the form

of a cash lump sum rather than a deferred annuity. This option can be offered either at

the point of termination of employment and/or through opening a ‘window’ at a point in

time and making the offer to either the whole or a subset of the population of terminated

vested participants.

The legally mandated minimum amount of the lump sum offer was historically determined

by discounting projected cash flows (with no allowance for operating expenses) at the 30-

year Treasury rate so, under our construct, this would have been substantially above the

corresponding US GAAP liability but below the Economic Liability for Category A companies

to the tune of capitalized operating expenses, which might be 3-5%.

From 2012 onwards, however, the discount rate has been increased to reflect a corporate bond

yield which means that the lump sum offer, if accepted by participants, now removes liabilities

at the amount being carried for US GAAP purposes. This is clearly very attractive in almost all

cases and represents substantial savings versus the corresponding Economic Cost.

EXHIBIT 22: DETERMINING THE LUMP SUM AMOUNT

Benefit payments PPA (AA) curve Optional lump sum amount

Will be close to the US GAAP curvefrom 2012 onwards so have assumed that liability


THE VALUE ASSESSMENT FRAMEWORK FOR RISK TRANSFERS

In order to bring everything together to illustrate the potential shareholder value released by pension risk transfer

actions for Category A companies, we have assumed the following:

• Retiree buyout cost is 110% of US GAAP

− This is more conservative than suggested by our monthly pricing survey but we think it is reasonable in order to

make some allowance for potentially more conservative mortality assumptions by life companies relative to those

used for US GAAP purposes, which is consistent with our own experience

• Terminated vested and active buyout costs at 110% of US GAAP assuming:

− Annuitization costs of 130% of US GAAP (we have chosen 130% based on approximate costs seen in

pricing exercises)

− 2/3rds of terminated vested participants elect lump sums at 100% of US GAAP liability, which is relatively

conservative based on take-up rates we have seen in terminated vested lump sum exercises pursued by clients

Exhibit 23 compares US GAAP liabilities with Economic Cost and Risk Transfer Cost assuming plan termination and

fully risk transfer according to the assumptions above for the largest 20 US plan sponsors in the S&P 500 universe.

For the purposes of highlighting the apparent US GAAP cost of risk transfer actions, we have ignored acceleration of

what are in some cases very material unrecognized losses through earnings.

EXHIBIT 23: ECONOMIC COST SAVINGS ON RISK TRANSFER VS. NEGATIVE APPARENT US GAAP IMPACT (IN $ MM)

COMPANY NAME


CAPITALIZED EXPENSES + PBGC COSTS

TRANSLATION TO RISK-FREE DISCOUNTING

ECONOMIC COST

GAAP VS ECONOMIC DIFFERENCE

RISK TRANSFER COST

SAVING VS ECONOMIC

APPARENT COST VS US GAAP

1 2 3

4 = 5 =

6

7 = 8 =

1 + 2 + 3 1 – 4 4 – 6 6 – 1

Boeing 59,106 887 11,821 71,814 -12,708 65,017 6,797 -5,911

IBM 51,293 769 10,259 62,321 -11,028 56,422 5,899 -5,129

Lockheed Martin 35,773 537 7,155 43,464 -7,691 39,350 4,114 -3,577

Northrop Grumman 25,263 379 5,053 30,695 -5,432 27,789 2,905 -2,526

UTC 24,445 367 4,889 29,701 -5,256 26,890 2,811 -2,445

Du Pont 23,924 359 4,785 29,068 -5,144 26,316 2,751 -2,392

UPS 21,342 320 4,268 25,931 -4,589 23,476 2,454 -2,134

Raytheon 18,407 276 3,681 22,365 -3,958 20,248 2,117 -1,841

Exxon Mobil 15,007 225 3,001 18,234 -3,227 16,508 1,726 -1,501

Johnson & Johnson 14,993 225 2,999 18,216 -3,223 16,492 1,724 -1,499

Honeywell 14,990 225 2,998 18,213 -3,223 16,489 1,724 -1,499

Pfizer 14,436 217 2,887 17,540 -3,104 15,880 1,660 -1,444

Caterpillar 13,024 195 2,605 15,824 -2,800 14,326 1,498 -1,302

Exelon 12,524 188 2,505 15,217 -2,693 13,776 1,440 -1,252

3M 12,319 185 2,464 14,968 -2,649 13,551 1,417 -1,232

PG & E 12,071 181 2,414 14,666 -2,595 13,278 1,388 -1,207

Consolidated Edison 10,307 155 2,061 12,523 -2,216 11,338 1,185 -1,031

Chevron 10,271 154 2,054 12,479 -2,208 11,298 1,181 -1,027

Deere & Company 10,197 153 2,039 12,389 -2,192 11,217 1,173 -1,020

Pepsico 9,851 148 1,970 11,969 -2,118 10,836 1,133 -985



We will use IBM as an example again as we walk through our overall logic5.

Walking through IBM’s numbers in the table:

• Prevailing long term Treasury rates are in the region of 3% at the time of writing. At this

level, any company which has debt trading inside a credit spread of 1.5% and which is

paying US income tax at 35% qualifies as a Category A company, meaning it can borrow

more cheaply from debt markets than pension plan participants

• IBM’s average credit spread on its traded US debt in October 2011 was 82bps so it met

this condition comfortably and we will assume that it met (or can meet) the tax condition.

• As a result, the economic cost of IBM’s pension provision needs to be considered as the

value of liabilities plus future expenses and PBGC premiums discounted using risk-free

rates, which we are taking as the Treasury curve

• At 12/31/2010 IBM disclosed a US GAAP pension liability for their US plan of $51.2 BN

based on adiscount rate of 5%

− This US GAAP liability does not capitalize future operating expenses and PBGC costs.

We have added these costs based on an average operating cost estimate of 0.15% per

annum and PBGC premium of 0.06%. In fact, IBM’s operating costs were close to 0.3%

based on their latest 5500 filing while PBGC costs were lower than average at 0.02%.

The additional $769 MM in capitalized operating expenses is therefore a relatively

conservative estimate

− We have converted from AA-discounting to the equivalent Treasury rate by adding

$10.3 BN which is 20% of the AA liability or 2% of assumed AA spread times 10 years of

assumed duration

− Allowing for these two adjustments, our Economic Cost is just over $60 BN which is

$11.0 BN above the US GAAP figure. In other words, we think investors should be

factoring this extra amount into their calculations when thinking about the cost of

pensions for IBM and when reacting to any actions around pension risk transfer the

company may take

• Based on the logic described for assumed pricing on insurance company annuitization for

retirees and a combination of lump sums and annuities for active and terminated vested

participants, we have provided an admittedly rough estimate of risk transfer cost for IBM

of $56 BN

5 For this example, we have chosen IBM rather than Boeing because Boeing and the other defense contractors on the list are subject

to accounting standards for Government contractors. These government accounting standards add additional complexity to our

economic view since they determine how pension costs are recovered from the US government by these companies. This causes an

interesting dynamic for which we would need to adjust in our Economic Cost. This is beyond the scope of this paper so we have chosen

IBM where the dynamic does not apply.


• The final two columns in the table then highlight just how problematic US GAAP treatment currently is. Looking

through our economic lens suggests that pension risk transfer would save IBM’s shareholders $5.9 BN whereas

executing the transactions involved under US GAAP would show a charge to earnings of $5.1 BN. In fact, this

economic-accounting gap would be even worse since IBM would also likely be accelerating unrecognized

pension losses which we have not reflected and would also be losing an element of expected return on assets

from earnings (as we noted earlier, we addressed this aspect of US GAAP in our ‘Funny Money’ paper last year)

Clearly the assumption of full risk transfer made in Exhibit 24 will be extreme in many circumstances. However, as

Exhibit 24 shows, all of the companies above have retiree liabilities that account for 50% or more of liabilities. Of the

illustrative saving versus economic shown previously, 50% could be achieved by annuitizing retirees only.

EXHIBIT 24

SPONSOR NAME

TOTAL LIABILITY ACTIVES RETIREES

TERMINATED VESTEDS ACTIVES RETIREES

TERMINATED VESTEDS

$MM $MM $MM $MM

AT&T 42,559 17,633 21,592 3,334 41% 51% 8%

General Electric 40,704 11,661 22,840 6,204 29% 56% 15%

IBM 36,747 9,168 23,251 4,328 25% 63% 12%

Ford Motor 35,754 4,822 29,869 1,063 13% 84% 3%

Boeing 35,265 14,390 18,459 2,415 41% 52% 7%

Alcatel-Lucent 22,404 1,492 19,535 1,378 7% 87% 6%

Lockheed Martin 18,286 7,159 9,593 1,534 39% 52% 8%

Northrop Grumman 18,116 7,502 8,496 2,119 41% 47% 12%

DuPont 13,632 3,075 9,727 831 23% 71% 6%

United Technologies Corp

12,352 4,192 6,977 1,183 34% 56% 10%

Source: 2009 Form 5500 Filings. Liability Figures differ from US GAAP due to calculation methodology


6. CONCLUSIONS

We have outlined a framework which allows a corporate pension plan sponsor to look

through an economic lens at pension funding and investment issues to determine optimal

value-adding strategies for shareholders. The approach allows sponsors to be segregated

into three categories, each of which this lens would suggest should pursue distinct sets

of actions.

• Category A – Corporates who can access capital market borrowing at spreads which

make pension fund deficits inefficient from a tax standpoint should look to fund and

transfer pension liabilities

• Category B – Corporates where spreads are such that maintaining a deficit (i.e.

“borrowing from participants”) is more attractive. For these corporates, the focus needs

to be on investment policy. The key consideration is the extent to which the corporate

derives value from surplus arising from pension risk taking compared to the downside risk

of taking a levered investment view on capital markets. A holistic, option-based view of

the balance sheet can inform such a decision.

• Category C – Corporates which represent a minority of the universe but where the

optimal approach should be to take very substantial investment risk taking which

obviously represents significant challenges from a fiduciary perspective

We have provided a framework for identifying those in Category A and focused this paper

on these companies. Even at the very low risk-free rates prevailing at the current time,

about one third of large sponsors fall in this group. These companies, we suggest, should

be actively pursuing pension risk transfer strategies in order to maximize shareholder value.

We have shown that US GAAP treatment of these strategies is unhelpful in that it suggests

that they are costly when, in fact, the issue is that accounting treatment of liabilities does

not reflect their economic cost. We believe, however, that market participants are becoming

more sophisticated in their understanding of the risks involved in pension provision and are

open to companies taking material value-adding derisking actions, even where accounting

treatment is negative. We hope that this paper will provide a useful reference and will

potentially support a framework for Category A companies pursuing sound pension risk

transfer strategies to help them communicate the value involved to their investors.

As we highlighted at the outset, we have looked at pension funding and investment purely

from the perspective of optimizing shareholder value. An obvious question which arises as

a result is whether there are circumstances in which shareholder objectives can be at odds

with participant interests and such circumstances do exist. We believe, as a result, that

pension risk transfer transactions will often result in far more conscious separation between

fiduciary and corporate actors than has often been the case in the US.

Given the demonstrated attractiveness of annuitizing liabilities, particularly those of retiree

populations in corporate plans, a question we often get is to what extent there is capacity


in the US insurance market to absorb a material level of risk transfer flow. We have spent

considerable time looking at this issue over the last two years. It is the case that flow in the

US has been very modest for the last two decades with no year exceeding $5 BN in total

amount annuitized. We are clear, however, that substantial capacity exists and that it is

possible to do deals at size that would look like an insurance company M&A transaction

to all intents and purposes. Therefore, there is no real issue of capacity as we see it in

the immediate term. There is, however, a question of capacity if volume really takes off,

which we think is worth weighing, and a related question about competitive dynamics at

large size (which we define as a deal in the billions) that needs to be carefully handled by

those executing.

We anticipate an interesting decade for those of us involved in advising and supporting

defined benefit plans as plans continue to become lower and lower risk, delivery

mechanisms continue to evolve and plan funding and accounting frameworks are

converging on underlying economics (which can only be helpful for everyone concerned).


APPENDIX: THE OPTIONS BASED FRAMEWORK

DERIVATION OF PART I OBJECTIVE FUNCTION

(1-ϕ)C – (1-λ)P= C – P + (λP - ϕC)

[S – Xe-rt] λP - ϕ(P + S – Xe-rt) Put-call parity i.e. C + Xe-rt = P + S = (1- ϕ)(S-Xe-rt) + P(λ - ϕ)

So: Hedge unless λ > ϕ when value is maximized by underfunding P and maximizing sigma on optionHedge can include buyout

USE OF PENSION FUND SURPLUSES

The tax treatment of surpluses in frozen plans is such that, ignoring potential retiree medical

transfers, it is not rational to take investment risk once full funding has been reached nor is it

sensible to take risk before that point which would lead to overfunding.

While retiree medical transfers may be useful to access surplus, the conditions required

still leave an unattractive asymmetry for shareholders both in terms of investment risk and

removing the option to decrease costs.

Impact of reversion

Liability Assets

SURPLUS

Excise tax

Straight reversion to corporate 50%

Use at least 25% to fundbenefits in replacement plan

20%

E�ectivetotal tax rate

85%

55%

Use at least 20% to fundbenefits increases

20%+ benefit

increase costs

Min. 64%(including

benefit costs)

REVERSION ON PLAN TERMINATION

RETIREE MEDICAL TRANSFERS

Assets in excess of 125% of a plan’s liabilities (determined on a prescribed basis) can be used to fund yearly retiree medical expenses subject to conditions which include:•Transfers from the plan can not exceed the annual amount of retiree medical expenses in the relevant year• Transferring assets in this triggers a requirement that retiree medical expenses can not decrease for a period of 5 years following the transfer


Copyright © 2012 Oliver Wyman

All rights reserved. This report may not be reproduced or redistributed, in whole or in part, without the written permission of Oliver Wyman and Oliver Wyman accepts no liability whatsoever for the actions of third parties in this respect.

The information and opinions in this report were prepared by Oliver Wyman. This report is not investment advice and should not be relied on for such advice or as a substitute for consultation with professional accountants, tax, legal or financial advisors. Oliver Wyman has made every effort to use reliable, up-to-date and comprehensive information and analysis, but all information is provided without warranty of any kind, express or implied. Oliver Wyman disclaims any responsibility to update the information or conclusions in this report. Oliver Wyman accepts no liability for any loss arising from any action taken or refrained from as a result of information contained in this report or any reports or sources of information referred to herein, or for any consequential, special or similar damages even if advised of the possibility of such damages. The report is not an offer to buy or sell securities or a solicitation of an offer to buy or sell securities. This report may not be sold without the written consent of Oliver Wyman.

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Oliver Wyman is a global leader in management consulting that combines deep industry knowledge with specialized expertise in

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ABOUT THE AUTHOR

Michael Moloney is a Partner in the Americas Insurance Practice.

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