Advisors working with pension plan sponsors embarking on an annuity purchase should understand there are additional uncertainty and risks due to the impact of COVID-19. Awareness of market conditions and a robust insurer due diligence process can give clients a better outcome.
Over the last decade, de-risking a pension plan with an annuity buyout has become prevalent. In 2014, total buyout sales were under $10 billion; in 2019 they had skyrocketed to $28 billion.
Plan sponsors that have offloaded liabilities to insurers through this strategy have saved on administrative costs and lowered funded status risk. In addition to use of buyouts as a de-risking strategy, there has also been an uptick in the number of plan terminations which ultimately end in a buyout contract. It’s clear that annuity buyouts have served as a valuable strategy for pension plan sponsors.
Many advisors are wondering whether, given the current COVID-19 world, annuity buyouts are still a good idea.
The short answer is, “Yes!”
However, given the market conditions we’re facing today, and the strains that are felt throughout the economy, and especially the financial services market, it’s imperative that advisors who are working with plan sponsors approach a potential buyout, whether for de-risking or for a plan termination, with extra diligence.
There are two areas where advisors need to be particularly alert: pricing and insurer solvency.
Interest rates are currently quite volatile. Typically, plan sponsors compare accounting liabilities to buyout prices to determine the cost/benefit trade off of purchasing a group annuity. The daily changes in the various elements of rates (duration, yield, credit spreads etc.) need to be closely monitored to assure the original analysis is still accurate.
The insurers that provide group annuities are all high-quality. However, how they invest their capital varies, and their level of exposure to the markets varies. Up-to-date analysis on quality is imperative.
Advisors need to ensure that their plan sponsor clients work with an annuity placement specialist that can help make sense of the day-to-day changes in the markets, so that they receive optimal pricing for their buyout along with the peace of mind that their fiduciary obligations under U.S. Department of Labor Interpretive Bulletin 95-1 — the document that sets the standard for plan sponsors’ evaluations of insurers — have been met.
The New Volatility
The amount insurers charge to take on pension liabilities is determined by the yield on high-quality bonds that they can purchase in the marketplace. The price will move, just like pension accounting liabilities, as these yields oscillate.
The onset of the COVID-19 pandemic has coincided with record volatility in the bond markets, with the Federal Reserve cutting rates to near zero, long U.S. Treasury yields falling dramatically, and credit spreads widening.
The overall yield, and thus the premiums insurers quote in absolute terms, is changing day-by-day, with weekly 1% moves the new norm. Such yield changes have given rise to annuity price or accounting liability changes of 10% to 15% in a week.
Annuity Purchase Costs v. Accounting Liabilities, Today
The past few years have seen typical annuity purchase costs for retirees come in at around 100% of accounting liabilities for plans that use up-to-date mortality tables and discount rates based on realistic bond yields. Many plans have also used liability driven investment (LDI) strategies to hedge the accounting liability or termination cost. It’s this relative price difference between the annuity purchase costs and accounting costs, or the value of LDI assets, that is of more relevance to plan sponsors.
Current market conditions make this relative cost difference more uncertain. The factors described below could make annuity pricing relatively more or less attractive. However, on balance, in the near term, we expect slightly higher annuity purchase prices compared to accounting values.
Downgrade risk (increases prices). Credit spreads (the yield difference between corporate bonds and U.S. Treasuries) are at elevated levels, which pushes accounting liabilities down. High spreads reflect fears that the coming recession will cause investment-grade companies to be downgraded, or even default. However, if the insurers choose not to buy some of these bonds due to these very reasonable fears, the price they are able to quote at will likely be higher than the value of liabilities on an accounting basis. Additionally, the constructed yield curve used to measure pension liabilities would exclude those bonds that are downgraded but those bonds may still be in the LDI funds used in a plan’s portfolio. Also, this mismatch will lend itself to differences in the price of the annuity purchase relative to the value of the accounting liability and the LDI assets.
Illiquid markets (increases prices). It has been challenging to buy or sell traded corporate bonds in the current environment. Transaction costs have increased. Many private debt transactions about to close will be on hold. (Consider for example, the uncertainty of a lender making a loan to the purchaser of a shopping mall, hotel or office.) Recent interventions by the Federal Reserve have helped, but insurance companies will be demanding a greater margin of error in pricing in these conditions.
Potential for change in insurer appetite (may increase or decrease prices). Current conditions may cause some insurers to be less aggressive, or step away from the market entirely. We have yet to see any evidence of this, and it is very early days, but it is a possibility over the rest of the year. However, if there are fewer transactions brought to market in the first nine months of 2020, that could increase insurers’ appetite in the last three months of the year, as insurers work to reach full-year sales targets.
Cheap assets (decreases prices). With financial market distress comes opportunity. As was the case coming out of the 2008 financial crisis, there will be high-quality assets that look cheap, and it is quite possible that insurers will choose to buy these and offer better pricing than expected at certain times over the rest of the year. With this, we expect that there will be a greater dispersion of bids between insurers.
Will COVID-19 affect insurer mortality rate assumptions?
The short answer is that we do not expect insurers to change their underlying mortality assumptions to account for COVID-19 related deaths.
Should you advise your clients to defer their annuity purchase transactions in these conditions?
There are a few items that advisors should consider when recommending that their clients re-think an annuity purchase in the current climate. However, focusing on pricing alone relative to accounting liabilities, it is not clear that pricing will improve over the course of the year, or even beyond that. If we do see downgrades and defaults in corporate bonds, as is highly likely and is already happening, accounting liabilities will increase and come into line with insurer pricing. Essentially, accounting liabilities do not yet reflect the ‘hit’ due to deteriorating economic conditions that insurers should already be allowing for.
Timing will be everything in deciding whether to execute an annuity purchase transaction. If a company is considering an annuity purchase for de-risking purposes, or for a plan termination, having some flexibility over when to implement the purchase will be the key to optimizing the outcome.
Will Insurers Remain Solvent?
Insurers participating in the pension risk transfer (PRT) market start from a strong position. They are heavily regulated companies that maintain a significant asset buffer against the economic storm that is coming. They are not leveraged to the same extent as companies in the banking sector.
Most PRT providers offer life insurance policies. Those policies will experience payouts due to deaths associated with COVID-19. The good news here is that the number of deaths in the insured population, which typically consists of people ages 35 to 65, is expected to be manageable, provided that the virus is not left to propagate completely uncontrolled. The virus, sadly, has a higher mortality rate in old age, so there may be some benefit to insurers with large annuity books. Insurers with large annuity books may no longer have to pay out annuities to the individuals affected by the virus.
“Pandemic risk” is a scenario that all insurers offering life insurance policies plan for, typically with a death rate higher than that projected for COVID-19. In addition, insurers generally reinsure this pandemic mortality risk away, meaning that they will not experience the full force of any claims on their balance sheets beyond a certain level.
For completeness, it should be noted that the insurance industry as a whole writes business interruption cover that could suffer larger losses as a result of the shutdown. Such policies are not written directly in the life and annuity companies that offer annuities, so that line should not impact their solvency, but some insurers will have affiliates with this exposure. Pandemic events are generally excluded from such policy terms, but state legislators have, in late March, passed laws to oblige insurers to pay out COVID-19-related policy claims retroactively. The losses here for the insurance industry are potentially vast, if this principle is extended to larger companies, and it is likely the federal government would provide some kind of support if such losses were essentially mandated by a change in the law.
The primary risk to life and annuity providers is the economic impact of the pandemic….
A Deep Recession
Despite global fiscal and monetary intervention, a deep recession is likely already under way. It remains highly uncertain how quickly economic activity will resume to normal.
The majority of past insurance company failures have arisen due to losses incurred on investment portfolios. Although the quality of insurers’ portfolios is high, with relatively few equities, insurers are exposed to higher-quality investment-grade bonds being downgraded to sub-investment grade or ‘junk’ status. A recent example was Ford Motor Company, which was downgraded by S&P on March 25. This represents one of the largest downgrades from investment grade, by value of debt, in history. Although Ford may not necessarily default on its debt, an insurer holding bonds issued by Ford may be effectively forced to sell them due to policy constraints or other covenants, realizing losses, or have to hold more capital against Ford’s bonds, worsening solvency.
Concerns around the impact of a recession on insurers’ portfolios, and the impact on profits of a persistently low interest rate environment, have driven the share prices of listed insurers drastically down in March.
Any insurer can fail, but it is reassuring that all companies active in the PRT market have books of business that have been in force for many years with a degree of ‘seasoning’. A hypothetical insurer that started from scratch in the past few years would be much more vulnerable to a recession, as the bond portfolio would consist entirely of assets bought at low yields. Those yields are now not sufficient compensation for the risks ahead.
What Should Advisors Tell the Plan Sponsors?
Advisors who are working with plan sponsors to undertake an annuity transaction can take comfort in the fact that all insurers active in the PRT market, at the time of writing, are still very likely to remain solvent and meet their obligations to make payments. The security of participant benefits is still likely to remain higher in an insurance company, with associated guarantees, than it is in any pension plan. In addition, if there is a higher relative cost of placing an annuity with an insurer, this higher cost may not be “real,” in that holding the liability, with matching bonds, in the plan may eventually lead to losses that match this higher perceived cost.
Advisors need to make sure that plan fiduciaries are aware of the risks and undertake proper due diligence on insurance companies. Fiduciaries are encouraged by Department of Labor Bulletin 95-1 to select the “safest annuity available” and to “conduct an objective, thorough, and analytical search.”
The majority of statistics available on insurers are available only annually — in other words, before the impact of COVID-19 — so it is essential that advisors bring in an annuity placement specialist with a deep understanding of how the insurers will be affected. Going beyond standard credit due diligence, for example, and assessing insurers’ ability to service participants offsite, in a disaster environment, also takes on particular importance in these times.
Given the current market environment, advisors working with pension plan sponsors need to have an annuity placement specialist who can help them make sense of the current market pricing for annuity buyouts as well as provide fiduciary cover under DOL 95-1. Because pricing and insurer solvency concerns are in a constant state of flux, the right specialist will have a rigorous process for looking at how the markets are affecting the insurers and their ability to provide the safest available annuity.
Michael Clark, FSA, FCA, EA, is a managing director and consulting actuary in River and Mercantile Solutions’ Denver office. He has handled pension risk transfers and other pension projects. He is president of the Conference of Consulting Actuaries.
James Walton, FSA, is an investment director in River and Mercantile Solutions’ Boston office. He is a qualified actuary and holds a master’s degree in physics from The University of Oxford.