Keeping Promises

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					Prudential Financial

                       Keeping Promises
                       New Solutions for Retirement Benefit Obligations
                                     Table of Contents
                                     Introduction ................................................................................................2
                                     The DB Plan Buy-in Annuity ......................................................................3

                                     The Retiree Life Insurance Buy-out ..........................................................5

                                     Combining the Use of a VEBA and Captive Insurer
                                     to Finance Retiree Healthcare Benefits ....................................................6

                                     Conclusion ..................................................................................................8

Keeping Promises: New Solutions for Retirement Benefit Obligations                                                                                     1
              Retirement benefit obligations, such as defined benefit (DB) plans and
              retiree healthcare benefits, are straining the finances of employers.
              Many DB plan sponsors are making larger contributions to their plans
              to address sharp declines in plan funding levels and to provide liquidity
              to make benefit payments. At the same time, the cost of retiree
              healthcare obligations continues to grow due to the significant increase
              in healthcare costs over the last decade.
              Business leaders and finance executives are focused on ensuring that
              their companies have the financial resources to fulfill long-term benefit
              obligations, while maintaining the flexibility to conduct core business
              activities. Although this is not an easy balancing act, a growing number
              of solutions are available to help companies fulfill their benefit
              obligations.The goal of this paper is to describe three such solutions:
              • DB plan buy-in annuities for an immediate and orderly transfer of
                pension risk.
                The buy-in annuity enables underfunded DB plans to substantially
                reduce pension risk before their plans become fully funded.The
                buy-in is an insurance policy that provides for the future benefits for a
                subset of a plan’s participants; the policy resides in the plan as a plan
                asset. Buy-in policies lower a DB plan’s overall exposure to longevity,
                investment, and interest rate risk, thereby increasing the stability and
                predictability of future plan costs.
              • Retiree life insurance buy-outs to strengthen a company’s financial
                This solution enables an employer to strengthen its balance sheet
                and streamline benefits administration by allowing it to fully transfer
                to an insurer the liabilities associated with providing retiree life
                insurance benefits.
              • Combining the use of a VEBA with a captive insurer to more
                efficiently fund retiree healthcare obligations.
                Employers that are funding retiree healthcare benefits through
                a Voluntary Employee Beneficiary Association (VEBA) trust can
                enhance this funding strategy by incorporating the use of a captive
                insurer to reinsure retiree healthcare benefits.1 This approach
                provides companies with tax and funding efficiencies that cannot
                be realized solely through the use of a VEBA as a funding vehicle.
              The rest of this paper explores each of these solutions in greater detail.

    1   While VEBAs are generally used to fund healthcare benefits for retirees, they can also be used to fund
        healthcare benefits for current employees.

2                                                                             Keeping Promises: New Solutions for Retirement Benefit Obligations
     The DB Plan Buy-in Annuity                                                 distinguishing features enable buy-ins to overcome the
                                                                                challenges involved in executing buy-outs:
     The challenge for DB plan sponsors
     DB plan sponsors are exposed to a number of risks                          • The buy-in does not trigger settlement accounting,
     with respect to managing their pension obligations,                          as the plan sponsor remains the primary benefit
     including longevity risk, investment risk, and interest                      obligor.
     rate risk. Liability-driven investing (LDI) strategies                     • The buy-in should not impact materially the overall
     enable sponsors to mitigate interest rate risk. However,                     funding ratio of the plan since the buy-in contract
     even sophisticated LDI strategies can fall short of their                    remains a plan asset.
     risk reduction objectives, because it is difficult to invest
     in a portfolio of securities that replicates pension                       After execution, the value of a buy-in contract is
     liability discount rate benchmarks for funding                             expected to more closely track the value of the
     requirements and financial reporting. For example,                         liabilities that the contract addresses than the value
     a DB plan’s liabilities often extend for more than 30                      of assets invested in an LDI strategy would.This is
     years, but the high-quality corporate bond market                          because the value of the liabilities and the value of the
     offers limited opportunity to invest in bonds with                         buy-in contract will respond in parallel to changes in
     maturities greater than 15 years.                                          factors including, but not limited to, interest rates and
                                                                                longevity, whereas the value of the liabilities and the
     The most effective way for sponsors to eliminate all of                    value of assets invested in an LDI strategy will only
     the risks they face is to buy an annuity. However, this                    respond in parallel to changes in interest rates.
     option is primarily available to plans that are fully, or
     nearly fully, funded. Underfunded plans would need                         The impact of a buy-in on the future expected returns
     to make contributions to their plans to close the funding                  and risk of a DB plan
     gap to enable the purchase of such an annuity. Instead,                    The buy-in contract is a plan asset that can be thought
     the more practical option for underfunded plans is to                      of as a fixed-income instrument. As a result, a DB plan
     purchase an annuity for a subset of a plan’s participants,                 sponsor can incorporate a buy-in contract into its DB
     such as its retirees. Even this option, however, presents                  plan’s asset allocation in a way that achieves a targeted
     challenges for underfunded plan sponsors:                                  level of future expected returns and risk. For example,
                                                                                a sponsor that wishes to minimize risk can fund the
     • A buy-out annuity triggers settlement accounting                         purchase of a buy-in contract through the sale of
       because the sponsor is fully transferring the liability                  equities. After executing the buy-in, such a DB plan’s
       to an insurer. Under settlement accounting, the                          future expected returns would be lower, but the plan
       sponsor must accelerate recognition of any deferred                      would have effectively increased its fixed-income
       losses or gains within its DB plan.                                      allocation, thereby reducing future funded status
     • A buy-out annuity lowers the overall funding ratio of                    volatility. Alternatively, a sponsor that wishes to reduce
       an underfunded plan. For example, a plan with $100                       the impact of a buy-in on the future expected returns of
       million in liabilities and $75 million in assets has a                   its DB plan’s portfolio could fund the buy-in by utilizing
       funding ratio of 75%. If this plan executes a buy-out by                 current fixed-income securities.
       paying a $25 million premium to an insurer to transfer                   Assessing the benefits of the buy-in solution through
       $25 million in liabilities, the plan would be left with                  a case study
       $75 million in liabilities and $50 million in assets.2 As a              The following case study demonstrates the benefits of
       result, the plan’s funding ratio would decline from 75%                  a buy-in by analyzing the pension liabilities of the 12
       to 67%. A lower funding ratio can have several                           companies within the Dow JonesTransportation Index
       negative implications for a DB plan, including an                        that have a DB plan.The analysis was conducted by:
       acceleration of required plan contributions.
                                                                                • Adjusting the total net debt of these companies by
     The buy-in as a new risk management solution                                 adding to it their unfunded pension and other post-
     for DB plans                                                                 employment benefit (OPEB) liabilities.
     The buy-in enables plan sponsors to purchase an
     insurance policy to realize the same risk reduction                        • Quantifying the risk associated with the total
     benefits of a buy-out without the negative accounting                        adjusted net debt by measuring its annual Value at
     and funding implications. Like buy-outs, buy-ins enable                      Risk (VaR),3 or the amount that the adjusted net debt
     sponsors to transfer longevity, investment, and interest                     could increase in any given year.
     rate risk to an insurer. However, unlike a buy-out                              The VaR of both financial debt and benefit liabilities
     annuity, the buy-in contract is retained as a plan asset.                       was measured because factors such as interest
     Further, the buy-in leaves plan sponsors ultimately                             rates impact both types of debt.The limitation of
     responsible for providing pension benefits.These                                VaR analysis is that it understates the impact of

     2   The premium cost above the value of the liabilities being transferred has not been shown to simplify the numeric example.
     3   Value at Risk (VaR) was modeled in this analysis by measuring the maximum possible annual increase in the total adjusted net debt of these
         12 companies in 95% of the modeled scenarios.

Keeping Promises: New Solutions for Retirement Benefit Obligations                                                                                     3
           catastrophic events such as the recent financial                                  billion to $21.3 billion.This analysis assumes that this
           crisis. However, with this caveat, VaR analysis can                               strategy was implemented by replacing bonds from
           serve as a useful risk assessment tool.                                           the Barclays Aggregate Index with bonds from the
                                                                                             Barclays Long Corporate Credit Index.4 This strategy
    • Sizing the impact of LDI-based risk mitigation
                                                                                             mitigates interest rate risk by better matching the
      measures, a buy-out annuity, and a buy-in on the
                                                                                             duration of these companies’ DB fixed-income assets
      VaR of these companies’ total adjusted net debt.
                                                                                             and DB liabilities. Alternatively, purchasing interest
            The two LDI-based risk mitigation measures that                                  swaps to match the overall duration of these
            are modeled are duration extension through the                                   companies’ DB portfolios and DB liabilities reduces
            purchase of cash bonds, and duration extension                                   the VaR to $18.9 billion.
            through the purchase of interest rate swaps.
                                                                                             Both the buy-out annuity and the buy-in reduce the
    The results of this analysis are shown in Exhibit 1.                                     VaR to $17.9 billion.This analysis assumes that both
                                                                                             of these transactions were financed through the sale
    As shown inTable A, the total net debt of the
                                                                                             of securities from each asset class within the DB plans
    companies in the index increases significantly after
                                                                                             of these companies in proportion to the portfolio
    being adjusted to include pension and other benefit
                                                                                             weighting of the asset class. In addition, this analysis
    liabilities.The VaR associated with the total adjusted
                                                                                             assumes that after the execution of a buy-out, the
    net debt, as shown inTable B, is $22.9 billion. If factors
                                                                                             companies make additional plan contributions to
    such as equity market performance or interest rate
                                                                                             maintain their plans’ funding ratios. Additional
    swings caused the total adjusted net debt to increase
                                                                                             contributions are not assumed in the case of the buy-in
    by this amount in any given year, these companies’
                                                                                             because the buy-in contract is retained as a plan asset.
    access to capital, valuation, and cash flow would be
    materially impacted.                                                                     Buy-ins and buy-outs have the most significant impact
                                                                                             on the VaR because they address all of the risks (i.e.,
    The impact of each DB risk mitigation measure is also
                                                                                             interest rate risk, longevity risk, and investment risk)
    presented inTable B. Buying cash bonds to extend the
                                                                                             facing DB plan sponsors.
    duration of the fixed-income portfolios within the DB
    plans of these companies reduces the VaR from $22.9

    4   Fixed-income assets comprise 35% of the portfolios within the DB plans of these companies.

          Exhibit 1:
          Impact of the Buy-In on the VaR of the Adjusted Net Debt of the 12 Companies
          in the Dow Jones Transportation Index With Defined Benefit Plans

                               Table A                                                                     Table B
                        Total Net Debt and                                                     VaR of Total Adjusted Net Debt
                      Total Adjusted Net Debt                                                            ($ Billions)
                             ($ Billions)
                                                                               of any Risk
                                                                               Mitigation        After Execution of Each Risk
                                                                               Measures          Mitigation Measure
                                          88.9                                   22.9
                      80                                                  20                                        18.9
                                                                                                                                 17.9        17.9
                      60    58.1                                          15

                      40                                                  10

                      20                                                   5

                       0                                                   0
                           Net Debt Total adjusted                                                 Extend       Extend          Buy-out     Buy-in
                                    net debt with                                                 duration      duration
                                     pension and                                                  via cash    via interest
                                    OPEB liabilities                                                bonds     rate swaps

         Note: Analysis based on 2009 financials; impact of each risk mitigation measure is modeled individually.
         Source: SEC filings, Prudential analysis.

4                                                                                                            Keeping Promises: New Solutions for Retirement Benefit Obligations
     The Retiree Life Insurance Buy-out                                             assuming that the buy-out was funded by deploying
                                                                                    available cash on the employer’s balance sheet.
     The challenge for employers
     Some employers offer employees life insurance                                • Future benefit costs cannot increase since the insurer
     benefits that extend into retirement. Employers usually                        assumes all responsibility for providing the benefit.
     offer each retiree a relatively modest amount of life                        • Benefits administration is significantly streamlined
     insurance, such as $5,000 to $10,000. However, when                            because the insurer takes on the responsibility for
     multiplied across thousands of retirees, this benefit                          administering the plan.The employer only retains
     can entail a significant obligation for a large employer,                      responsibility for tax and Employee Retirement
     and presents several challenges:                                               Income Security Act reporting.
     • Employers must record the net liability for retiree                        • Moreover, for employers that have set aside assets
       life insurance benefit obligations on the balance                            to fund retiree life insurance obligations, the buy-out
       sheet, thereby increasing a company’s liabilities-                           eliminates investment risk on these assets because
       to-equity ratio.                                                             the insurer becomes solely responsible for investing
     • Employers may have to absorb increases in                                    the buy-out premium and absorbing unfavorable
       insurance premiums because of unfavorable                                    investment returns.
       mortality experience or increases in the price                             Executing this transaction does require employers to
       of insurance.                                                              pay the premium for a buy-out. However, for employers
     • Administering retiree life insurance programs can                          with available cash to pay the premium, the retiree life
       require significant overhead because companies must                        insurance buy-out can be an attractive option, because
       service a large and dispersed retiree population.                          the insurer can price the buy-out premium using a
                                                                                  higher discount rate than the rate the employer is likely
     Retiree life insurance buy-outs provide a one-stop                           earning on its cash.
     solution for settling retiree life insurance obligations
     Employers can execute a retiree life insurance buy-out                       An example of the benefits of a retiree life insurance
     by paying a single, tax-deductible premium to an                             buy-out is shown in Exhibit 2.
     insurer to completely address their future obligation                        In this example, the employer pays a $22 million
     related to retiree life insurance benefits.This                              premium to eliminate its unfunded retiree life liabilities.
     transaction addresses the challenges discussed above:                        The premium is slightly more than the net liability
     • The retiree life insurance buy-out completely                              because the premium includes the capitalization of the
       removes the liability associated with retiree life                         insurer’s administrative costs.The buy-out removes the
       insurance benefits from an employer’s balance sheet.                       liability from the balance sheet, thereby improving the
       This improves an employer’s liabilities-to-equity ratio,                   employer’s liabilities-to-equity ratio from 1.50 to 1.46.

           Exhibit 2:
           Impact of a Retiree Life Insurance Buy-Out

           Hypothetical employer with retiree life insurance liabilities ($ Millions)
           Assets                                      Liabilities                       • $20 million unfunded liability on balance sheet
           Current assets                   $500       Retiree life liability     $20    • Annual premium expenses of $750,000
           Long-term assets                 $500       Other liabilities         $580      after taxes
                                                       Shareholders’ equity      $400    • Additional costs per year to administer
                                                                                           the program
           Total                         $1,000        Total                    $1,000
                                                                                         • Liabilities-to-equity ratio of 1.50

           Hypothetical employer after executing a retiree life insurance buy-out ($ Millions)
           Assets                                      Liabilities                       • $22 million premium paid to insurer
           Current assets                   $478       Retiree life liability      $0    • Retiree life insurance liability is removed
           Long-term assets                 $500       Other liabilities         $580      (settlement) from the balance sheet

                                                       Shareholders’ equity      $398    • Annual premium and administrative
                                                                                           expenses are eliminated
           Total                            $978       Total                     $978
                                                                                         • Liabilities-to-equity ratio improves to 1.46

Keeping Promises: New Solutions for Retirement Benefit Obligations                                                                               5
    Combining the Use of a VEBA and                              Using a VEBA and captive insurer to efficiently fund
                                                                 retiree health obligations
    Captive Insurer to Finance Retiree                           Companies use captive insurers for a number of
    Healthcare Benefits                                          reasons, including insuring risks that may be difficult
    The challenge for employers                                  to insure in the commercial insurance markets. Now,
    Some employers are using a VEBA to fund retiree              in a new application, captive insurers can help
    healthcare obligations. VEBAs are trusts that enable an      companies maximize the efficiency of funding retiree
    employer to make tax-deductible contributions to fund        health obligations.
    future healthcare expenses, such as medical claims, for      An employer providing retiree health benefits can
    its retirees. In a typical arrangement shown in Exhibit 3,   direct its VEBA to purchase a non-cancellable group
    the employer makes tax-deductible contributions to the       Accident & Health (A&H) policy from a third-party
    VEBA to fund retiree healthcare obligations. Employees       insurer.The third-party insurer’s policy would provide
    and retirees file claims with a claims administrator.The     for the reimbursement of all retiree healthcare claims
    claims administrator processes and pays the claims,          within an annual corridor of benefits for each
    and is then reimbursed by the employer’s VEBA.               beneficiary.The third-party insurer then cedes its
    Funding retiree healthcare obligations via a VEBA            liability under the policy to the employer’s captive
    creates a few challenges for employers:                      insurer.This funding strategy creates several benefits
                                                                 for the employer:
    • Earnings on assets held in a VEBA may be subject to
      Unrelated Business IncomeTax. (This tax applies to         • The captive insurer receives a premium from
      earnings within management VEBAs, not collectively           the third-party insurer for assuming the retiree
      bargained VEBAs.)                                            healthcare liability, and can accumulate earnings on
                                                                   a tax-advantaged basis on assets held in support of
    • Assets placed in a VEBA are, for all intents and             the liability.
      purposes, unavailable to the employer, as any
      withdrawals from the VEBA for purposes other               • The captive insurer can dividend its income to the
      than paying benefit expenses are taxed at 100%.              employer, thereby providing a conduit for favorable
                                                                   investment returns or claims experience to flow to
                                                                   the employer.

       Exhibit 3:
       Using a VEBA to Fund Retiree Healthcare Benefits

                                     Employer       Plan Contributions        VEBA

                                                                                   Claim payments
                                                      Retiree medical

                                                      Claim payments      Administrator

6                                                                             Keeping Promises: New Solutions for Retirement Benefit Obligations
     Exhibit 4 illustrates how an employer can use its                          efficiencies for the employer. Assets provided to the
     captive insurer in conjunction with a VEBA to fund                         captive to assume the third-party insurer’s liability
     retiree health obligations.                                                generate earnings on a tax-advantaged basis. In
                                                                                addition, the employer gains access to favorable
     As shown in the left-hand side of Exhibit 4, the retiree
                                                                                investment results and claims experience within the
     experience remains the same when a captive is used
                                                                                captive insurer.
     to reinsure retiree health benefits.The employer
     continues to make tax-deductible contributions to                          Implementation considerations
     the VEBA to fund retiree health obligations. Retirees                      Companies must have already established a VEBA and
     continue to file claims with the same claims                               a captive insurer domiciled in the United States to take
     administrator that was in place prior to the reinsurance                   advantage of this transaction. In addition, companies
     transaction.                                                               must obtain an exemption from the U.S. Department
                                                                                of Labor (DOL) to reinsure their retiree health benefits
     The right-hand side of Exhibit 4 demonstrates how the
                                                                                with a captive insurer.The DOL provided approval for
     introduction of a captive insurer to finance retiree
                                                                                the first transaction of this type in March 2010.
     healthcare obligations creates tax and funding

        Exhibit 4:
        Combining the Use of a VEBA and Captive Insurer to Fund Retiree
        Healthcare Benefits
                    Employer and Participant View                                                     Captive Insurer View

                                                                      Premium                                Reinsurance
                                   Plan                                                                       premium
                               Contributions                                                                                   Employer’s
                                                                       Claims          Third-Party
             Employer                                  VEBA                                                                     Captive
                                                                                                          Reinsurance           Insurer
                                                                    Claim payments                      reimbursements

                                                                                     • Third-party insurer                 • Tax-advantaged
                                                           Claim payments              takes on liability                    investment earnings
                                                                                       for reimbursing                       within captive insurer
                             Retiree medical                                           claims within an
                                                                                                                           • Potential to dividend
                                  claims                                               annual corridor
                                                                                                                             excess returns to the
                                                                                       of benefits for
                                                                                       each beneficiary
                             Claim payments

Keeping Promises: New Solutions for Retirement Benefit Obligations                                                                                     7
    The solutions presented in this paper provide three potential ways for
    companies to address certain aspects of their benefit obligations while
    reducing risk, strengthening their financial position, and maximizing
    funding efficiencies. In particular, these solutions enable finance
    executives to evaluate the benefit risks embedded within their
    companies’ balance sheets, and to transfer selected risks to third-party
    insurers that may be better positioned to manage these risks over the
    long term. By assuming these risks, third-party insurers serve as a
    specialized source of funding for companies that need to fulfill benefit
    obligations, and thereby help finance executives further diversify their
    companies’ funding sources.

                 For more information,
                 please contact the contributors:

                 David Brooker
                 Vice President, Prudential Financial

                 Vincent Grillo
                 Vice President, Prudential Retirement

                 Vishal Jain
                 Vice President, Prudential Financial

                 Glenn O’Brien
                 Vice President, Prudential Retirement

8                                                        Keeping Promises: New Solutions for Retirement Benefit Obligations
The Prudential Insurance Company of America, Newark, NJ

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