Benchmark Rates Liquidity Monitor: Issue 5
May 2021: ESTR volumes drop, EURIBOR volume stable, and SONIA volumes well above GPB LIBOR swaps
One of our clients asked us to review the single-employer defined benefit (DB) pension plan of a target company they were looking to acquire and assess the financial impact of the cash cost and balance sheet impact. The only information provided to our client was the latest pension valuation report and five-year projections from the current actuary. It was a smaller acquisition (a few hundred employees) with a pension plan. However, because the buyer did not have a pension plan, they engaged us to review the pension plan and advise on the impact it would have on the total cost of the potential acquisition. Our analysis revealed that the divesting plan sponsor had undervalued the DB plan liabilities by at least 60% of the value proposed in the purchase agreement presented to our client, the buyer.
Many times, we find inconsistencies in the due diligence phase that are of significant concern. Some of these findings lead to a purchase price adjustment or other arrangements to address concerns. In this particular deal, there were four main areas of concern: the mortality assumption, demographic assumptions, terminal funding upon retirement, and associated investment risk.
The current actuary did not reflect the anticipated IRS required mortality improvements in the cash projections. The IRS stated that a change in the statutory mortality tables for cash funding purposes was imminent. Our substitution of the new mortality tables increased pension liabilities for the forecast by 3% to 5%.
The current actuary assumed that all participants would retire at age 65. However, the plan provisions indicated that participants could retire at age 60 with fully subsidized (unreduced) pension benefits. Not reflecting early retirement subsidies significantly understated the pension liabilities and increase in cash contributions. We requested the retirement age history to verify the retirement assumption. Unfortunately, the seller did not provide the requested data for our analysis. If pension participants retire at age 60 (instead of age 65), their pension liability could increase by 40% to 50%.
Terminal funding upon retirement
The divesting plan sponsor has a history of purchasing annuities for all participants upon retirement. We believe that the plan sponsor costs were understated as proposed for several reasons. First, purchasing annuities increases the cost of the pension plan and that increased cost becomes due upon retirement. Second, it affects the investment horizon of the pension assets.
Insurance companies require a premium when purchasing pension liabilities. The premium is to cover the administrative expenses and loads for items such as marketing fees, assumption of risk, and profits for taking on the book of business. The increase in cost for purchasing annuities was not reflected in the cash projections. As such, the cost projections were at least 20% to 30% too low for the demographics of this plan.
Investment risk exposure
The second issue mentioned above with purchasing annuities is the shortened investment horizon for the plan. The investment horizon is significantly shorter if assets are expected to be paid out at retirement rather than over the lives of the retirees.
In addition, the plan was invested very aggressively in 85% equities and only 15% bonds. To reduce pension volatility, most plan sponsors are investing more conservatively and more heavily in bonds. Some plan sponsors are also wisely employing duration matching strategies to further reduce pension volatility. An investment allocation of 85/15 over a shortened investment horizon was very concerning to us. It also meant the pension projections assumed too high of an asset return. A more practical asset allocation could lead to the investment return assumption dropping by as much as 200 basis points. Too high of an assumed investment return meant that contributions were understated.
As a quick side note, after the potential buyers submitted their initial bids, the seller provided the retirement age history and confirmed that our earlier retirement age assumption was accurate. Every participant that they provided retired at the exact age of 60, the earliest possible age to receive the fully subsidized early retirement benefit.
The issues we identified significantly increased the required cash projections provided by the seller. We revised the pension liabilities to reflect adjustments for each of these items. The result was that the divesting plan sponsor had significantly understated the DB plan liabilities. Our cash projections nearly doubled from estimates provided by the seller.
Because of this analysis, our client was able to decrease the purchase price for assuming the pension plan as part of the acquisition. They were apprised of the issues in the due diligence stage and started thinking about options to mitigate the increased cash requirements.