QUESTION
- The report should be on 2 pages.
- No need for front page and table of content.
- Space line 1.5
Guideline Questions
You have been hired as an advisor for the parties of the PRT. Odd number groups are advising ABC and even number groups are advising PRU. To prepare for the discussion of this case you should think about the following questions.
1. What are the goals of pension risk transfer (PRT) transactions? What are their potential benefits and draw backs?
2. What is the problem ABC is trying to solve? Assets? Liabilities?
3. What are the alternative courses of action open to ABC to solve its problem?
(a) Could ABC implement a “home made” portfolio reallocation similar to the contemplated PRT? What would the
implications for the plan’s allocation be?
(b) How much would ABC need to set aside to fund the liabilities that are the object of the PRT:
i. If is used a portfolio having the same allocation as the current ABC pension portfolio?
ii. If it used a portfolio including mostly FI securities?
iii. If it used a portfolio including only government (Federal, state, Municipal) -issued or -backed fixed—income securities?
4. What are the advantages and draw backs of having an insurance company as the acquirer of pension risk?
(a) In terms of asset allocation for the portfolio supporting the pension liabilities?
(b) In terms of managing the risk of the pension liabilities?
(c) Does the fact that Pru Fin is a regulated insurance company constrains its asset allocation options?
5. What is the minimum price that PruFin should require?
6. What is the maximum price that ABC should be willing to pay? Keep in mind that the insurance regulations require insurance companies to only use safe assets (i.e. 95% FI) to back up annuity claims Additional Material:
• See also http://pensionrisk.prudential.com/team/index.php
ANSWER
Executive Summary
This case talks about a typical problem that a non-financial company faces in maintaining the plan that promises future pension to both its working as well as retired employees. Pension Risk Transfer is one such thing that can free up the liability of the company by transferring the liability to an insurance company and thus helping the corporation to concentrate on the core business activities. But there are few problems in the transfer such as different investment strategies that were employed by the corporation earlier which are not suitable for the insurance company. Also, every plan is different for the insurance company therefore the insurance company has also required to decide where and how much to invest to meet the liability.
Pension Risk Transfer
There are two types of pension plans, Defined Benefit Plan and Defined Contribution Plan. In DB Plan the company promises to pay a Defined Benefit to the retiree once he retires. In Defined Contribution Plan the company contributes and leaves the responsibility of managing the fund to the employee. The liability of company in DC plan is current but the liability of the company in DB is present as well as the future. Therefore, post the 2008 crisis, the Defined Benefit Plan gave rise to something called pension risk transfer which basically means that an organization offloads either some or all of the Defined Benefit Plan’s risk to an insurance company. This is basically a liability transfer from an organization to the insurance company for a premium. In the above case ABC Corp. is transferring a part of its pension liability of retirees to Prudential for a premium.
ABC Corp.
ABC Corp. is a manufacturing company that provides a defined benefit plan to is employees. Recently with the fall in the interest rate, the present value of the future liabilities has increased thus putting pressure on the income statement of the company. Also, another problem that ABC was facing was that the allocation of ABC’s plan was mostly in Equities (60% post 2008) and once the 2008 crisis hit the market the value of the plan’s asset also started falling, making the plan’s liabilities greater than the assets. The only option with the company is to transfer the plan to an insurance company. This is because if the company try to change the policy of the plan the cost of reconstruction and rebalancing would be high and in future if the economy changes the company will have to incur the whole cost. Therefore, ABC is only left with an option to transfer the plan to an insurance company. Here there is another problem as ABC’s plan consist only 40% fixed income securities and rest in equities whereas Prudential requires that the whole amount be invested in Fixed Income. That leaves ABC either with an option to restructure the plan and then transfer or transfer with a premium.
Prudential Finance
Prudential Finance is an Insurance Company that expertise in taking over the pension liability of the corporations and managing them and earning return on the investments. Most corporations wants to transfer the liability to an insurance company because it saves them from three major risk, which are interest rate risk, investment risk and longevity risk. An insurance company is able to provide a corporation to mitigate all these risks and thus freeing up their resources so that they can concentrate on their core business activities. Though, there would be problems when the plan is transferred as more and more defined benefit plans in USA are invested in equities whereas companies like prudential prefer to invest in Fixed Income.
Also, prudential is facing a hard time to decide how to invest the money of the ABC Corp. plan as to meet the future liability of the plan.
Recommendations
My first recommendation would be to the companies like ABC Corp. who are giving Defined Benefit Plan to their employees, should switch to defined contribution plan thus reducing their uncertain liabilities.
For the transfer of plan, ABC would be willing to pay around 10% to 15% of the liabilities as premium whereas Prudential would be demanding 25% to 30% of the liabilities as the premium. This is because prudential have 13-15% as the stated RoE adding cost related to reconstruction of the portfolio will land the premium in the above given range.
Lastly, when it comes to investing the amount, Prudential should use various slabs of investing. Like, investing the 60% of liabilities in corporation debts, 30% in treasury bonds and remaining 10% of the amount in short term bonds which can be used in case of emergencies.
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