Art by Wesley Allsbrook
CIO: United Technologies (UTC) had a very big announcement a few weeks ago: Cutting nearly $2 billion of liabilities through a pension-risk transfer (PRT) and a lump sum deal. Tell me how it all happened.
Robin Diamonte: CIOs now have to think beyond just investment management. We have to think about liabilities, risk, and even pension accounting. Unfortunately, there is only so much you can do in the investment space to improve the funded status of the plan—especially if you’re underfunded and concerned about volatility. Our funded status is in the mid- to high-80s, and we want to be around 115% funded to immunize our plan. This would take a combination of interest rates rising, increased contributions, and higher returns. When you work for a multinational corporation focused on quarterly earnings with a lot of analyst coverage, senior leadership is concerned about pension cost since it can be a major driver of absolute and year-over-year earnings-per-share volatility.
Because of the asset volatility and continually declining interest rates, we started to look to other places to try to cut the pension plan’s volatility and the cost. We looked to minimize investment fees and administration fees, but even after doing everything we could with them, Pension Benefit Guaranty Corporation (PBGC) premiums still kept our costs up. We had more than 200,000 participants in our plan, and with a funded status in the 80s, that means a high flat rate and skyrocketing variable premiums. That’s when we started to seriously consider the idea of a pension-risk transfer.
When the concept of PRT first came out, I was against it. I found others were paying high premiums to insurance companies and largely they were not taking into consideration the investment returns of the assets they held in the break-even analysis. My view has changed somewhat—especially because of the segment of the plan we transferred. But I still don’t think it makes a lot of sense to pay insurance companies significant premiums to take the entire plan’s liabilities when an investment team can essentially immunize the portfolio at lower costs.
CIO: So how is UTC’s risk transfer approach different from others?
Diamonte: We first looked at the part of our liabilities that was the most expensive. We wanted to find a segment of the retiree population that had the highest breakeven cost. We ultimately targeted a group of retirees with very small monthly annuities of $300 or less. We were able to transfer more retiree liabilities than a regular PRT would with this group of smaller-balanced retirees. The analysis showed the savings we would get from PBGC and administration costs were larger than the insurance premium—it was a no brainer.
We also didn’t want to transfer more than $1 billion. This meant we were able to transfer 36,000 retirees, reduce our liabilities by $800 million, and reduce future volatility. We’re chunking away at the problem.
CIO: I suspect the process of getting to this solution—and ultimately implementing it—was not so simple.
Diamonte: It was definitely complex. We began thinking about the transfer late last year. We got approval to pursue the opportunity from our investment committee in December of 2015. We then created fiduciary and settler committees within UTC and simultaneously worked on the data-cleaning process, which was quite time-intensive. We worked with our actuary on project management, legal contracts, and the request for proposal (RFP)—it took multiple rounds of RFPs and meetings with each insurance company before choosing Prudential.
CIO: It’s a good thing you have a strong team! (Some of whom were featured in our Forty Under Forty lists).
Diamonte: Yes, all five of our investment staff members had a part in working the deal. Joe Fazzino [UTC’s senior manager] served as the project leader. He really understands everything from LDI to accounting—all the aspects of managing a pension fund. This is important because the deal required working with many teams within UTC including HR, accounting, controllers, and legal. We decided to transfer $520 million in bonds and the rest in cash. This meant we needed to decide which bonds to transfer and from which active manager. We wanted to create a bond portfolio that the insurance company would want to receive. Since we also completed a buyout with several phases in 2016, the team also needed to track cash flow and asset allocation carefully throughout the year. In total, we efficiently liquidated $1.6 billion in assets.
CIO: How about the lump sum payment?
Diamonte: It created accounting and economic savings for us. Lump sums are calculated using a discount rate at a certain point in time. For UTC, it was from November of last year, which was a much higher rate. We targeted a group of term-vested employees who weren't in retirement status and basically said, ‘we owe you an annuity of x amount in the future and the present value is this lump sum. Would you like to take your retirement sum now?’ From about 30,000 offers we gave, 30% took it. We ended up paying out $750 million in lump sums.
The idea actually originated from a colleague in CIEBA [the Committee on Investment of Employee Benefit Assets], 3M. If an employee takes an early lump sum and the discount rate to calculate the sum is higher, it has a positive accounting impact. You also save on administration costs and PBGC premiums for each person who takes the offer.
CIO: You mentioned earlier that pension expense is a major concern. How did those savings shape up for UTC?
Diamonte: We reduced our liabilities by nearly $2 billion, but reduced our assets only by $1.6 billion. This gave us a $400 million improvement in funded status. In total, we calculate a present value savings of $600 million. Pension expenses went down by $30 million. And the most important thing is the risk transfer and the lump sum payments are a win-win for the company and our employees. Prudential is a secure and stable company with a high credit rating. For those who have taken the lump sum, they had the ability to roll it over to UTC’s 401(k) plan or the plan of their current employer. We’re very comfortable with how the deal progressed.
CIO: UTC is lauded as one of the most innovative corporate funds out there—and I’m sure the buyout only adds to this popular opinion. In addition to the pioneering annuity plan, UTC has added risk parity and portable alpha to defined contribution plans, and is implementing smart beta and liquid alternatives. Simply put, you’ve done a lot. What’s next?
Diamonte: We did use a lot of tools out of the toolbox, especially from the non-investment toolbox—and there’s not a lot left. We need to put our focus back on our liabilities and investments. For us, this means optimizing the risk parity bucket and the structured equity bucket (portable alpha strategies over equities). We want to hedge our liabilities effectively and we want alpha on top of it.
We’re also looking at increasing the opportunistic portion of our real estate portfolio. Could we be doing something entirely differently? Perhaps the answer is in smaller opportunities.
Another idea we’re exploring is strategic partnerships. Britt Harris [now-CIO of the Teacher Retirement System of Texas] ran the strategic partnership network when I was working for him at Verizon—and he still has them at Teachers. We never implemented formal partnerships because UTC is a much smaller plan. Strategic partnerships give you information on the market and on tactically moving between various strategies. Up to this point, we have been more strategic than tactical in our asset allocation. We think that the right partnerships could add value in different ways—help us move quickly into opportunities, become creative in LDI, and provide research. We may be looking to add a few over the next year.
CIO: You wrote a letter for us last year in which you said concerns over global growth, global deflation, and an extended period of low returns are keeping you up at night. What about this year?
Diamonte: Definitely interest rates, again. A lot of CEOs, CFOs, and even CIOs are betting on interest rates rising and funded status improving. I continue to worry that they will stay low longer and future returns will not be as strong as in the past. This means the road to being fully funded is becoming more and more difficult. At some point, this could be an issue for benefits. I also think about the funded status of the state pensions and multi-employer plans. There is no clear path on how these plans will get funded, and I am concerned that many participants may never receive these benefits or at least at the level that they were originally promised. All of these issues could point to a major retirement crisis in this country.