Is Annuitization the Answer?
Pension Risk: Substantial but Manageable
Pension Risk Down, Credit Rating Up?
- Changes in pension deficits directly affect a firm’s market value. That is, a one dollar increase in pension deficit represents an additional liability of the firm, thus
decreasing the total market value of the firm (debt plus equity) by exactly one dollar.
- Standard deviations to default = market cap / annual firm volatility.
- Probability of default is based on the assumption that firm risk is normally distributed.
- This analysis solely analyzes the impact of pension risk on total firm volatility. All other factors that may affect a firm’s total volatility are assumed to be unchanged.
- Market cap: Current market cap (Source: Bloomberg 10/31/12)
- Debt outstanding: From Bloomberg, short-term debt + long-term debt + operating lease adjustment (10/31/12).
- Pension liability (PBO): From Moody’s Special Comment: Pension Terminations: No Free Lunch (8/2/12).
- Funded status: From NISA’s PSRX (10/31/12).
- Pension asset and liability volatility: From NISA’s PSRX using forward-looking option-implied volatilities (10/31/12). The volatility of US Steel’s pension based on their actual asset allocation and liability data may be different.
- Firm-specific equity volatility: One year ATM option-implied volatility from Bloomberg (10/31/12).
- Firm-specific debt volatility: Historical 24-month return volatility for outstanding bonds. Calculated using Barclays POINT10 (10/31/12).
- Correlation between firm’s debt and equity: Historical 24-month correlation (10/31/12).
- Correlation between pension assets and pension liability: Historical 24-month correlation (10/31/12).
- Correlation between pension and firm: Historical 24-month correlation between pension surplus and firm market value (10/31/12).
P = Pension Funded Status (Assets – Liabilities) Value
C = Core Operating Company (Firm ex Pension) Value
Step 1: Calculate Total Firm Volatility
Using market data, we can estimate the volatility of a firm’s outstanding debt and equity as well as the correlation between the two. Applying this data, we calculate the total firm volatility for US Steel (amounts in millions):
Conceptually, the total firm volatility (σF) depends on: (1) pension surplus volatility (σP), (2) core operating volatility (σC) and (3) the correlation between the pension and core operating business performance (ρP, C):
Once the pension is de-risked, the only sources of surplus volatility are tracking error and longevity risk. Based on NISA’s experience analyzing pension risk, we assume a 2.75% tracking error to the liability measured with a high quality corporate discount rate and a 0.40% annualized longevity risk. These risks are assumed to be uncorrelated. The tracking error assumption is intended to reflect a reallocation of all plan assets towards liability hedging assets:
Adding the volatility of the de-risked pension to the volatility of the operating company:
In order to estimate the volatility of equity after de-risking, which would not otherwise be needed, but is a required input of the Bloomberg DRSK function, we assume the firm’s debt volatility and its correlation to equity has not changed.
By entering US Steel’s equity volatility into Bloomberg’s DRSK function before and after de-risking, we estimate the credit rating would improve from BB to BBB-.