Prudential Financial Signs More Institutional Agreements, But Will Need To Manage Margins

Last week, Prudential Financial (NYSE:PRU) announced agreements with Bergmann Associates and LiveOps to manage their retirement plans. ^[1] Prudential will assume responsibility for Bergmann Associates’ $33 million retirement plan for 330 participants and LiveOps’ $13 million retirement plan. The deal is a part of Prudential’s effort to expand its retirement division through institutional agreements. Last year, the insurer signed pension risk transfer agreements with General Motors (NYSE:GM) and Verizon (NYSE:VZ).

Research from Mercer shows that there is still a $138 billion deficit in the funding levels of pension plans sponsored by S&P 1,500 companies, even though the funded ratio (assets divided by liabilities) has improved to a five year high of 93%. ^[2] During the third quarter conference call, Prudential’s management indicated the potential for additional deals, particularly with mid and large cap companies. ^[3] We believe that the company can achieve bottom line growth in the coming years, but will have to carefully manage margins on this incremental business.

Our $80 price estimate for Prudential Financial’s stock is in line with the current market price.

See our full analysis of Prudential here

Investment Returns Will Be Crucial

At the end of the September quarter, Prudential reported record-high retirement account values of $312.5 billion, about 32 billion of which came from the transfer agreements signed last year. Adjusted operating earnings for the division through the first nine months of 2013 were up nearly 80% over the prior year. However, after including net investment losses and investment losses on trading account assets supporting insurance liabilities, the operating income was actually down 60%.

Returns from investments remain crucial for Prudential. Excluding investment income, the expense-to-income ratio for the retirement division was around 108% last year, indicating that the company would be running on losses if it was not generating sufficient returns from its investments. More than 75% of the company’s assets are invested in fixed maturity securities like government and corporate bonds. The yields from these investments have been low in the last few years due to the quantitative easing program and low short-term interest rates set by the Fed.  The 10-year Treasury bond yield, which can be used as a benchmark for bond yields, was around 5% before the financial crisis, but fell to around 1.5% in 2012. ^[4] As a result, Prudential’s yield from fixed-maturities fell from 5% in 2008 to 3% in 2012.

This had a direct impact on the operating margin for the retirement division, which fell from 20% in 2009 to 4% last year. Bond yields have been increasing this year on speculation that the Fed will soon start tapering the QE3 program. The 10-year Treasury bond yield is now close to 3%. Prudential’s yield from fixed maturities was around 3.75% for the last quarter. We expect a gradual increase in the company’s operating margin in the coming years, but there is a 20% upside to our price estimate, should Prudential realize pre-recession margins within the next three years. This will not only require a macroeconomic recovery, but also strong execution on the part of management.

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1. Prudential Financial Inc : Prudential to Manage Retirement Plans for Bergmann Associates and LiveOps, December 2, 2013 [↩]
2. http://www.mercer.com/press-releases/1569960, S&P 1500 pension plans continue year-long improvement, reach five year high funded ratio, Mercer Press Release [↩]
3. Prudential Financial Management Discusses Q3 2013 Results – Earnings Call Transcript [↩]
4. Daily Treasury Yield Curve Rates, U.S. Department Of The Treasury [↩]