Pension Risk Transfer on the Rise

The trend in defined benefit (DB) plan sponsors transferring their plan’s liabilities to participants or to an insurance company is increasing. In their reporting to the LIMRA Secure Retirement Institute for all of 2018, insurers cited having sold 29,632 pension buyout contracts, versus 29,417 in the first quarter of this year alone.

Pension risk transfer (PRT) is done by one of two methods. In the first, the plan purchases annuities from an insurance company, transferring liabilities for some participants (partial risk transfer) or all (full risk transfer). In the second, it gives a certain category of participant—e.g., terminated vested employees—the choice of receiving a lump sum, which satisfies its liability for these individuals; this can be either a one-time offer or become a permanent plan feature.

There is also an annuity buy-in and an annuity buyout. With the buy-in, the insurer is responsible for funding the payments to participants. The plan sponsor, and the plan, however, maintain a connection with the participant. With a buyout, all obligations and communications are the responsibility of the annuity provider.

New York City-based chairman of the American Academy of Actuaries’ Pension Committee Bruce Cadenhead says it is a good environment for PRT because many insurers have entered the business, making pricing competitive.
Interest rates, which are currently low, are a factor both in liability calculations and annuity pricing, observes Mark Unhoch, a partner and practice leader for October Three Annuity Services in Chicago. Corporate bond rates and 10-year Treasury note rates are additional factors in calculating liability, as is mortality, which affects an annuity’s cost.

For PRT, Unhoch says, there is a minimum threshold requirement that a plan be 80% funded prior to an annuity purchase and remain so afterward. Unless a plan is more than 100% funded, the sponsor will have to put in additional cash because the annuity will cost more than the liability being transferred. Unhoch says it could cost 103% to 105% of liabilities to purchase an annuity. So, for example, if a plan is 90% funded, the sponsor would have to contribute 13% to 15% of the liabilility, in cash, for the plan to be able to purchase the annuity.

Following a partial PRT, the sponsor may have to add cash to the plan if its funding falls below 80%, Cadenhead says. Provisions of the Pension Protection Act of 2006 (PPA) impose benefit restrictions on plans that are less than 80% funded, with increased restrictions on those less than 60% funded.

“What we’ve found in talking to many CFOs [chief financial officers] is they are willing to pay a little extra to give them certainty rather than volatility,” he says. “When they look at their liability versus the present value of future expenses for retirees, it ends up being a wash.”

Both Cadenhead and Unhoch agree that the decision to implement a PRT depends on the unique circumstances of the plan sponsor.

When Is a Plan Ready?

If a defined benefit plan is at the 80% minimum funded threshold or higher, its adviser can look at several factors to gauge whether the plan is ready for a PRT transaction.

The most obvious factor is whether the plan has been frozen. “In that situation, it’s a question of when, not if, the plan sponsor will transfer risk. Most sponsors of frozen plans don’t intend to hold onto the plans forever, especially with increases in PBGC [Pension Benefit Guaranty Corporation] premiums,” Cadenhead says.

This leads to the consideration of expenses for maintaining the plan. Unhoch says PBGC premiums are the biggest expense for a DB plan sponsor. The per-participant flat premium rate for plan years beginning in 2019 is $80 per participant for single-employer DB plans; the variable-rate premium is $43 per $1,000 of unfunded vested benefits, capped at $541 times the number of participants. “If a plan sponsor is at the PBGC cap, for every participant taken out of the plan, that would save the plan sponsor $621—$80 for the flat premium rate and $541 for the variable premium rate,” he notes.

According to Cadenhead, if a plan has many participants with small benefits, considering the cost of PBGC premiums, its sponsor may be advised to offer a lump sum or do a partial transfer to an annuity for those participants.

Advisers should also look at the plan’s liabilities in relation to the market capitalization of the company, Unhoch says. At the time General Motors transferred its pension risk, the liabilities were larger than the market capitalization of the company, he observes.

Further, advisers should help the client calculate the expense of a PRT. The cost to purchase an annuity will depend on the plan’s funded level. “If the plan is well-funded it’s easier, but, for those that are not, they’ll have to come up with considerable cash,” Cadenhead says. “Even if a sponsor is doing a partial risk transfer, it will want to consider whether it has enough money to make that happen.”

Cadenhead adds that insurers are most competitive for retiree liabilities—these people have shorter life spans than those still employed, and the insurer already knows the amount of benefits to be paid. Plan sponsors can get the best pricing on a partial risk transfer of retirees. For terminated, vested or active participants, there is more uncertainty for the insurer, so the price charged may be higher.

According to Cadenhead, in some cases, plans may have complicated features, and the sponsor will be unable to find an insurer to assume the liabilities.

Three such examples would be:

• A plan offers retiring participants the greater of a traditional annuity benefit or a cash balance benefit; which is greater may depend on the interest rate environment at the time and the age at which the person retires.
• A plan offers a choice between a fixed annuity and an annuity that begins paying at a lower amount but is adjusted for inflation each year, making its future cash flows more unpredictable.
• Once a cash balance plan is terminated, the interest credit rate and the annuity conversion rate are fixed—helpful from an administrative perspective, but it may be difficult to invest to match the expected payout.

For plan sponsors that offer the better of cash balance or traditional DB plan benefits, it is unclear which benefit will be more valuable when someone retires, so the insurer needs to consider both alternatives and will price for the more expensive one.

Advisers should also make sure DB plan sponsors understand the potential hits to their balance sheet from a PRT. Besides the impact from adding cash to purchase an annuity, DB plan sponsors may, because of accounting rules, have unrecognized losses on their balance sheet that are amortized over time. But, Cadenhead says, when an annuity purchase or large lump-sum payments trigger settlement accounting, the sponsor will have to recognize a portion of those losses all at once. “That can be fairly large for some plans,” he says.

Advisers might also suggest annuity purchases to lock in funded status gains, Unhoch says. DB plans often use liability-driven investing (LDI), which moves assets to less risky investments, typically bonds, at certain funded status triggers.

Getting Into the PRT Game

If an adviser serves a plan sponsor’s defined contribution (DC) plan, he may see an opportunity to help the sponsor gauge whether pension risk transfer (PRT) is right for its defined benefit (DB) plan.

Mark Unhoch, with October Three Annuity Services, suggests asking these simple questions, to open the door to that opportunity:

• Have you looked at options regarding your DB plan?
• What are your goals regarding the DB plan?
• Are you happy with the investments or expenses of your DB plan?

Once advisers know the answers to these questions, they will understand how to go about advising the client about its plan, Unhoch says. —Rebecca Moore

Art by Linda Liu