By Dylan J. Tyson
The economic and market volatility of the past decade significantly affected many employers that offer traditional pensions plans. Stephen Ellis, CFO of Hickory Springs Manufacturing Company, sought a means of transferring his firm's pension risk, while maintaining a direct relationship with its 981 retired workers and enhancing their retirement security.
Following months of research, Ellis opted to overcome this challenge with one of the industry's newest solutions: the pension buy-in, whereby a plan sponsor shifts some or all of the employer's pension risk to an insurance company so it can better manage volatility and risk, and efficiently meet its fiduciary obligations.
An increasing number of U.S. companies are now turning to pension risk transfer as a means of achieving contribution certainty, eliminating financial statement volatility and enabling a greater focus on their core business.
A number of reasons are driving the move to de-risking:
First, volatility is creating difficulties for plan sponsors: Twice in the past 10 years, U.S. sponsors of defined benefit plans lost more than 35 percent of their funded status, according to the Milliman 100 Pension Funding Index. Despite recent improvements in investment returns, many plans remain underfunded. Now that most advisors believe volatility is the new normal, all plan sponsors -- including those with well-funded plans -- face tougher questions about how to manage volatility while maximizing returns.
Secondly, stricter pension accounting rules and increasing longevity have many plan sponsors worried about their ability to manage risk and consistently meet future plan obligations.
Finally, according to a recent study by CFO Publishing, more than half of U.S. CFOs say their defined benefit plans are a major constraint to growth. A defined benefit plan doesn't stand alone and managing it can distract from a plan sponsor's business plan. Pension risk transfer solutions allow greater focus on a sponsor's core business.
There are two main pension risk transfer solutions currently available to U.S. plan sponsors: buy-outs and buy-ins. While both solutions use annuities to help plan sponsors transfer asset, benefit-option and longevity risk to an insurance company and protect against market volatility, they have myriad differences, beginning with their evolution.
While U.S. companies have used pension buy-outs for decades, the first pension buy-in didn't occur in the U.S. until 2011, when U.S. companies began implementing this U.K. pension staple (more than $8 billion of U.K. pension risk has changed hands through buy-ins since January 2009), according to the Lane Clark & Peacock LLP Pension Buy-outs Report 2011.
The buy-out and buy-in also work in different ways?and benefit different plans. Here's a look at each:
A pension buy-out enables a plan sponsor to fully transfer risk, including investment, longevity and benefit-option risk. A buy-out also completely removes administrative, actuarial and investment management expenses, as well as eliminates Pension Benefit Guaranty Corporation premiums, for participants whose benefits are fully purchased. A buy-out removes pension liabilities from the balance sheet guarantees payments to plan participants, and diminishes both accounting and funding volatility.
Some insurance companies have recently expanded their buy-out options to include partial buy-outs, in which the sponsor transfers part of the pension responsibility (say, the retiree portion) to an insurance company, rather than the entire responsibility. In doing this, the sponsor removes that portion of pension liability from the balance sheet and guarantees payments to that segment of plan participants. While sponsors may choose a full buy-out as a way to terminate the plan, the partial buy-out allows them to manage risk even within active or frozen plans, and may reduce the impact of funding and settlement accounting issues triggered by a full buy-out.
A pension buy-in allows a plan sponsor to reduce its pension risk by purchasing a single-premium or bulk annuity from an insurance company and holding it as a liability-matching asset of the plan. A buy-in provides guaranteed payments to the plan to match the covered liability, and enables the plan sponsor to maintain a direct relationship with its participants. Furthermore, it allows sponsors to preserve funded status, and does not trigger settlement accounting or accelerate pension contributions. A buy-in decreases the size of the pension risk, but not the size of the pension plan.
Pension risk transfer solutions like buy-outs and buy-ins can help almost any company alleviate the burden of dealing with its pension plan. As a general rule, companies with underfunded pension plans and those that want to maintain a relationship with their plan participants should consider a pension buy-in. Conversely, companies with well-funded plans and those that want to relinquish all responsibility for their plan to another party should consider a pension buy-out. Of course, the decision is more nuanced than that, and ultimately depends on your company's specific goals. To determine which of these solutions is right for your company, sponsors should work with actuaries and advisors to: 1) examine the health of the plan; 2) consider how management of the plan impacts the company; and 3) explore the pension risk transfer solutions available.
1. Examine the health of the pension plan
To meet pension obligations, many plan sponsors may have to enact time-consuming or costly solutions that detract from the company's core business. To discern whether your firm might face such a situation, collaborate with your actuaries and advisors to review the "health" of the plan. Investigate whether the plan may face deficits, asset/liability mismatch, unpredictable funding requirements, escalating contributions or excessive exposure to risk in the coming decades -- and whether and how the company is prepared to address these issues. Furthermore, analyze how the pension may impact the company's future financial statements and growth.
This review will require your team to create models that analyze these issues using a variety of inputs, from sustained market volatility, to varying interest rates, to differing longevity and discount-rate assumptions. While modeling different scenarios is a key to ensuring the company can meet pension obligations using multiple scenarios, many don't do it. When asked if they had modeled for volatility or longevity, nearly half of all plan sponsors said they had not or weren't sure if they had, according to CFO Publishing.
Furthermore, it's important to build some flexibility into these models because internal calculations can be flawed. For example, studies show that plan sponsors typically undervalue their pension liabilities -- largely due to accounting rules that underestimate longevity and the use of discount rates that are higher than in the market context -- with the average plan sponsor underestimating the true economic liability of their retiree population by approximately 10 percent.
The takeaway: If the plan faces deficits, asset/liability mismatch, unpredictable funding requirements, excessive exposure to risk or rapidly escalating contributions -- or if it may hinder future company growth -- consider a pension risk transfer solution, which can help manage risk and volatility and ensure contribution certainty, enabling the company to concentrate on its core business strategies.
Consider how management of the pension plan impacts your company
Even well-funded, healthy plans can benefit from a pension risk transfer solution. For many firms, management often devotes significant time and resources to reviewing and overseeing the pension plan, which distracts from its primary goals. A buy-out would eliminate these pension issues, and a buy-in could help the company save time and resources. In fact, because of these issues many sponsors are now considering buy-ins as part of their liability-driven investing (LDI) strategy. The LDI strategy?in which the plan sponsor aims to reduce funded status volatility by generating enough assets to perfectly match liabilities -- requires frequent re-balancing amid interest rate and liability changes. A buy-in doesn't demand this level of administration, and provides guaranteed payments to plan sponsors that exactly match their covered liabilities.
The takeaway: If managing a pension plan isn't one of your company's core competencies, consider a pension risk transfer solution. With pension risk transfer, you will free management to deal with other key priorities -- and move some or all of the pension risk to an insurance company, whose core competency is managing these kinds of risks.
3. Explore pension risk transfer
An effective method for evaluating your pension risk transfer solution options is to engage insurance companies to provide free, no-risk quotes. Request that they include product details and pricing, as well as projections for the cost of your pension liabilities and estimated future risks, so you can learn how pricing is calculated. Pension risk transfer solution products vary greatly, and you can't compare these solutions on price alone, though you can expect to pay about 110 percent of the liability value for retired employees and between about 110 percent to 140 percent for current employees.
The takeaway: Work with actuaries and advisors to evaluate the pension risk transfer solution proposals on product quality, price and suitability with your company's specific goals.
Dylan J. Tyson, CFA is senior vice president and head of Prudential's pension risk transfer business.
June 12, 2012
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