Why are more defined benefit plan sponsors terminating their plans? Among other reasons, to end the financial risks they face in keeping those plans active. But that de-risking process also carries its own set of risks.
There are ways sponsors can de-risk the de-risking process by working with insurers from the start, and not just when plan terminations are complete. Pension buy-ins, which let plan sponsors guarantee future benefit payments to some or all plan participants at the start of the termination process, can help take the risk out of de-risking.
Not Going back
Regardless of how one de-risks, there’s no turning back on the continuing trend of employers terminating their DB plans amid improved funding status, higher Pension Benefit Guaranty Corporation premiums and more insurer capacity, according to a recent Prudential Retirement white paper, “Unlocking Value in Pension Plan Terminations.” The pension risk transfer market, based on sales of single-premium buy-outs and buy-ins, has risen from a $1 billion-to-$2 billion market prior to 2012 to $30 billion in 2019, according to LIMRA’s Fourth Quarter Group Annuity Risk Transfer Survey. Sponsors of plans large and small now see termination as a viable way to remove pension exposure.
The traditional way of terminating a pension plan with an insurer is through a pension buy-out — a financial process in which a plan sponsor transfers the pension plan’s liabilities to an insurer when a termination is completed. What’s risky about that? There are unique risks encountered between the announcement of intent to terminate and the final shutdown of the plan that can impact a plan sponsor, as well as the variety of risks that sponsors contend with in the general operation of a pension plan.
The three specific risks associated with plan terminations are basis risk, insurer capacity risk and lump sum risk.
Terminating a plan can’t be done overnight. The termination process from inception to completion can take anywhere from one to two years, mostly because of external factors like awaiting regulatory approval, notifying participants and, if lump sum pensions are being offered, providing time for participants to decide whether to take a lump sum or annuitize. And while those factors are playing out, basis risk such as volatility in investments and changes in interest rates can affect a plan’s assets and liabilities.
For example, a pension plan with $1 billion in assets and liabilities that announced its termination at the start of 2020 would require no contribution for buy-out with an insurer if the termination had been done immediately, since the plan would have enough assets to fund the insurer premium. But if the termination process spanned the first quarter of this year, that plan sponsor would have been hit with an interest rate drop of 100 basis points and an equity decline of 25%, all because of basis risk. The lower interest rates would have resulted in a premium increase of $90 million, assuming a liability duration of nine years and the insurer’s assets used to back the liability, which are largely long-duration corporate bonds with high credit quality.
During the same period, the market value of the plan’s assets, assuming a typical 60% equity/40% fixed income allocation with an average duration of 15, would have decreased by $90 million. The basis risk thus would mean a $180 million contribution for which the plan sponsor was not prepared.
Insurer capacity Risk
Changes in plan assets and liabilities in the time between announcing and concluding a plan termination also can affect how many insurers will bid for the plan sponsor’s buy-out based on insurers’ ability to handle all of the annuitization. This is a particular problem for pension plans with larger assets or those that are including active or deferred participants as well as retirees in a buy-out, as deferred participants add longevity and behavioral risk to annuitizations. A reduced number of insurers available to handle a buy-out could jeopardize the termination.
Lump sum Uncertainty Risk
Plans offering participants the option of taking a single lump-sum pension payout must deal with the uncertainty of how many participants will accept the offer and how many will annuitize. As with basis risk, the time required in a traditional buy-out process to allow participants to choose their option opens the plan to market and interest rate risk. Additionally, the final asset amount going to lump sums often isn’t known in a traditional buy-out until near the end of the termination process, making it very difficult to estimate the final amount that an insurer will be annuitizing. This uncertainty could add unforeseen cost to a buy-out.
Buy-ins: Mitigating the De-risking Risks
Similar to buy-outs, a buy-in covers all market and longevity risk on future benefit payments, but, unlike buy-outs, it does not settle plan liabilities. Since they’re agreed upon at the start or early in the termination process, buy-ins are held as a plan asset and the sponsor continues to make benefit payments to participants with funds provided by the insurer. Since liabilities are not settled, the sponsor will continue to pay premium payments to the PBGC. The buy-in can be converted to a buy-out at no additional cost whenever the sponsor wants, at which time the insurer begins making payments directly to participants, and PBGC premium obligations end.
Buy-ins allow plan sponsors, working with insurers, to create a customizable approach to plan termination with risks of traditional buy-outs reduced or eliminated. Basis, insurer capacity and lump sum uncertainty risks are mitigated by using buy-ins in three ways: offered exclusively for current retirees, for a combination of retirees and some active participants, and for all active and retired participants.
In exclusive retiree buy-ins, those participants are offered the same choice as in a buy-out, to annuitize their benefits or take a lump sum of the outstanding benefits, but the offer is made early in the termination process. The buy-in becomes a buy-out when the termination is complete and active participants are added. This is the simplest buy-in method, as it has a more predictable liability determined by the known number of retirees covered by the plan. The three de-risking risks are eliminated for the retiree benefits.
Some active participants also can be added to retiree buy-ins at an early stage of the transition process as a way for plan sponsors to further reduce the impact of the three risks as well as cover the funding and termination costs that could be greater if all active participants are only included at plan termination. In this way, some of the costs are paid at the start of the process, leaving the final termination less expensive. The larger the active group included in the buy-in, the lower the overall risk.
The most risk-averse process involves lump-sum risk transfers, in which all participants — active and retired — are offered the choice of accepting a lump-sum benefit outlay or annuitization early in the termination process. In this, the sponsor pays one premium up front and the insurer is responsible for paying the lump sums. While this eliminates the three risks of termination, it could mean a higher up-front contribution to the pension plan as it must be 100% funded to qualify and the premium could be higher than the original expected termination cost. But the lump-sum risk transfer is the only one that eliminates basis, insurer capacity and lump sum uncertainty risk at the start of the termination process.
The Importance of Risk Awareness
Plan sponsors should be aware that, in the process of pension plan de-risking, the process itself can carry its own risks. But that awareness can open the door to a more streamlined and potentially less costly termination process, one in which insurers like Prudential can help.
Scott Gaul is head of Investment & Pension Solutions at Prudential Retirement, a business unit of Prudential Financial, Inc. (NYSE: PRU), and a leading provider of defined contribution, defined benefit, nonqualified deferred compensation plan administration, and institutional investment and risk management services.