Despite the turbulence of 2022 and the losses for both stocks and bonds, many corporate defined benefit (DB) plans are finding themselves in a better funded status position than at the end of 2021. As such, the pension “end game” is coming into clearer focus, and sponsors are considering pension risk transfers (PRTs)—a hybrid or insurance solution that allows a plan sponsor to transfer some or all of the plan’s liabilities to an insurer in exchange for a portion of the plan’s assets—as they de-risk toward hibernation or termination. (See our webinar on the topic.)
Many of the initial considerations are settlor decisions but have important implications to the sponsor’s organization.
- The constituency of the target demographics and their level of benefits:
- Many times, plan sponsors focus on smaller benefit demographics first, since Pension Benefit Guaranty Corp. (PBGC) premiums can be very impactful on small benefits. Given that there is a fixed and variable component to the PBGC calculation (2023 will see a $96/participant flat rate—a 9% increase—and a $52/$1,000 rate for unfunded vested benefits up to a $652 cap), a participant with a $500 benefit per month could “cost” almost 11% to carry under the current structure.
- Most PRTs are focused on retirees. They are the least expensive to annuitize due to the lack of uncertainty on future benefit accruals. The cost of administering these retiree payments is a component of a PRT savings calculation.
- Generally speaking, some demographics are less costly than others to insure. Blue-collar versus white-collar populations, for example, can exhibit different mortality characteristics. Large PRTs will require more information like mortality experience studies to be conducted by the insurer to finalize pricing.
- Downgrades: A less often-considered part of the PRT decision but an important part of building a liability-hedging strategy is the difference in how credit downgrades affect the liability discount rate vs. the investment portfolio. This is likely about 50 bps per year. It disappears in a PRT but remains a headwind for a de-risking move.
- Settlement accounting: Many PRT transactions are likely to trigger settlement accounting. This can be a very significant charge and should be considered before a PRT is approved.
- Data: One of the largest “unseen” risks associated with a PRT is bad data. Incomplete participant records, inaccurate benefit calculations, “lost” participants, and inaccurate or missing beneficiaries can significantly increase the risk that a transaction will create litigation risk.
Broadly speaking, by the time plan fiduciaries are engaged in the pension risk transfer process, a number of settlor decisions have been made that broadly define the scope of the PRT (size, affected participants, structure). Once the decision to engage in a PRT has been made, the fiduciaries are then charged with implementing that decision with all the accompanying fiduciary obligations that come with it:
- Participant communications
- Market risk between deal and payment dates
- Annuity provider selection
- General vs. separate account at the insurer
- Management of assets (pre and post)
- Legal advice/use of independent fiduciary
- Decision to fund in-kind vs. cash
- Impact to remaining funded status
- Re-examination of asset allocation
- Best timing (insurers have more appetite earlier in the year)
- Special considerations for jumbo transactions
As fiduciaries of the asset pool, many ongoing duties consistent with “normal” practice continue to occur (rebalancing, oversight of the managers, etc.). One of the single largest “new” obligations to the fiduciaries will be the selection of the annuity provider(s).
The Department of Labor produced an interpretive bulletin (C.F.R. § 2509.95-1), commonly referred to as 95-1, that provides reasonable clarity around the criteria for selecting an annuity provider (“safest annuity available”). Outside specialist firms (typically large actuarial practices) will have a specialized team that conducts pension risk transfers, and the 95-1 process will be included in that project plan.
Even with their support, outside legal advice is critical. There can be an accompanying decision to retain an independent fiduciary in the selection of the annuity provider. The reason for that is that there can be conflicts related to the selection of the provider (i.e., focusing on the lowest-cost provider at the expense of safety) or other corporate interests. In order to mitigate this conflict, an independent fiduciary can select the annuity provider. As the selection of the annuity provider can have far-reaching impacts on plan participants, retention of legal counsel with specific expertise in this area is highly recommended.
As the conversations around the pension endgame continue, 2022 registered a record year for pension risk transfer activity. In addition to higher funded status, higher PBGC premiums have also provided motivation for PRT activity. Whether a sponsor decides to de-risk, hibernate, or terminate, PRTs will be an important consideration in the pension management toolkit.
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