CONSIDER DE-RISKING WITH AN ASSETS-IN-KIND TRANSFER TO A GROUP ANNUITY SOLUTION

Defined benefit plans continue to explore asset strategies for their pension de-risking journey, including pension risk transfers to group annuity solutions. Moreover, the Covid-19 outbreak and ensuing market volatility has led to more interest in preparing for such transactions in advance and transferring assets-in-kind (AIK).

“An assets-in-kind transfer is when a plan sponsor pays for a group annuity premium by transferring actual assets as opposed to paying for a premium in cash,” said Neil Drzewiecki, Head of Pension Risk Transfer & Institutional Actuarial in Institutional Solutions at MassMutual, speaking at Pensions & Investments’ Managing Pension Risk & Liabilities Virtual Series in October. He added that a key benefit of the strategy is potentially lower costs for the plan sponsor.

“One of the savings is the elimination of the bid-ask spread on the sale and subsequent purchase of assets by the insurer. Assets are traded at a mid-price, which could lead to a lower price for the annuity and transaction cost savings for the plan sponsor,” he said, at the session titled, ‘The Pension De-Risking Journey: What Assets should I be Holding?’ Coupled with the standardized process for AIK transfers in the industry today, plan sponsors are able to secure the benefit of AIK transfers, even some transactions with less than $100 million—a transaction size that wasn’t always viable before, he said.

The illustration [below] shows that potential impact of the interest rate risks associated with a cash annuity purchase for the plan sponsor.

Drzewiecki indicated that during the pandemic not only was day to day market volatility a key concern, there was a lot of intraday movement to consider. “During the crisis…we saw interest rates and spreads moving a lot during the day,” he said. During highly volatile markets, dealing with knowns versus unknowns is preferred and makes AIK transactions desirable.

“Knowing that you have an assets-in-kind portfolio that you've already valued, and you already know what the values of the bonds are and the yield you will get, as opposed to having to deal with the risks of intra-day, and ultimately multi-day movements of interest rates … add to the value of AIK transfers,” Drzewiecki said. Additional benefits to the insurer include eliminating the need to speculate on investments the insurer would need to purchase with a cash transaction and avoiding related costs and risks. The AIK transfer can also provide considerable risk reduction as the insurer earns a known spread from the portfolio right from day one. Generally, these factors generate an opportunity to offer lower price for the group annuity, Drzewiecki said.

As an insurer, “when you receive cash, there's a potential for delay as you wait to put money into the real assets as well. Spreads could tighten and move on you. While some of these risks can be hedged, actually having the known AIK portfolio in your hand with the spreads that you're earning right off the bat is a benefit that could save on transaction costs,” he explained.

Plan sponsors should be aware of the type of asset portfolio that insurers prefer and would get them the best price, as different insurers can have different preferences. In general, “You’re really looking to have a well-diversified fixed income portfolio that delivers meaningful spread income and does match the duration of the liabilities,” Drzewiecki said. High-quality spread assets like long duration investment grade bonds are the obvious choice, he noted. But the asset portfolio can also include a small portion in high-yield assets in the single A to single B credit rating, he said. “You're trying to manage a balance of yield and risk, of course.” And it could include private equity, which can be appropriate for backing pension liabilities given their long duration, but he cautioned that it introduces more complexity in the due diligence and agreement on pricing can, on occasion, be a challenge as well.

“We generally would want to also limit exposures to equities and real estate which are generally not appropriate in an insurer account,” Drzewiecki said, adding “You want some shorter, higher-quality assets, and while those aren't the type of assets that will deliver the yield benefit or the discount benefit to the AIK transaction, it will help in creating that overall well-diversified portfolio, and you want to cover all the different tranches of cash flow that you have.”

Plan sponsors need to clearly articulate the long-term objectives of their pension plan, and the de-risking strategy, including the specifics of an AIK transaction with a group annuity purchase, that can move them closer to that goal, Drzewiecki said. “We've seen many plan sponsors start the [de-risking] process in a number of ways: they can go through a lump-sum project and lower the amount of deferred lives that are in their plan; they could start with a carve-out of some low balance retirees before they get to an ultimate or full plan termination. If the path is purchasing a group annuity they should start with data cleanup, making sure they actually have a data set that is ready to hand off to an insurer,” he said, adding, “By having a plan, you can really prepare and execute a successful transaction… on that path to fully de-risking your plan.”

Getting the portfolio set up is key. Employing an LDI strategy and investing in longer-duration fixed income assets puts the sponsor on the path toward doing an assets-in-kind de-risking strategy, Drzewiecki said. “Having that path planned out and ultimately transferred through to the insurer on an AIK portfolio can keep the pension plan fully invested throughout the process, minimize risks and lessen costs, and it can be a win-win scenario right through the end.”

The industry has done a great job of standardizing the process of executing an AIK transfer as many AIK transactions have been done in recent years, Drzewiecki said. That includes setting the strategy, determining the size and type of bond portfolio that can be used to fund the transaction, doing a data cleanup, and execution of the transfer, including selecting the insurer and ensuring that all the parties are prepared for a seamless transition. Communication is also critical to the process, he added, such as having daily meetings and securing agreement on key issues such as asset valuation, handling of coupon payments during that transfer period, and having a well-prepared bank custodian. “It's a very standardized process that I've seen go very smoothly now.”

For more details on AIK transfers to group annuity solutions, please read MassMutual’s recently published white paper, Mitigating group annuity buyout costs and risks with Assets-In-Kind Transfers.

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