UNDERSTANDING BUY-INS IN THE RISK TRANSFER SOLUTION SET

“As plan sponsors think about pension de-risking, what is the potential value of a series of buy-ins that will enable them to step out of their pension liabilities and achieve their long-term objective?” said Glenn O'Brien, managing director, U. S. Market Leader at Prudential. “As an insurer, we think a lot about risks and the risks that are rewarded and those that are not. The market turmoil in March and April this year bought home to a lot of people that we don't know enough about our underlying circumstances to meaningfully measure the risk. That’s been a long-term tenet of how we think about managing pension liabilities on behalf of all plan sponsors and participants,” said O’Brien, at Pensions & Investments’ Managing Pension Risk Strategies virtual series.

“Then, price is important. How do you evaluate the price of moving a set of pension liabilities?” he added, at the workshop titled ‘Getting out with a buy-in.’ “Obviously, you would want to do that in the context of the cost to own that set of pension liabilities. There are the hard costs of waiting to move the pension liabilities, whether it's PBGC premiums and asset management fees, but credit migration and credit defaults can also be significant holding costs,” he said. “Finally, what's the reward for taking risk away from the balance sheet? We hear from sponsors that running a set of pension liabilities is just not their core business, which is really to focus on delivering value to their customers.”

Corporate pension plans have been on a funded status roller-coaster over the past 20 years, O’Brien said. The Milliman 100 Pension Funding Index shows the tremendous volatility across funded status, even while there has been about $830 billion in contributions into this universe, he noted. “Yet, we are still at an 83.7% funded level. There may, arguably, be a better use of that money. It highlights how much capital can be consumed by a pension plan over time, whether through mortality losses, change in regulation, expenses, rate changes and market volatility and equity markets. The pension plan can make money as well, but that is not accretive to your shareholders. The question becomes, ‘Can we meaningfully understand all the risks and potential costs of managing pension liabilities?’ ”

As plan sponsors consider the economics, they should make their decision in the context of the material risks involved in choosing hibernation versus retaining pension liabilities. O’Brien noted that Prudential is relatively agnostic as to whether pension plan sponsors choose LDI or settle a set of pension liabilities through an annuity buy-out or begin to leg out through a series of buy-ins.

While plan sponsors may get a false sense of safety in considering fixed income as a safe haven versus equity, credit downgrades and defaults occur more frequently than they may realize and are large tail risk events, O’Brien said. “The average loss in a portfolio from credit migration over time hides the true volatility and tail risk, which can be -3 standard deviation in the tail, particularly in recessionary events.” In this challenging economic environment, sectors like airlines, retail, hospitality have really suffered, and being credit investors in their pension plan in those businesses will likely be quite difficult over the next 12 to 24 months, he added.

“What that really means to a pension plan sponsor is your cost of ownership. We help orient pension de-riskers by showing that a GAAP definition that measures your pension liabilities held on the balance sheet does not include any of the ongoing costs to deliver those pension benefits over a long period of time. It’s these economic cost evaluations that will give investors pause to reconsider where they need to be on their pension de-risking journey,” O’Brien said.

Looking at the economic scenario of a buy-out, for illustrative purposes, a GAAP liability of $500 million would mean 4% administrative and PBGC expenses; 7% costs due to credit defaults and downgrades, and 1% to 3% active management fees to optimally manage the credit portfolio, O’Brien said. “We could then estimate that the true economic cost of holding the liability is $560 million to $570 million for the plan sponsor, versus an estimated $525 million buy-out pricing with an insurer,” which comes from economies of scale and the insurer’s own asset portfolio, he said. The specific circumstances of moving the liability to an insurer would, of course, vary by plan sponsor, he added.

If you consider a pension buy-in for the same situation, the structure and pricing are similar to the buy-out, except that the insurer does not make the benefit payments to individuals but to the plan sponsor, O’Brien said. “Rather than a complete settlement of the plan liability at the moment of purchase, it is a guaranteed asset that matches the plan liability. The plan sponsor retains the PBGC payments which, at approximately 4%, are factored back into the overall costs. For the buy-in scenario, we estimate $545 million as the economic value of the liability with the insurer bearing most of the risk,” he said.

“We see the evolution of buy-ins as a very elegant way for plan sponsors to define the economic cost of an early exit from the plan termination process. It can be done opportunistically for the whole set of liabilities or for a subset, it can be held as long as you would like and converted to a buy-out when you’re done,” O’Brien said. “As we live through relatively volatile markets, or there is corporate action like a merger, acquisition, any of those events where you might hesitate to strike settlement at that particular moment but you would like to be risk-off, the buy-in is really a very elegant solution and can be deployed quickly.”

“As plan sponsors consider their de-risking alternatives, discussions that coalesce around costs are a bit of a distraction from the bigger issue, which is, ‘As an industry, should I have a meaningful footprint in the insurance business?’ I spoke with a $20 billion plan sponsor who said he runs the program with three staffers. He may run a good program, but it’s in a non-core business. An insurer has dedicated staff and can run it more efficiently with scale and expertise,” O’Brien said, adding, “Insurance companies are not allowed to run underfunded liability businesses.

To reiterate the evaluation of a pension risk settlement, O’Brien emphasized that:
• Tail risk events occur more frequently than a normal distribution
• The one standard deviation analysis used to support hibernation is deficient in measuring risk and financial outcomes
• GAAP accounting of the pension liability does not capture true economic costs to the sponsor
• Pension settlement is often better value for sponsors and shareholders and brings better credit for participants via a highly-rated capital reserve insurer.

“Since the Covid-19 pandemic, many clients who have done these pension risk transfers have shared with us that it has helped them tremendously to not have to manage the plan liability on their book,” he said. “As we continue to see these non-one standard deviation events, we learn the lessons ever so often that a big frozen pension liability might not be in the best interest of all the parties involved.”

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