Market risks: Funded status volatility, which is eliminated from the sponsor's perspective in a buyout, can be reduced to as low as 1% with a hibernation strategy — a small fraction of a typical plan's current volatility. If the primary goal is to reduce the pension plan's risks derived from equity markets and interest rates, hibernation likely satisfies that objective.
Contributions and liquidity: A buyout requires a payment equal to the annuity price offered by the insurer. For most plans, this implies an immediate cash contribution from the sponsor, whereas a hibernation solution does not. With both strategies, future contribution volatility might be greatly reduced as a result of the reduced market risks affecting funded status. However, the reduction in expected return on assets implies a higher expected contribution total over the life of the plan, compared to a return-seeking strategy.
Sponsor health and credit rating: As Moody's was quick to point out following the announcement of the General Motors Co. deal , the risk-reducing benefits of a pension annuity buyout may be offset by the required cash infusion. However, hibernation solutions can provide the benefits of reduced risk without requiring any immediate additional contributions — even suggesting an improvement in sponsor credit rating in some cases.
Longevity risk and mortality assumptions: We estimate longevity risk to be small relative to other plan risks — less than 1% annually in funded status terms — and therefore not likely to justify a buyout on its own.
Separately, the question of whether the plan's current liability value is based on outdated mortality assumptions is relevant. A plan will be forced to immediately recognize any “stale” assumptions in a buyout transaction, but might be able to delay this recognition for accounting and funding purposes in a hibernation strategy.
Conflicts of interest in insurer selection: The sponsor decides whether to terminate, but the fiduciary chooses the annuity provider. While pricing is likely to be a key factor in the sponsor's decision, the fiduciary might be obligated by the Department of Labor to choose the safest available provider without considering pricing as a primary criterion. One could imagine a situation in which the safest available annuity provider is charging a notably higher price. The fiduciary might be obligated to choose this provider, potentially undermining the sponsor's initial analysis of the costs and benefits of termination.
Ongoing plan costs: Some plan costs (e.g., administrative and management costs) might be substantially reduced in a hibernation solution. With the assets primarily dedicated to liability hedging, the fiduciary's management role is likely to be simpler without the complexities of overseeing a broader portfolio across many asset classes. If the hibernation solution is based on a fully funded plan, PBGC variable rate premiums (i.e., the “underfunding charge”) would be eliminated, for example. Most or all of these costs might be eliminated in a buyout scenario, though any structuring or advisory costs should not be overlooked.
Insurer profit margin and pricing opaqueness: The pricing of a buyout transaction will naturally include some profit margin for the insurer, representing a cost for the sponsor. The narrowness of the annuity provider market, the relative dearth of comparable transactions for large plans, and any uncertainty regarding the various pricing components might lead a sponsor to question whether pricing of an annuity buyout is transparent and competitive. However, some sponsors might find value in the certainty of having a single, defined price tag associated with their derisking solution.
Conclusion: The good news for plan sponsors and fiduciaries tasked with choosing a pension derisking strategy is that they have options. The bad news is that they have options — and choosing among them isn't likely to be easy, given the multitude of factors to consider.
Further, while we have simplified the choices into the broad categories of “buyout” and “hibernation,” the lines are less clear-cut when considering partial buyouts, annuity buy-ins, lump-sum offerings and longevity swaps that might be utilized in a hibernation strategy. The choices also are not mutually exclusive. For example, the liability-focused portfolio resulting from a hibernation solution would likely make any eventual handoff to an annuity provider that much simpler.
In reality, those plans seeking to derisk benefit from having a wide array of tools at their disposal to design a strategy that meets their objectives. Because both buyouts and LDI-based hibernation can achieve similar derisking results, sponsors might weigh other advantages of each approach and their specific circumstances in making the appropriate decisions for their plans. n
This is a summary of a longer paper, “At the Crossroads,” available on NISA's website.
