Head of Retirement Solutions
Actuarial firms, bankers and insurance companies have been urging U.S. defined benefit plan sponsors to transfer their liabilities to a third party. Transferring the total liability has proven too onerous for most plan sponsors, so these institutions have been pitching partial risk transfers (PRT) instead. However, the touted long-term cost savings and pension risk reduction may turn out to be underwhelming, if not elusive.
Hibernation strategies, a lower-cost alternative to pension risk transfers, may lead to better outcomes for plan sponsors in the medium term – and even put the plan sponsor in a better position for a more successful pension risk transfer in the future.
A common argument in support of PRTs revolves around the idea of reducing Pension Benefit Guarantee Corporation (PBGC) premiums. The PBGC levies premiums on single-employer plans on two fronts – a “per head” premium (the fixed rate premium) and, for underfunded plans, a variable rate premium (VRP) based on the percentage of a plan's unfunded liability.
There is some merit to the idea that PRTs can help plan sponsors reduce their participant count and, as a result, also reduce their fixed rate PBGC premiums. The fly in the ointment, however, is that while premiums are reduced, they may not fall as much as if the sponsor were to choose a strategy other than PRT.
Partial pension risk transfers: Two scenarios
Figure 1 shows a hypothetical plan with 10,000 participants and a 90% funded ratio ($900 million in assets and $1.0 billion in liabilities). The plan sponsor is considering transferring the liability associated with small balances to an insurance company in an effort to reduce its liability value, participant count and PBGC premiums. For example, in exchange for providing annuity payments for $125 million of liabilities, the insurer will require a single premium that exceeds the value of the liability transferred, as the insurance company builds in conservatism margins, capital costs, profit loadings, etc. Assuming a 5% premium over the value of the projected benefit obligation (PBO) liability, our hypothetical plan sponsor would transfer $131.25 million of assets to annuitize $125 million of liabilities.
The funding ratio would fall given the plan's initially underfunded position and because a larger amount of assets than liabilities is transferred. Further, in fairness to participants who remain in the plan after the transaction, plan sponsors typically make a contribution to restore the funding ratio to its pre-transaction level. In our example, the plan would need to contribute $19 million to maintain the funding ratio at its pre-transaction level.
When all is said and done, it may appear as if the plan sponsor achieved its objective owing to a meaningful reduction in participant count (25% or 2,500 individuals) and liability value (a 12.5% decline, or $125 million).
But how do we assess whether this constitutes a sufficient reward in light of costs and resources commitment incurred by the sponsor?
One could begin an assessment by quantifying the benefit in dollar terms and comparing this to the “costs” incurred. In our example, the plan sponsor achieved a $12.8 million reduction in its deficit and a $0.7 million reduction in its annual PBGC premium. Overall, the plan gets advantages worth $13.5 million in exchange for a $19 million contribution to the plan. (Our intent, of course, is not to compare these two numbers because the $19 million outlay is a one-time cost while some elements of the $13.5 million advantage will be recurring).
The question remains, however: Would the sponsor achieve the maximum possible benefit for its $19 million commitment?
For an answer, consider a different way to use the $19 million. In scenario 2, the full $19 million is contributed to the plan without pursuing a PRT. As Figure 2 shows, the plan sponsor would achieve
1. A lower deficit and better funding ratio
2. Roughly the same PBGC premium savings compared to the PRT scenario
All things considered, the plan would get a total benefit of $19.8 million of deficit reduction and premium savings (compared to only $13.5 million with the PRT transaction) for the same $19 million contribution and commitment of resources (see Figure 2).
In scenario 2, the plan can achieve a better outcome without a PRT transaction. While there are other situations where the PRT option may lead to a better outcome (e.g., with meaningfully overfunded plans or plans that are deeply into the maximum per-head PBGC premium), it is important to recognize that PRT transactions do not necessarily lead to meaningful savings.
In many cases there is a better alternative. In scenario 1 (with PRT), for example, the $19 million contribution is spent on reducing the least-costly form of PBGC premium (fixed rate premiums are generally significantly lower than VRPs for underfunded plans) and funding the conservatism and profit margins of the insurer (see Figure 1).
In contrast, in scenario 2 (without PRT), the $19 million goes toward reducing the most meaningful form of PBGC premium (the VRP) and counts completely toward reducing the plan deficit instead of covering the insurer's margins (see Figure 2).
While cost savings are helpful, the main objective of a pension risk transfer is just that - transferring and eliminating risk from the plan sponsor's balance sheet. So before going down that path (and incurring significant costs and resource commitments), it is important to ensure that the transaction will indeed eliminate a significant amount of risk.
Let's go back to our hypothetical plan and assume that the sponsor is contemplating annuitizing its entire retiree population, which represents roughly 50% of the plan's total liability. We will further assume that this plan has been on a de-risking glide path for several years and has achieved a 75%/25% allocation between liability-driven investing (LDI) and return-seeking assets.
As shown by comparing the first and second columns in Figure 3, this PRT transaction does not achieve meaningful risk reduction. In fact, the funding ratio risk (in percentage terms) actually goes up (doubling from 4.6% to 9.3%) if we compare the pre-buyout and post-buyout bars. That is because the liability transferred is actually the least risky portion of the obligation. Retiree cash flows are fairly predictable, have lower sensitivity to changes in interest rates or credit spreads and therefore are relatively low risk.
By transferring part of its liability, the plan is left with only the riskiest part, which drives funding ratio risk higher. To be fair, the higher risk level is applied to a smaller liability figure in dollar terms; so, it is important to look at the difference in risk on a dollar basis. As shown in the table beneath Figure 3, the funding ratio risk in dollar terms is relatively similar before and after the buyout ($41 million before versus $35 million after). However, the $6 million reduction is likely insignificant relative to the sponsor's market capitalization or balance sheet size. In other words, the benefit of a smaller liability value is offset by the increase in risk (in percentage terms) and the sponsor is left without any meaningful risk-reduction benefits.
In addition, the PRT drastically reduces the funding ratio (to 75% from 90%). This is because it costs the plan $105 to annuitize every $100 of benefits, an outlay covered by transferring assets from a plan that owns only $90 against the $100 of liabilities being transferred. In short, by accepting a significantly lower funding ratio after the transaction and if no additional contribution is made, the participants who remain in the plan would subsidize participants being bought out. As noted above, to avoid this most plan sponsors often make a contribution at or around the time of the buyout to maintain the funding ratio at its pre-buyout level. In our example, the plan would need to make a $75 million contribution to maintain its funding ratio.
In the end (see third column in Figure 3), the plan sponsor will have invested a significant amount of corporate personnel and financial resources to execute the transaction and contributed $75 million to the plan in exchange for a meager $10 million reduction in risk. In our view, this is an underwhelming result.
In a way, the transaction is analogous to an individual with a diet dominated by vegetables and donuts who decides to cut down on vegetables to lose weight. Although the vegetables contribute a small amount of calories to the diet (just as the retiree liability contributes a small amount of risk), cutting down on veggies while still enjoying donuts is likely to have limited weight-loss benefits.
It is true than in other circumstances the trade-off may be more appealing. But this again highlights the importance of doing a thorough cost-benefit analysis before investing significant resources in a PRT transaction.
But why do all the cool kids do it?
When providing customized analyses to clients, we often get asked: Why does everybody do it if it's that unattractive?
Actually, PRTs are less prevalent than the many public discussions, conferences, articles and webcasts might lead you to believe. The truth is that only a tiny fraction of the outstanding stock of liabilities gets annuitized every year. Figure 4 shows the annual volume of PRT transactions in the U.S. market in recent years. Using the last five years, the annual average is around $16 billion dollars. This represents approximately 0.5% of the stock of liabilities outstanding. Obviously, not everybody is doing it.
If not PRT, then what?
Many plans may be better off with a hibernation strategy. Hibernation implements a likely low-risk liability immunization program that deploys plan assets primarily in liability-matching investments. Hibernation strategies can help achieve the objective of reducing funding ratio risk and volatility to levels that are extremely low, while alleviating issues that have plagued sponsors in the past – such as underfunding, contribution volatility, high PBGC premiums, heightened complexity and significant commitments of internal resources.
Moreover, hibernated plans – assuming they are frozen to new accruals or closed with small remaining benefit accruals – will shrink significantly over five to 10 years as benefits are paid.
At that point many sponsors would most likely be comfortable sticking with the hibernation strategy. However, if desired, a PRT could potentially be achieved at a meaningfully lower cost given the smaller size of the plan. The hibernation portfolio is also likely to constitute a better annuity-in-kind (AIK) portfolio after several years of hibernation as it would conceivably hold a considerable proportion of seasoned bonds that are often prized by insurance companies. This could further reduce the buyout cost through a more significant AIK discount.
Hibernate now. Consider PRT later
We believe that partial PRT transactions are often costly when one considers the premium relative to the PBO liability as well as the ancillary costs involved in execution – and may provide very limited risk-reduction benefits. In addition, while there may be some small reductions of the PBGC fixed rate premium, plans can often get more significant cost savings by contributing a similar amount of capital to assets than would have been spent on the PRT transaction. This option can help reduce the more costly PBGC variable rate premium and simultaneously improve the plan's funding ratio – as opposed to worsening it, as is often the case with a PRT transaction from an underfunded position. We believe that a better course of action is to hibernate the plan for several years before considering a risk transfer transaction or full termination of the plan.
All investments contain risk and may lose value. The objectives and funding needs for defined benefit plans will vary and a liability driven investing (LDI) strategy should not be considered a complete investment program. The examples provided are not intended to be a recommendation for any particular defined benefit plan's use, and should not be relied upon as such.
Hypothetical and simulated examples have many inherent limitations and are generally prepared with the benefit of hindsight. There are frequently sharp differences between simulated results and the actual results. There are numerous factors related to the markets in general or the implementation of any specific investment strategy, which cannot be fully accounted for in the preparation of simulated results and all of which can adversely affect actual results. No guarantee is being made that the stated results will be achieved.
Forecasts, estimates and certain information contained herein are based upon proprietary research and should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. In addition, references to future results should not be construed as an estimate or promise of results that a client portfolio may achieve. No representation is being made that these scenarios are likely to occur or that any portfolio is likely to achieve results similar to those shown. The scenarios do not represent all possible outcomes and the analysis does not take into account all aspects of risk.
Statements concerning financial market trends or portfolio strategies are based on current market conditions, which will fluctuate. There is no guarantee that these investment strategies will work under all market conditions or are suitable for all investors and each investor should evaluate their ability to invest for the long term, especially during periods of downturn in the market. Outlook and strategies are subject to change without notice. Investors should consult their investment professional prior to making an investment decision.
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