In the current environment, many corporate pension plans’ funding levels have risen given the inverse relationship between interest rates and pension liabilities. As such, many plan sponsors are well positioned to derisk their pension plans. PRT transactions — an approach through which pension risk is transferred to an insurer — are occurring at record volumes. Ian Cahill, head of pension risk transfer at MassMutual, offered his perspective on a variety of PRT considerations that can help plan sponsors determine the most suitable and cost-effective approach given their circumstances and objectives.
A Closer Look at Pension Risk Transfer Solutions
Plan sponsors have choices when considering a pension risk transfer approach
The effects of interest rate and spread volatility on PRT transactions can be managed
Evaluating the annuitant experience is essential
Which solution: buy-outs vs. buy-ins
Both buy-outs and buy-ins allow plan sponsors to transfer investment and longevity risk to an insurer. “The difference is whether they’re looking to transfer the administration and eliminate Pension Benefit Guaranty Corporation premiums and associated ongoing expenses — which is the case when a buy-out makes sense,” Cahill said. “But if the plan sponsor has a more nuanced strategy or other objectives, a buy-in might help to accomplish those.”
“The advantage of a buy-in in an unpredictable environment is that a sponsor can lock in the annuity pricing and convert the transaction to a buy-out at a later date,” he said, which could be another 12 to 18 months down the road in the case of a plan termination. “Ultimately, it’s decided by evaluating the plan sponsor’s objectives and determining which solution gets them there.”
“Plan sponsors should work closely with their intermediaries to determine what their objectives really are. But given the current volatile market, we could see plan sponsor interest in buy-ins increase,” he said.
“One key issue is that [interest rate] volatility caused by rising rates is having a significant impact on pension risk transfer pricing,” said Cahill. Even in the days immediately before a PRT transaction, there can be significant interest rate movements of 5, 10 or 15 basis points, sometimes intraday, and this volatility can have a material impact on the final group annuity purchase price set by the insurer, he said.
Another consideration is the accelerated movement in credit spreads, said Cahill, while speaking at Pensions & Investments’ Managing Pension Risk and Liabilities conference in October. “The element that you have to layer on top of rate volatility is the spread environment. Spreads [the additional return, on top of the the risk-free interest rate, paid to an asset holder to compensate for the risk associated with investment] have widened and have become a lot more volatile, which has an additional impact on annuity pricing.”
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Consider an AIK
Asset-in-kind transactions — where a portion of the annuity contract price is funded with a transfer of securities, typically bonds, to the insurer — offer a way to manage the impact of volatility in interest rates and credit spreads on annuity pricing. “AIK allows plan sponsors to minimize the impact of rate and spread volatility around the time they agree to pricing and have to fund the annuity purchase,” Cahill said. Historically, AIK has been utilized in the upper end of the market for transactions of over $500 million, but it’s become much more common today to see the AIK process utilized with $100 million to $500 million transactions.
As described in detail in MassMutual’s white paper, Managing Group Annuity Costs and Risks with Assets-in-Kind, an AIK transaction mitigates the risks associated with having to liquidate pension fund assets, usually long corporate bonds, and any exposure to potential interest rate movements until the insurer provides the annuity price. This significantly decreases interest rate and volatility risk, as the assets are transferred directly to the insurer to pay the annuity premium, Cahill explained. “If a plan sponsor liquidates the plan’s investments to cash and rates fall before the insurer selection date, the annuity price will rise [given the inverse relationship to interest rates], but the value of the cash will remain the same, and there won’t be an offset. With an AIK transaction, this risk is hedged throughout the PRT process.”
In addition, “an AIK transaction is a mutually beneficial option as, typically, the types of assets that a pension plan holds are similar to those that an insurer would look to invest in following receipt of the premium for the transaction,” Cahill said.
Inflation can also affect annuity pricing for plans that may have built-in cost-of-living adjustments based on a market indicator, like the Consumer Price Index. While Cahill noted this feature is less common, he said that insurers will take that risk into account when providing PRT pricing when applicable. “All else being equal, the annuity cost would be higher, and an inflationary environment — as we have now — highlights that risk.”
Differing lens on credit quality
While both plan sponsors and insurers typically invest in public investment-grade fixed income, the insurer will evaluate the portfolio in the context of its own broader investment holdings and portfolio strategy, which include several other investment classes. “Plan sponsors should be aware that an insurer may view credit quality differently than a plan sponsor does,” Cahill said.
It’s also important to note that insurance companies can have different investing philosophies: They can specialize in different asset classes, which can lead to differences among them for how they price group annuities.
“This [evaluation] can be highlighted when rates are not only rising but are volatile,” Cahill said. For an annuity purchase, while pension plan portfolios tend to be valued based on their high-quality public fixed income, the insurer’s target portfolio may, for instance, require higher-yielding assets. “Plan sponsors can’t expect 100% precision between the way they think of spreads and liabilities and the way that an insurer does, because they may move relatively closely but are not exactly the same,” he said.
The participants’ perspective
In addition to reviewing an insurer’s financial ability to satisfy the pension obligations, having the administrative ability to do so is equally essential. MassMutual’s white paper, Leveraging Modern Digital and Robotics Technology to Satisfy Pension Obligations, describes an insurer’s administrative processes and annuitant service delivery models as key elements in successfully meeting contract obligations over the long term.
“A lot of the discussion tends to be around financials and plan sponsor objectives, but we always work the participant’s perspective into the transaction as well. Focusing on the communication strategy to plan participants is crucial. Given that it’s a volatile environment, it’s important to be thoughtful [about this aspect], and it is core to this business,” Cahill said. In addition, “we are seeing increased sponsor interest in our annuitant service delivery model and communications strategies. The annuitant experience is increasingly becoming a key driver in the insurer selection process.”
Some key items for plan sponsors to review when evaluating an insurer’s administration model include understanding the insurers’ commitment to serving the annuitant customer, their engagement and service delivery model, and their communication strategy. Annuitants need to know where and how to access their benefits, and access needs to be simple yet secure. ■
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