Pension Risk Transfer Solutions

This article originally appeared in the Fall 2013 issue of Plan Consultant. To view a PDF version of this article, please click here.

Pension risk transfer (PRT) is a term that is quietly incubating within the U.S. pension marketplace. A close cousin of terminal funding (a term which may be more readily familiar to asset-liability practitioners), pension risk transfer involves the use of institutional annuity products to reduce and/or eliminate pension risks. 

PRT solutions are differentiated from terminal funding in that their utilization is not relegated to being part of a plan termination process. Rather, PRT solutions are a new guaranteed asset class for pension sponsors to consider as they evaluate their overall fixed income investment portfolio. The objective of this article is to provide a high-level outline of the pension risk transfer solution spectrum, and challenge pension stakeholders to consider the utility of these products as part of the fixed income universe of pension investments.

The chart below illustrates how a plan’s ability to “afford” annuitization is to some degree a function of its funded status and the proportion of plan liabilities it annuitizes. Thus, for plans funded in excess of 90% it is likely that they may be able to comfortably afford to annuitize some portion of their plan liabilities. This strategy concentrates on annuitizing retiree liabilities that can be most efficiently priced by insurers (typically less than 110% of GAAP liability value) and reducing the plan’s cash flow/benefit payment expense burden. For plans which may be waiting for rates to eventually rise, this approach may be preferable to an alternative settlement approach of issuing voluntary lump sums to terminated vested participants, in that a future rise in interest rates will have a more dramatic liability reduction impact on the long-duration liabilities associated with younger terminated vested participants.

High Level Impact of Partial Annuity Buy-Out on Remaining Pension Plan

A new PRT product based on investment contracts has recently come to market that is designed to be a turnkey, bundled LDI solution. This investment contract guarantees that a plan’s expected cash flows will be valued equal to the prevailing rate of the same pension discount curve the plan uses to value its liabilities. This approach essentially allows a plan sponsor to invest in a contract (asset) whose value is equal to the liability. That is a powerful proposition for sponsors interested in de-risking their plan and increasing allocations to fixed income to protect their funded status.

The primary advantage of using investment contracts as a PRT solution is that the terms can be customized to cover as few or as many cash flows as the sponsor is comfortable with. While an investment contract approach does not provide protection against mortality risk, it does allow a sponsor to diversify its fixed income investment by employing a guarantee. Additionally, an investment contract based approach to PRT allows a sponsor to engage an institutional insurer in a relationship in advance of more fully annuitizing its liabilities via a buy-out or buy-in solution. The advantage of being an existing client of an institutional insurance provider can potentially be a significant factor when it comes time for that carrier to evaluate its annuity pricing for a plan’s liabilities. Based upon our experience, we believe that in certain instances this “existing client effect” could result in a cost savings of 1-2%. 

The customized insured pension solutions detailed above are all similar to each other in that they are all built on a guaranteed group annuity contract chassis and leverage the fixed income investment capabilities of some of the largest fixed income asset managers. That said, the array of different solutions allows for a consultative approach in which PRT can be discussed with pension clients in a product-agnostic way. 

PRT solutions can be delivered at all points on the fixed income yield curve, offering an effective alternative to short, intermediate, core or long-duration fixed income funds (see chart below). The customization offered in these products may be particularly attractive to mid-sized plan sponsors who typically rely on mutual and collective funds, which are more benchmark-driven and are not customized to the specific cash flow needs of the pension plan.

Pension risk transfer solutions come in many different shapes and sizes, but all employ powerful financial guarantees backed by the some of the largest, best-capitalized life insurance companies. The ability to customize the PRT structure to employ an optimal mix of covered guaranteed cash flows (based upon investment and funding objectives) provides pension sponsors with a compelling alternative to traditional fixed income mutual or collective funds. 

While the benefits of PRT solutions are clear to professionals who have experience working with these institutional insurance products, the fact is that these products are not part of the broader pension investment conversation, which relies on more traditional market valued (non-guaranteed) investment products. This fact presents both a challenge and an opportunity for the PRT market and its products.