In a previous article, I discussed several methods for reducing defined benefit (DB) plans’ funded status volatility. But as one source pointed out, advisors should also look at the plans’ liabilities when discussing volatility with clients. In the right circumstances, pension risk transfer (PRT) methods could play a role there.
As with asset management strategies, the goal of PRT is risk-management. George Palms, president of Stamford, Conn.-based Legal & General Retirement America, describes DB plans as dinosaurs. “They're on a path to extinction and some are further along that path than others,” he says. “When a plan sponsor closes its plan to new entrants and to accruals, they're at a point where they've really got a pension plan that is ultimately going to run off over time.”
At some point the sponsor’s chief financial officer and senior leadership may decide that maintaining the pension plan and managing its risks internally are no longer in the company’s best interest. When that happens, the focus becomes finding methods to de-risk the plan, Palms says: “That's where both liability-driven investing and then ultimately pension risk transfer become really important tools.”
PRT Market Dynamics
The final stop on the road to eliminating plan risk is a termination. One challenge with terminations, however, is that they can take 12 to 18 months from start to conclusion. According to Legal & General’s Pension Risk Transfer Monitor, the relative volume of terminations among PRT-transactions has varied in recent years. For example, terminations accounted for 66% of transaction premium volume during the first half of 2020, with retiree lift-outs accounting for the remaining 34%. Those figures reversed in the last quarter of 2020, though: lift-outs generated 75% of premiums while plan terminations had 25%.
Between the two methods, the overall PRT market has grown steadily since 2013. (2012 was an outlier with very large transactions from General Motors and Verizon.) U.S. premium volume in 2013 totaled $4 billion, which grew to an annual average of approximately $28 billion for 2018 through 2020.
Lift-outs have several advantages, Palms explains. They take less lead time—typically three to four months—and they’re easier to complete than full terminations. They also allow a sponsor to take an incremental risk-management step by focusing on a target segment of plan participants. He cites what he calls “bottom-slice” transactions as an example. In this scenario, the plan has numerous retirees receiving small monthly pensions, with the plan setting the cutoff threshold, perhaps $200 per month or less. In a bottom-slice transaction, the plan identifies those accounts and does a PRT deal to transfer them to an insurer.
In addition to getting the pensions off the balance sheet, the transaction reduces administrative burdens and pension benefit guarantee premiums. Those premiums have been increasing lately. According to the PBGC website, the per-participant fee for flat-rate premiums is $86 in 2021. That’s a significant increase from the $64 increase five years ago in 2016. “If you're taking a lot of low-benefit people out, for a given dollar premium you're relieving yourself of a substantial amount of your pension benefit guarantee charges,” Palms notes. “So that's a big motivator of those bottom-slice transactions.”
When Do PRTs Make Sense?
Palms identifies two circumstances in which PRTs fit well. Plan sponsors that are in the 90% range of funded status are a primary segment in a position to do a pension risk transfer deal, he explains. Plans with much lower funded levels, say, 60% or 70%, will face significant corporate cash contributions to make a transaction work. “I think funded status is an important indicator for an advisor to consider in approaching a plan sponsor and discussing pension risk transfer,” he says.
The second set of circumstances is less obvious: company culture and approach to risk management. Palms cites the case in which a younger CFO, who is perhaps in his or her 30s, takes over the position from an older executive. While long-term employees who are vested in a pension are likely to value it highly, younger executives may have a different experience and resulting view on the plan’s value.
First, the plan is probably frozen so they can’t join it. Second, when they examine the amount of staff time required to maintain the plan, they’re likely to ask if those functions can be outsourced. Additionally, when they evaluate the plan’s potential impact on the organization’s finances, they’ll probably ask if keeping a non-core business activity like the pension is justified.
Advisors should recognize that leadership changes, particularly to a CFO in a younger generation, can create openings to raise PRT options, says Palms: “I think that becomes the opportunity to perhaps educate that CFO and help them understand the nature of the liability that they're dealing with and the alternative ways of managing it.”