Defined benefit plan sponsors continue to deal with a challenging pension landscape. One trending activity we’ve seen in the marketplace has been pension risk transfers, that is, the process of transferring risk to insurance companies or to participants themselves.
According to the LIMRA Secure Retirement Institute (2017), 8 in 10 employers of traditional defined benefit plans are interested in pension risk transfer (Heating Up: Plan Sponsor Interest in Pension Risk Transfer).
Lump sum payments of deferred vested benefits and retiree annuity buyouts target specific populations, but another option is plan termination, which eliminates the entire defined benefit plan.
The potential for higher interest rates may also increase activity, since higher rates often mean lower liabilities and lower termination costs.
Organizations that engaged in pension de-risking transactions generally can attest to the importance of having a strong professional team to help the process run smoothly. We have helped numerous small and large pension clients go through the plan termination process and would like to provide a few recommendations that can help improve the overall experience.
Issue Lump Sums to Help Reduce Costs
Plans generally need to be more than fully funded in order to terminate, mainly because insurers charge a premium to take on obligations. One rule of thumb is that for the retiree population, the premium is typically around 4–6% of the plan’s market liability (that is, the retiree portion needs to be 104–106% funded). However, for participants who are not yet in pay status with less predictable payouts, the premium charged is typically 15–30% or more and depends in large part on the plan benefit features. To help reduce the total cost to terminate, plan sponsors are encouraged to offer lump sums at plan termination to active and deferred vested participants (under current law, lump sums cannot be offered to retirees). The cost to provide a lump sum is approximately equal to the liability (that is, 100% funded requirement), though there are some nuances with the assumptions used to calculate the lump sums.
The larger the portion of participants who elect to take a lump sum, the lower the total cost to terminate the plan.
After lump sums are paid, the plan sponsor can purchase annuities for the remaining participants and for the retirees.
Transfer Assets-in-Kind to Help Reduce Costs
For pension plans with $300–500 million in assets, insurance companies will generally accept only cash as payment to cover future obligations. However, larger plans may have the option to transfer assets-in-kind to the insurer instead of cash. The benefits of in-kind transfers to the insurer include:
- allowing funds to stay invested from day one, given that it takes time to fully invest a large portfolio; and
- reducing transaction costs in the event that the insurance company will hold the same securities that are transferred.
Given the cost savings, insurers will generally reduce the premium charged on a transaction with an in-kind-transfer. Insurers are specific about the types of securities they are willing to accept, preferring fixed income assets with a reasonable fit to the liabilities. However, some companies may accept small allocations to other types of securities depending on their appetite at the time of the transaction. In a recent transaction PNC Institutional Asset Management® assisted with, the insurer accepted 97% of the securities in the portfolio. The other 3% of the securities were not accepted because the insurer held sufficient amounts of these securities in other asset pools.
The large acceptance rate provided significant cost savings to the plan sponsor. Even for smaller plans (under $300 million), having a liability-driven investment portfolio in place helps improve the likelihood of getting cost savings through an inkind transfer, as some insurers accept smaller plans.
Plan sponsors benefit from working with our fixed income team, which has experience managing portfolios at insurance companies and an understanding of how insurers invest assets.
Consolidate Assets with an Experienced Manager
Once a company decides to terminate the plan, we believe it is best practice to consolidate assets with one investment provider. Since plan termination liabilities are bond-like in nature, a fixed income manager with liability-driven investment (LDI) capabilities is best suited to run the entire portfolio in the one- to two-year period leading up to termination, in our view. Assets will need to be available for lump sum distributions to participants or to purchase annuities with insurers. The exact timing and amount of assets required are not known well in advance and could vary significantly based on market factors and participant behaviors. In the case of annuity purchase, market interest rates can have a significant impact on the amount of assets an insurance company will need to cover future obligations.
A customized asset-liability matching approach can help avoid undesirable surprises in a volatile market.
For lump sums, the amount of funds required is largely driven by the volume of participants who elect to take their benefit as a lump sum. Therefore, it is beneficial that the investment manager has experience structuring the portfolio to handle the various payouts that have uncertain timing and dollar amounts.
Frequent Communication Helps Avoid Missteps
Given the complexity of plan termination, it can be necessary for many parties to be involved in the project, including the investment manager, actuary, custodian, insurance company, annuity broker, legal counsel, and plan administrator. It is likewise important that all professionals involved are in frequent contact so the process runs smoothly. We recommend weekly discussions with all parties engaged in a large plan termination.
This is a complex process, and it’s crucial that the parties communicate frequently and at appropriate times while they are working on the solution.