Risk Management

Pension Risk Transfers Gain in Appeal and Importance

Companies can lower their risk and reduce costs by offering participants a lump sum or transferring liabilities to an insurance company.
Robert ScharffSeptember 9, 2016
Pension Risk Transfers Gain in Appeal and Importance

Decisions about the transfer of pension risk is a conundrum for many CFOs. While the benefits following such a transaction are usually clear and compelling, the process of getting there can be difficult and time-consuming. Mid-size companies with smaller finance and human resources staff can find this especially challenging.

Robert Scharff

Robert Scharff

A pension transfer involves offering vested participants a lump-sum payment and/or negotiating an annuity deal with an insurance company that will pay the benefits. For many companies, it makes sense to address pension transfers sooner than later. They stand to realize significant cost savings and to lower their risk, thus providing greater financial stability and clarity, while obligations to plan participants are still addressed.

CFOs must be prepared to address pension fund valuation changes that will occur during the 12-plus-month process of transferring often volatile defined benefit obligations to group annuities. With careful and astute planning, companies can still find it worthwhile to proceed with the transfer even if the plan significantly decreases in value. If necessary, they can also have steps in place to implement a strategic pause on the transfer.

One thing is very clear: Pension transfers are accelerating and expected to continue at a brisk pace for some time.

The LIMRA Secure Institute recently reported that group annuity risk transfer sales increased 54% in 2015, totaling $14.4 billion. A good portion of the growth in the market was attributable to smaller plans, as companies reported selling more than 300 separate contracts worth less than $100 million each.

As many analysts have noted, the factors driving pension risk transfers include Pension Benefit Guaranty Corp. (PBGC) premium increases, market volatility, changes in mortality tables, and continued low interest rates.

The PBGC premium increases have been staggering and are scheduled to keep rising sharply. The PBGC premium is $64 per participant in 2016, an 83% increase from $35 in 2012. The premiums will reach $80 per participant by 2019, up 25% from today. The costs for plan underfunding are also escalating. In 2016, the variable-rate premium is $30 for every $1,000 a plan was underfunded, a 233% increase from 2013. These premiums are scheduled to rise a further 36% by 2019.

There are also broader, more fundamental business reasons why companies find pension transfers advantageous.

For some companies, earnings volatility associated with plan obligations and fluctuations can become so large it overshadows the operating business and its growth prospects. As such, pension plans impact the value of the business and even its strategic direction.

Other concerns with maintaining existing plans include:

  • High and rising costs for administration and compliance
  • Continued contributions that are too costly and volatile
  • Employees placing less value on the plans, which reduces the plans’ ability to help retain valuable employees

The key issues that companies should analyze and address as part of a pension transfer include the following.

  • The liability and risks that are faced, including interest rate risk, credit default risk, market risk, and longevity risk
  • Identifying and implementing a formal risk strategy
  • Implementing the most appropriate strategy to address pension liabilities, in whole or in part

Whether a company’s plan is active or frozen, it should be strategically managed to protect the company. The earlier these issues can be addressed, the more opportunity that there is to manage risk and reduce costs. Both the balance sheet and P&L can be improved.

To help ensure the transfer process proceeds smoothly, here are some important steps that should be taken:

  • Create a clear, disciplined decision-making process
  • Form a team that involves an ERISA attorney, financial advisor, and actuary
  • Conduct a full due diligence review of U.S. Department of Labor Interpretive Bulletin No. 95-1, which governs plan transfers to an annuity provider
  • Develop a Bid Solicitation package with contract specifications to insurance carriers, and anticipate subsequent issues for negotiation
  • Carefully assess the quality and diversification of the insurer’s investment portfolio

It will also be important to enact a thorough communications campaign with plan participants to explain the change, and to address the extensive administrative issues.

Pension transfers help companies to increase shareholder value and operate more efficiently while also meeting beneficiaries’ needs. For these compelling reasons, many companies are expected to evaluate and implement plans in the near future.

Robert Scharff is a senior executive benefits consultant with The Todd Organization, which designs, finances, and administrates non-qualified retirement plans and related services. He can be reached at [email protected] and 314-259-5007.