In this second article on pension risk transfer, Legal & General’s Chief Executive Nigel Wilson describes ways that companies can optimize the transfer of pension risk, whether through a buyout or buy-in, plan termination, or lift-out.
In our first article, we talked about the $6.6 trillion in public and private U.S. defined benefit pension plan assets, about half of which is currently in private plans, and how many of the existing plans present potential risk to the sponsor’s CFO. Here, we discuss how CFOs can transfer this pension risk, and the choice of processes available.
Pension risk transfer (PRT) helps companies deliver on their promises. It can take several forms, all with the goal of ensuring the financial security of a company’s employees, past or present, who are enrolled in the plan. We’ll look at buyouts and buy-ins, plan terminations, and lift-outs, and why a company’s CFO might take one course or another. In all cases, the plan sponsor is paying to transfer to another entity the financial risk of meeting those pension promises to the plan participants. The plan sponsor is also removing or reducing the risks associated with funding and running the plans.
Pension deficits tended to get bigger in the low interest rate environments that have typified the last decade — or if the original plan didn’t sufficiently take into account the increasing longevity of the participants; the plan lacked the expertise or efficiency to manage the investments and administration; or the plan sponsor lacked the profits to sufficiently fund it. What is the best way for a company to transfer pension risk, and how does a CFO know which route to take? There is no one-size-fits-all answer.
Buyout or Buy-In, Termination or Lift-Out?
While there are several ways to transfer defined benefit pension risk, they generally fall under two categories: buyout or buy-in. In the case of a buyout, plan sponsors can take out a certain segment of the participants, a “lift-out,” or they can terminate the plan by completely transferring all the obligations of the plan to an insurer. The plan is then closed, and the insurance company is responsible for the administration of the terminated plan’s liabilities and payment of the benefits promised to the participants.
A termination typically takes between 12 and 18 months to complete, as companies have to go through a stringent regulatory and government approval process.
The reasons for choosing a plan termination vary. Company goals may have changed. It may no longer want responsibility for the ongoing contributions or administrative costs, or it may feel that employees value other savings plans more, or the plan sponsor might have been acquired by another company.
Often, though, companies take a partial approach before arriving at a full termination. It could start with lifting out a tranche or two of the plan and eventually progressing all the way to full plan termination.
One such partial approach is the aforementioned lift-out. In this case, a subset of plan participants is lifted out and transferred to an insurance company. A CFO might take this route if the plan is not fully funded or when the company sponsoring the pension plan isn’t in a position to fund a full plan termination right away.
A company might specify, for example, that it wants to lift out all retirees who are receiving less than $1,000 a month. A lift-out reduces the overall costs associated with the selected segment of participants, such as Pension Benefit Guaranty Corp. premiums and other administrative charges.
Lift-outs can usually be accomplished in a much shorter time frame than a full termination — as little as 4 to 6 months in some cases. This is because lift-outs don’t typically require the same amount of preparation and regulatory approval as plan terminations. Additionally, pricing parameters for retirees who have already made their pension choices are narrower than for other categories, such as deferred participants.
Alternatively, a less common option used by companies in the United States is a buy-in arrangement, wherein the plan purchases a contract from the insurer to cover the benefits payable but retains the administrative responsibility.
To date, buy-ins have only taken the form of lift-out. The first such U.S. transaction happened in May 2011. Although the buy-in approach is seen less frequently here than in the United Kingdom, it is picking up pace. In a buy-in, the sponsor is transferring two facets of the plan to the insurance company: generating the returns and matching the longevity needed to meet the total obligation of all future benefit payments owed to the participants who are covered. The plan sponsor is relieved of this financial risk, but still carries out all other functions of the plan, i.e., administrative control of the participants, sending payments, and doing all paperwork.
It is important to note that plan sponsors have another option to reduce liabilities: a lump sum offer. Offering a lump sum to plan participants prior to a PRT transaction is common in the United States, especially for terminated vested participants, which are former employees with a vested benefit. Doing so could lower the number of deferred participants in the population, making it more appealing to insurance companies to bid on.
Which Approach Is Best?
Here’s where nuance, strategy, and a certain amount of forecasting come into the picture. If you simply want to offload the risks completely and are financially prepared to do so, you might simply say, “Take it all, how much?” That’s your straight-on plan termination.
But CFOs could also consider taking a more gradual approach with lift-outs, either transferring administrative and financial responsibility of the selected segment of the plan to an insurance company with a buyout, or, in the case of a buy-in, retaining the administration of the plan. Tactically, it’s about weighing the cost of producing the requisite returns over the life of the plan by taking a gradual approach, versus the lump sum cost of totally and immediately offloading it.
Understandably, with regards to PRT, most CFOs are focused first and foremost on the cost of removing pension obligations from their books. Their considerations tend to be market-driven: Is the price going to go up or down? Should I pull the trigger now, or wait to execute? How competitive is the market?
It might be advisable, especially for larger plans, to take the stepped route, but CFOs and their advisers should weigh the risks one by one in order to optimize the aggregate cost of paying an insurance company to take the plan off their hands. While requiring more time, the stepped approach could hold more potential benefits than going straight to a full termination, depending on market conditions and the funded level.
Depending on how the assets are re-invested, the finer points of PRT can also render the process into a social benefit, as in the Rolls-Royce/Oxford University example I cited in the first article.
In a PRT transaction, where both the assets and the liabilities are transferred, the pricing is partly influenced by how the purchaser of the pension plan redeploys those assets. In the United States, as in the United Kingdom, alternative investments such as real assets and urban regeneration can become part of the picture, creating a virtuous cycle of benefits from reducing or entirely removing the company’s risk, to ensuring retirees receive their promised benefit, to reinvesting in assets that can generate a broader societal benefit.
Nigel Wilson is group chief executive of Legal & General. He can be reached at Nigel.Wilson@group.landg.com.