Employers navigate defined benefit pension risk
Conditions are favorable for U.S. corporations to offload some or all of their defined benefit pension risk in 2017.
“What you’re going to see is the continued evolution of the marketplace,” says Matt Herrmann, leader of the retirement risk management group at Willis Towers Watson. “For a number of years, folks predicted revolutionary change, but it has been more evolutionary.”
There has been an increase in news stories and activity concerning benefit pension risk lately, according to Herrmann. “When you look at it, certainly the last five years have been transformationally different than the five years prior to that. But when you add it all up, it is still materially less than 10% of DB that is transferred to a third party for participants.”
What is spurring this move to offload pension risk?
Interest rates, which are starting to slowly rise, have an impact on whether a company decides to transfer pension liability off its books. Also, funded status matters a great deal. The more funded the plan is, the less a company has to pay out when it transfers the risk. The premiums corporations pay to the Pension Benefit Guaranty Corporation also figure into a company’s decision to manage their risk, as premiums continue to rise each year, making it more expensive to keep traditional pension plans.
If a pension plan’s funded status is at a point where the company could terminate it effectively on a costless basis, many companies will make the move, Herrmann says.
“The reality is that not everybody is going to wait until it gets to that point because we are in the middle of a pretty good environment,” he says. “Folks recognize that volatility is always looming.”
Lynn Esenwine, partner and senior buyout strategist for Mercer, says that the number of corporations transferring risk from their pension plans has steadily increased every year since General Motors and Verizon offloaded much of their pension plan risk in 2012. In 2015 and 2016, there was more than $14 billion in group annuity sales and pension risk transfer.
“Looking ahead to 2017, there is a great deal of interest from our clients,” she says. “There’s been a lot more press on this; so many transactions have been done a lot of our clients and plan sponsors are well educated on the topic.”
The biggest trend has been corporations purchasing annuities for their retirees, who are already receiving a check from the company. It is a bit harder to offload the risk of pension plan participants who are still working.
U.S. corporations need to weigh the benefits of passing their risk on to an insurance company or making lump sum payments to close out their DB plans, according to Mercer.
Mercer’s US Pension Buyout Index “tracks the relationship between the accounting liability for retirees of a hypothetical DB pension plan and two cost measures: the estimated cost of transferring the pension liabilities to an insurance company and the approximate total economic cost of retaining the pension obligations on the balance sheet.”
In January, the average cost of purchasing annuities from an insurer increased from 104.7% to 105.1% of the accounting liability, according to Mercer. The cost of maintaining the plan stayed the same at 105.8% of the accounting liability. “The economic cost reflects increasing future PBGC premiums, which increases the economic cost of maintaining the liability,” Mercer found.
Mercer concludes that “a buyout is now significantly more attractive compared to the balance sheet liability. As plan sponsors recognize these longevity increases, the relative value of the economic liability compared to the balance sheet liability also decreases.”
According to Mercer, “the expected shift toward fiscal stimulus and tighter monetary policy should cause an increase in funded status for defined benefit pension plans, leading to more plan termination and elective buyouts.”
A recent Wall Street Journal article alluded to the fact that more and more retirees will receive their pension checks from an insurance company in the future, rather than from the company that sponsored their pension plan.
But, Esenwine says, insurers don’t have infinite capacity for these types of risk transfers.
“It is a capital intensive business when you take this on; a very regulated business,” she says.
She points out that there are a couple trillion dollars in corporate pension plans and only $14 billion in pension transfers a year. In short, there are a lot of pensions still out there and there is never a one-size-fits-all solution. At some point, insurance companies will assess how many billions of dollars in DB plan liability they have shouldered and figure out if this is still the appropriate strategy and risk profile they want to implement, taking into account their other lines of business, she adds.
When a corporation makes the decision to march down the path to ultimate pension plan closure, they have to deal with the PBGC and the IRS, which are the two governing bodies of pension plans.
“Some other pension risk transfer options, especially with retirees, can be looked at opportunistically,” she says. A company can decide if it wants to transfer its risk based on certain criteria, like whether it likes the pricing, likes the insurance company and the experience a participant will get from the transaction.
She recommends that plan sponsors test drive the market to see what will work best for them and when. In the past, most of the pension risk transfer happened in the fourth quarter. Now, it is an all quarter business, she says.