Pension Risk Transfer: Interview with James Walton and Kevin Morrison

James Walton

The cost of maintaining pension plans has increased dramatically in recent years, and as a result, more and more firms are considering pension risk transfers. P-Solve’s James Walton and Kevin Morrison are here to explain how market conditions for pension plan risk management have changed, and why pension risk transfers have become an increasingly attractive alternative to consider…

Kevin Morrison

How have recent legislative changes impacted the pension risk transfer landscape?

Legislative changes have increased the costs of maintaining a defined benefit plan which makes pension risk transfers more attractive. There have been significant increases in the premiums paid to the Pension Benefit Guaranty Corporation (PBGC). Since 2012, the future rates used in determining the premiums paid to the PBGC have been increased three times for single employer defined benefit plans. Currently the flat rate premium (per participant) and the variable rate premium (liability based) rates scheduled for 2019 will be over two times and over three times the rates that applied in 2012, respectively. Combined with other changes in market conditions, some plan sponsors are expected to see total premiums that are four to five times the levels that were paid just a few years ago. Reducing liabilities and participant counts through pension risk transfers is one way we are helping clients to reduce the impact of these premium costs.

*Assumes pension plan has a deficit large enough to hit the per-participant variable rate premium cap. Gross variable rate premiums in 2017 will be 3.4% of the PBGC deficit, and will rise to over 4% by 2019.

How did the mortality tables issued by the Society of Actuaries in 2014 impact the pension risk transfer landscape?

Mortality tables were published by the Society of Actuaries (SOA) in October 2014, and additional changes to the expected rate of mortality improvements were published in October 2015 and October 2016. The result of the study published in 2014 was that people are living longer and mortality is improving at a faster rate than observed by the SOA in their previous mortality study from the early 2000s. Many clients immediately began reflecting the new tables for financial reporting purposes, resulting in increases to liabilities ranging from 5% to 10%, depending on plan characteristics and previous mortality assumptions.

However, the IRS has not yet adopted these newer tables, which will impact required annual contributions to plans and the cost of paying lump sum benefits. Based on recent communications from the IRS we expect these new tables to be reflected beginning in 2018. This has two major impacts to the pension risk transfer landscape: (1) The cost of purchasing an annuity from an insurer, which previously was seen as cost-prohibitive compared to accounting liabilities, now appears less costly – and sometimes can be cost neutral – as the new mortality tables are more in line with the assumptions insurers had already been using; and (2) the cost of paying a lump sum to a participant in lieu of future payments is now considerably less than the accounting liability being held, for many plans.

The cost of paying a lump sum will increase and will come close to converging with the accounting liability once the IRS adopts the newer mortality tables.

How did the pension risk transfers by Ford, Sears, J.C. Penney, General Motors, Verizon, and others further alter the playing field?

Large pension risk transfers have dominated the headlines in recent years, positively and negatively, which caught the attention of plan sponsors and their consultants. The early response was often, “this may make sense for a large corporation like that, but it can’t make sense for me.” While that perception held true for many plan sponsors, this perception has changed over time, and conversations between consultants and plan sponsors progressed to explore the benefits of pension risk transfers, often starting with lump sum windows to terminated vested participants, continuing with annuity purchases, and at times ending with a full plan termination.

From the insurer side, the completion of larger transactions, and the prospect of more, is supporting a diverse and very competitive insurer marketplace which has the capacity to continue writing transactions. The larger transactions have required insurers to be more innovative and plan focused, for example by quoting on the basis that the majority of the premium will be paid using bond assets the pension plan already owns rather than all cash which results in lower costs for the plan (also known as ‘assets in kind’). This is a feature that is gradually finding its way into the smaller end of the market.

Annuity purchases were actually quite common in the 1970s and 1980s. They fell out of vogue due to changing market conditions, but as pension plans have become a much larger burden on plan sponsors in recent years, they have re-emerged as a valuable option to consider. When market returns were stronger – and accounting rules and funding rules were more lax – and expenses were lower, there was less urgency to fully transfer the pension risk to participants (via lump sums) or to an insurer (via an annuity purchase).

What impact has market volatility and decreasing interest rates had on pension risk transfers?

From a plan sponsor perspective, market volatility and declining interest rates have increased plan sponsor awareness to the risks associated with maintaining a defined benefit plan. This has led to almost all plan sponsors considering and many implementing pension risk transfer strategies, as well as implementing risk mitigation strategies as part of the plan investments (e.g. liability driven investing).

Market volatility in itself does not usually change the willingness of insurers to transact but it can cause the prices offered by insurance companies to move up or down. For example, the insurer may identify assets they consider as cheap as markets are falling which is reflected in lower prices offered to the pension plan.

Based upon the current landscape, what developments do you expect to happen with pension risk transfers in the coming year?

We anticipate that the strong demand for pension risk transfer transactions will continue. While insurers generally offer attractive pricing on retirees, the pricing on deferred participants has been less compelling to date. This is an area to watch over the coming year for pension plans looking to purchase annuities for terminated vested participants as insurers are increasingly looking to quote in this area.

If you think of insurers as plan administrators, it’s easier to understand why pricing annuities for deferred participants is more complicated. For starters, it’s a lot more difficult to administer a deferred participant than to process immediate annuities (i.e. retirees). Deferred plan participants require notifications and election processes. This involves many more steps and a much more onerous process. You have to understand detailed plan provisions to calculate benefits, and you essentially become an outsourced plan administrator.

How can plans prepare for annuity purchase pension risk transfers, and what is P-Solve’s approach? How does it differ from the traditional brokers’ approach?

There are broadly two stages to annuity purchase pension risk transfers: preparation and analysis ahead of a transaction and then the process of obtaining quotes and transacting with the selected insurer.

The first stage is to understand the possible financial impact of undergoing a pension risk transfer and identify which participants would be subject to an annuity purchase. This involves looking at the impact to the plan sponsor’s balance sheet and income statement, projected contributions, and PBGC premiums. In some cases, depending on a plan’s funded status, it involves looking at the contribution necessary to consider a pension risk transfer or potentially future liquidity requirement contributions.

We then assist plan sponsors with data preparation. This process may also coincide with an exercise to offer terminated vested participants a lump sum. Plan sponsors need to provide clean and complete data and prepare additional data fields if possible, such as occupation and zip code, as this gives insurers confidence that they are pricing the risk correctly and is likely to result in a lower annuity purchase.

At the execution stage, a professionally managed bidding process is important. Insurers will review each opportunity against a set of criteria in order to take a view that the transaction will actually proceed and that they can win it. At P-Solve, we send a comprehensive package setting out timelines and the data as described above, which gives the insurers confidence to devote the attention to a client’s plan and to price it competitively. This is all important because prices can drop by as much as 5% from an initial quote with limited data compared to a final quote with an engaged set of insurers.

Brokers may only be able to assist with the placement of the annuity and may not be able to give comprehensive advice regarding the entire process including transition and implementation as well as other key metrics around post-purchase participant service. In addition, many brokers will seek out bids on a more speculative basis, with less preparation work, which can diminish their credibility with the insurance companies and ultimately results in inaccurate quotes.

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