Factors to consider before undertaking a DB plan pension risk transfer
|Illustration by Julianna Brion|
As U.S. pension plans struggle to maintain their funding status, more are searching for ways to lighten maintenance costs. One option starting to gain traction is the pension risk transfer (PRT).
A PRT involves a plan sponsor transferring its company’s pension risk to an insurance carrier, to protect the plan from market volatility. According to Cynthia Mallett, vice president of corporate benefit funding at MetLife, “The way we think about pension risk transfer is that it is the basic and long-standing way of transferring the obligations that a plan sponsor has developed under a defined benefit (DB) plan to an insurance company. The concept is not new; it is a concept that is being used in new ways,” she says.
There are two main types of PRT options—the buyout and the buy-in.
As Michael Devlin, principal at BCG Terminal Funding Company explains: The buyout allows the company to transfer its pension fund to an insurance carrier; in turn, the insurance carrier is responsible for paying the benefits to the retirees. The buyout is an irrevocable transfer that eliminates all the pension risk of a particular participant block from the plan.
In the buyout route, the chosen insurance carrier is responsible for making the monthly retiree payments for the rest of the retirees’ lives, rather than the company writing out monthly checks to each of the retirees, Devlin says.
The buy-in option is almost the same as a buyout, but rather than the insurance carrier paying the retiree benefits each month, the carrier makes a deposit into the plan to cover checks the company sends out every month to retirees, he says. “With a buyout, the retiree is fully aware that payments are coming from the carrier, versus a buy-in, when [they are] still coming from the employer pension plan.”
Another difference: With the buyout, payments are not made to the Pension Benefit Guaranty Corporation (PBGC). With the buy-in option, though, the plan sponsor still needs to pay the PBGC, Devlin says.
Typically, those companies that choose a buy-in aim to eventually turn it into a buyout, he adds. “The idea is to transfer the risk and eventually convert it.” This most likely will happen when the company finally decides to fully terminate the pension plan.
According to Mallett, there are several benefits to conducting a PRT for a plan. “Any kind of risk-transfer type of strategy can reduce investment risk, early retirement risk,” she says. “This is going to reduce volatility for the plan. It can have a variety of positive financial [effects] on cash flow. It depends on what is important to the plan financially. It turns a source of uncertainty into certainty for the plan sponsor.
“No one knows for sure,” she adds “what the future will hold with economic risk, with plan expenses, with fiduciary costs, with litigation [and] with liability risks that go with the nature of managing a DB plan. You are reducing those things with a PRT.”
Still, she does not recommend a PRT for all plans. “Every plan sponsor really needs to think about its program—about the cost of maintaining the plan and the cost of transferring the risk of the plan.”
One benefit of a PRT that experts cite is it reduces the uncertainty of a company’s financial situation. “When we have an uncertain pension cost, we don’t know [the total expenditure],” says R. Evan Inglis, principal at Vanguard Investment Strategy Group. “If I reduce the size of the pension plan by buying an annuity or a buy-in contract, I’m going to get more certainty into the planning process.”