Factors That Determine Whether the Time Is Right for PRT
The stage is set for a record year for pension risk transfer (PRT) transactions. Legal & General Retirement America (LGRA)’s third quarter Pension Risk Transfer Monitor estimated that more than $16 billion in sales occurred in the third quarter. Fueled by strong equity returns and rising interest rates, third quarter transaction volume was nearly twice the combined $8.8 billion recorded during the first two quarters of 2021.
The third quarter was also reported to be the second highest single quarter to date, behind only the fourth quarter of 2012, when General Motors completed a transaction of $26 billion. With Q4 2021 transactions projected to be between $10 billion to $15 billion, total annual market volume could be between $35 billion to $40 billion, potentially surpassing its previous high set in 2012 at $36 billion.
“We’ve seen secular behavior with de-risking this year eclipsing 2012, which included the GM and Verizon deals, which have been the biggest deals in the PRT market,” says George Palms, president of LGRA in Stamford, Connecticut. “Also unusual this year is there have been 10 transactions of over $1 billion in assets.”
He says the PRT market skews toward high-dollar transactions, but in the years that follow big deals, smaller plan sponsors tend to follow that trend. “That’s what we’re likely to see in coming years,” Palms says.
In the height of the COVID-19 pandemic in spring2020, plan sponsors were seeing a big deterioration in funded status as the markets and interest rates fell, but the market has rallied since then, notes Sean Kurian, head of institutional solutions at Conning in New York City. Plans that have maintained their equity allocations have benefited from the rally and are now more funded than they were even before the crisis of the pandemic.
“So the ability to think about implementing a PRT transaction is more of a reality now,” he says. “If funded status is in the high 90s percentage range, plan sponsors can start to think about implementing PRT.”
Kurian adds that there seems to be a bigger appetite for PRT than there was during the pandemic. There was a slowdown in PRT activity in 2020, but that has reversed this year.
Is Now a Good Time for a PRT Transaction?
Kurian notes that when plan sponsors make an annuity purchase, they pay an insurance company to take responsibility for taking the payments to participants and beneficiaries off plan sponsors’ hands. The premium could include all or some assets in plan, depending on whether the plan sponsor is transferring liabilities for a specific group of employees or all of them.
A main component to consider is the difference between what assets the plan already has versus the premium the insurance company will charge, says Kurian. There are different methodologies to evaluate pension obligations. The basis plan sponsors use for reporting is usually discounted on a corporate bond basis, but insurance companies are usually more conservative, so the value of obligations might not be the same. Kurian says, generally, liabilities calculated for insuring purposes are more than for plan reporting, so a plan might be 100% funded on an accounting basis, but an insurance company might require 105% of liabilities as a premium.
“This is the first disconnect worth understanding. Plan sponsors might need to get to up to 110% funded to insure through a PRT,” he says. “The plan sponsor must determine whether it has enough money to fund for that or whether it will need to set up an investment strategy to get to that amount in the future.”
When considering transferring pension risk to an insurer, plan sponsors must first look at their funded status and consider whether they have the financial capability to move forward, Palms says.
Palms notes that LGRA’s sister company, Legal & General Investment Management America (LGIMA), is seeing funded status oscillate from quarter to quarter. However, most plans are in a good place with funded status, which will be a factor leading to a record year for PRT activity.
Insurance market competitive pressures will help set premiums, but plan sponsors need to determine what assets they have to meet the premium obligation and how to close any gap, Kurian adds.
“Plan sponsors can’t just put all their assets in risky strategies; if bets don’t pay off, they may lose funding,” he says. “So they have to consider the equity market as well as interest rates for bond investing. If they are not fully hedged and interest rates fall, the amount of pension obligations might increase. If they are hedged, they can worry less about the interest rate component and rely more on contributions to fund obligations.”
Kurian says Conning tells clients to think of a journey plan. If the plan is 95% funded on an accounting basis, how does the plan sponsor need to balance risk and return to get to where it needs to be? He suggests plan sponsors set appropriate risk tolerance as they step along the investment glide path.
While the high degree of volatility in interest rates could affect the pricing of annuities for PRTs, Palms says LGRA is seeing insurers not only using public fixed income but private fixed income and alternatives to back PRT deals. He also says many insurers are owned by private equity organizations whose investments are used to insure transactions.
“When plan sponsors see public bond rates going down, that doesn’t mean the other things backing PRT deals are going down,” he says. “In the fourth quarter, we are seeing very competitive prices.”
Considerations for Implementing a PRT Transaction
In addition to getting the plan’s funded level equal to the premium amount, when a plan sponsor has decided to implement a PRT transaction, it should engage a fiduciary adviser to move forward and consider implementing a lump-sum distribution window first to get pension obligation amounts off their books, Kurian suggests.
Palms says Pension Benefit Guaranty Corporation (PBGC) premiums are a motivator for some companies to do what LGRA calls “lower-benefit traunch transactions.”
“Plan sponsors get lower-benefit participants out of the plan to lower PBGC premiums,” he says. This could be in the form of a lump-sum distribution window, for example.
When preparing to implement a PRT transaction, plan sponsors should consider whether their funded status will allow them to move forward, says Palms. They should also understand the impact the transaction will have on their balance sheets—in other words, the effect of PRT costs should be weighed against the reduction in PBGC premiums and reduction in risk.
Plan sponsors also want to have a sense of what annuity pricing looks like in relation to their pension benefit obligation (PBO), Palms adds. “We’re seeing all retiree deals transact at moderate premiums, with some actually less than PBO,” he says.
Plan sponsors should go to the marketplace to see how insurers are priced, work out a timeline with considerations of different regulatory requirements for PRT transactions and continue to manage assets to maintain a funded status equal to the insurance premium.
Then there is the process of getting ready to implement transactions. Palms says plan sponsors need to have their data in good order—they don’t want the pricing to include retirees that might have already died, for example.
PRT Timelines
From a timing perspective, Palms says it is generally better to implement PRT transactions in the first half or first three quarters of the year. The fourth quarter is a time of peak activity, and plan sponsors won’t get as many competitors when PRT activity is high.
For a lump-sum distribution window, the timeline depends on how long it takes a plan sponsor to prepare for the strategy. Palms says this includes calculating lump-sum values based on prescribed interest rates to make sure enough funding is in place, as well as distributing communications to participants and beneficiaries. “It could take from three up to nine months from conceptualizing to delivering,” he says.
For an annuity purchase, the timeline can depend on which group of participants is being insured, with all-retiree transactions the most straightforward, Palms says. “From what we hear from brokers and intermediaries, initial conversations to set expectations start four to five months out from the transaction,” he says. “If there is a lot of data to clean up, preparation could take nine to 12 months.”
When plan sponsors go to market to select an insurer, the transaction timeline could be about three months, Palms says. However, it depends on the size of the transaction. “Plan sponsors should get bids two to three weeks out from when they want to implement the annuity purchase, then select and insurer and sign the contract,” he says.
One thing to keep in mind, according to Kurian, is that, ultimately, as more plans undertake PRT activities, the ability of insurers to take them on will be reduced. “The competitive landscape will decline,” he explains. “The million-dollar question is whether there is a limitless supply of resources out there, when will the supply change and how should plan sponsors react—how long should they wait.”