Whitepaper Outlines an LDI Alternative

The  whitepaper – part of MetLife’s Topics in Pension Risk Management Series – claims that a Partial Risk Transfer can mitigate more risk than can a Liability Driven Investment (LDI) program “at a cost that’s competitive with such a program, factoring in the costs and risks of both approaches”.

The white paper defines a partial risk transfer as “the removal of a portion of the assets and liabilities from a plan by “settling” them with an insurance company through the purchase of a group annuity contract.”   It notes that the strategy was popular in the 1980s “as double digit AA bond rates allowed sponsors to transfer liabilities to insurers inexpensively,” and that it regained some popularity in the late 1990s as sponsors sought to reduce the risk profile of their overfunded plans through what were termed “FAS 88 settlements.”   The paper’s authors say that the emphasis placed on risk mitigation by the Pension Protection Act (PPA) and FAS 158, as well as the “huge recent volatility in funded ratios” has led to a renewed interest in the idea.

The whitepaper says the strategy offers the following advantages:

• Provides a hedge that fully offsets the liabilities transferred.
• Reduces the plan’s asset-based fees and administrative fees and generally eliminates Pension Benefit Guaranty Corporation (PBGC) premiums for annuitized persons.
• Reduces the size and risk of the plan.

The paper's authors also outline some of the disadvantages associated with partial risk transfer:

• Settling liabilities may appear costly relative to the plan's accounting or funding liability (primarily due to the more conservative assumptions that must be made when an insurer irrevocably assumes the risks, according to the paper).
• Any settlement will require the realization of a proportional amount of the plan's accumulated actuarial gain or loss in the income statement (though the paper notes that this is "merely the accelerated realization of an accrued gain or loss that would otherwise have been amortized over time", though it notes that the recognition will nonetheless impact the quarterly income statement)
• It will affect the funded status of the remaining plan assets and liabilities, as well as the future GAAP expense, and
• Partial Risk Transfers involve fiduciary responsibility, as with any plan-related investment decision.

As for what liabilities may be generally "settled," the paper notes that:

• Retiree groups are not particularly risky to underwrite, due to the short duration (generally about 8 years, compared with 14 or more for active lives).
• Terminated vested liabilities can also be easily settled, although it notes that the existence of heavily subsidized early retirement benefits may make this approach appear less "competitive" with the plan actuary's liability estimate.

Regarding the latter point, the paper's authors note "This is a significant issue; a one year decrease in the assumed average early retirement age can increase the present value (cost) of benefits by 5% or more," going on to caution that "sponsors may therefore wish to consider a "participating" approach for these liabilities if they are large enough to make this approach cost-effective."   That approach entails the possibility of getting participation payments (in essence dividends) if early retirement experience is more favorable than the insurer had anticipated, according to the paper.   While the initial premium will be higher than a non-participating approach, the paper says that "the difference can be viewed as the price of the call option on favorable experience that would otherwise accrue to the insurer."

The paper's authors also note that larger plans may have concerns about particular "tail risks" they wish to protect against, such as a sudden increase in early retirements, or longevity increases far greater than had been anticipated.   "It may be possible to tailor a partial risk transfer transaction to address such plan-specific risks; for example, it might be beneficial for a sponsor to transfer all benefits payable to retirees past age 85 — and only those benefits," the paper says.

You can access the whitepaper at https://www.plansponsor.com/uploadfiles/METLIFE PARTIAL RISK XFER.pdf