- LDI Team Chair, LDI Strategist, and Portfolio Manager
United States, Institutional
Change
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As someone who works closely with corporate defined benefit (DB) plans, I am often asked whether a pension risk transfer (PRT) is the right choice for fully funded plans. While I acknowledge right up front that I am not an unbiased observer and the decision will ultimately depend on each plan’s circumstances, my answer is that in many cases, the downside risk reduction does not justify the costs or the lost upside optionality on pension surplus. And when it comes to managing downside risk, I think plan sponsors today have access to more sophisticated investment and plan design strategies than ever before.
Looking at PRT through a cost/benefit lens
Plan sponsors who terminate their plans often do so to address concerns about costs and balance-sheet volatility. But I see several reasons to reconsider the pitch for PRT:
1. It may not be the bargain some expect.
A for-profit organization that terminates its plan might expect to receive, at best, 59 cents for each dollar of surplus assets and, at worst, only 29 cents after surplus excise taxes and regular corporate income tax.1
While the cost of transferring retiree pension risk to an insurer has become more competitive over the past 15 years, insurers generally still charge a premium relative to a plan’s projected benefit obligation (PBO) for future retirees. In addition, retiree buyout pricing can be choppy and has trended up over the past few years, according to the Milliman Pension Buyout Index.
Lump-sum windows can be costly too — particularly if rates rise during the election window, as we saw in 2022, when many eligible participants accelerated lump sums to take advantage of below-market-rate cashouts.
2. It may not achieve much more downside protection than a plan can on its own.
Plans may be able to keep costs low and still effectively mitigate balance-sheet volatility through straightforward investment strategies and innovations in risk-sharing plan design (e.g., the use of a cash-balance plan that pays a market rate of return) that were non-existent or in their infancy when the pension buyout trend took off in 2012.
For example, investing the majority of a plan’s portfolio in liability-hedging assets (e.g., 80%) and a small portion in return-seeking assets (e.g., 20%) could, in many cases, help keep the funded ratio relatively stable and the risk of a deficit low, while also generating a small but sufficient return to cover PBGC premia and administrative expenses.
It’s also worth a reminder that Congress loosened the minimum funding rules a few years ago, so even if a plan were to slip into deficit, the sponsor has 15 years to fund back up. That, in combination with a relatively low-risk investment strategy, should help reduce the risk of a large, unexpected mandatory contribution.
3. It will permanently eliminate the option to use surplus assets for other purposes.
This could have implications down the line as the retirement benefit landscape evolves and some plans find that having surplus pension assets allows them to be more nimble. We’ve noticed a few plans in strong overfunded positions starting to think about creative uses of surplus, with the most prominent example being IBM’s decision to reopen its frozen DB plan — offering a cash-balance-type benefit and funding it with surplus assets.
It’s too soon to tell whether this is a trend in the making, but the need for new ideas is clear: Members of Generation X start to turn 60 next year, and while theirs will be the first generation to rely almost exclusively on defined contribution (DC) plan assets for retirement, the average Gen Xer has accumulated only about $182,000 in DC plan assets.2
Eventually, this may give rise to a "regime change" where employers and employees alike place more value on DB plans — employers for talent attraction/retention and workforce management, and employees for the stability and income. Sponsors that can use surplus pension assets for these purposes may be at an advantage.
There are other potential uses of surplus assets, as well, such as funding retiree medical benefits, helping to reduce M&A costs when a target has an underfunded pension plan, or paying for benefit increases (such as an ad hoc retiree cost-of-living adjustment or uplifts in a new collective bargaining agreement) — though I would note that there are nuances to these use cases and they don’t necessarily apply widely. The key message is that there may be value in preserving the optionality, especially in the event the retirement landscape evolves.
Thoughts on PRT lawsuits and regulation
Recently, retiree groups have filed several lawsuits against corporate plan sponsors alleging, among other things, that their pension buyout transactions with an annuity provider constituted a breach of fiduciary duty. We’ll be keeping an eye on these cases to see whether they proceed to a stage that could have a chilling effect on buyout activity or drive fiduciaries to more traditional insurers (i.e., non-private-equity-backed insurers), as the companies targeted in the lawsuits all transacted with an insurer owned by a private equity (PE) firm.
In addition, the lawsuits come at a time when PE-backed insurers are in the spotlight with insurance regulators and ratings agencies scrutinizing issues such as the investment of insurance premiums in more complex and illiquid assets (e.g., securitized and private credit) and the use of offshore reinsurance affiliates to manage capital requirements. While regulators have made clear that these practices are not exclusive to PE-backed insurers, their more complex business models and interrelationships across their insurance, asset management, and reinsurance arrangements put them under greater focus.
It's also worth noting that the US Department of Labor (DOL) recently completed a review of Interpretive Bulletin 95-1 relating to fiduciary standards when selecting an annuity provider for a corporate plan. The DOL reaffirmed the previously issued guidance but also left the door open to further guidance and study on the complex issues involved.
Bottom line: I expect continued scrutiny over PE involvement in insurance and think that's another consideration to weigh when plans are evaluating a potential buyout.
This is not intended as legal advice and plan sponsors should consult their legal advisors about their specific situations.
1 Assuming an excise tax of 20% – 50% on surplus reversion, depending on whether some surplus assets transferred to a Qualified Replacement Plan, plus regular corporate income tax of 21% | 2 Fidelity Investments, “Building Financial Futures” report; based on data from 26,100 corporate defined contribution plans and 24 million participants as of 30 June 2024.
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