When It Comes to Maximizing Shareholders' Returns, Defined Benefit Pension Plans Should Consider Options Beyond Pension Risk Transfer

Rising interest rates mean overfunded plans could do better by their participants.

Commentary by Pension Strategist Andy Ashworth, AFA

With almost $50 billion in annuities purchased, 2022 was a record year for pension risk transfer activity by defined benefit (DB) pension plans1—and the first quarter provided a strong start to 2023, as well, with $6.3 billion in total U.S. single premium pension risk transfer sales (up 19% from Q1 2022).

As DB plan sponsors continue to grapple with pension risk management, they might consider that pension risk transfer and outright pension buyouts are not their only path forward. If anything, today's economic environment should encourage sponsors to hit the PAUSE button before they break out the pension buyout calculator. One idea worth evaluating is pension plan hibernation. It turns out a good old-fashioned DB pension plan may be the most sustainable retirement vehicle—now and in the future—as many find themselves overfunded for the first time in many years.

How did defined benefit pension plans get here?

Right now, many DB pension plan sponsors find themselves overfunded due to events that occurred more than a decade ago, and more recent events—notably rising interest rates.

In response to the Global Financial Crisis of 2008—2009, many U.S. pension plan sponsors took active steps to rein in their pension deficit and pension funding ratio. There's an old adage: If you find yourself in a hole, stop digging. DB plans did that, freezing accruals. The next step to escaping a hole is to backfill it. DB plan sponsors did that too.

Spurred by low borrowing costs and loose monetary policy, many DB pension fund sponsors increased their cash contributions to reduce deficits along with their Pension Benefit Guaranty Corporation premiums—a quasi-tax on plan sponsors who maintain underfunded pension plans.

In addition, when reviewing pension plan investment strategy, many DB plans took steps to hedge some (or all) of their interest rate exposure via liability-driven investing (LDI).

However, after more than a decade of managing pension risk by working to reduce their deficits, a rapid rise in interest rates has pushed many DB pension plan sponsors into an overfunded position.

Why now might be the time for alternatives to pension risk transfer

With pension plan funding ratios in a stronger position, there are several reasons why it could make sense to consider pension hibernation rather than pension risk transfer or a pension buyout. The reasons include: cost, confidence, and control.

There are "hidden" costs

It is more costly to crystallize pension plan costs into a single transaction such as buying annuities through a pension risk transfer.

  • Administrative expenses aren't "saved." They are transferred. No savings here. In a pension risk transfer, plan sponsors pay up front for all future costs to administer the plan.
  • Insurers charge for plan provision optionality. Just as subsidized early retirement options come at a cost, insurers "charge" for plan provision optionality through higher premiums. DB plan sponsors could wait to see how the realized experience plays out. If participants do not take advantage of these subsidies, the plan sponsors do not have to "pay" for it.
  • Insurance company shareholders demand a return on their investment. Insurance companies must build this profit requirement into their premiums. This increases the cost to buy annuities in a pension risk transfer.

Plan sponsors can have more confidence in their pension risk management

Plan sponsors likely have all the tools necessary to manage their DB pension plan risks with greater confidence than they could have in the recent past.

  • The investment friction of the past has been significantly reduced. LDI, derivatives, return-seeking assets, global diversification—all may be had at cost and scale for plan sponsors.
  • Technology solutions exist to help provide cost effective plan administration, especially for retired participants. Some of the largest deals in the pension risk transfer marketplace are for retirees only. Why? Because these are the least risky for the insurance companies—plan provision optionality is gone, administration expenses are low. Insurance companies get a reliable pool of assets to write checks that cover a very well-defined liability stream—and this pool of assets will never leave. It's a sound business model—for the insurance company.

Plan sponsors are in control of their own destiny

A pension risk transfer is an irreversible transaction, that reduces optionality for the plan sponsor.

  • Reduced optionality comes at a cost. If a plan sponsor decides that it is no longer willing or able to manage the plan going forward, then this cost may be worth bearing.
  • A hibernated plan may provide many alternative benefits especially if a plan is in surplus, as many are today.
  • Plans in surplus can support the sponsor in a variety of ways, including:
    • Corporate transactions: A merger of the overfunded DB plan with an underfunded DB plan, capturing the surplus.
    • Workforce management programs: These provide an early retirement window.
    • Replacing cash 401(k) benefits with non-cash cash balance accrual: This reduces cash outlay by providing a "pay credit" within the pension plan.
    • Retirement income goals: A frozen pension plan can support lifetime income needs of employees who have 401(k) accounts through a plan-to-plan transfer. This provides a cost-effective way to annuitize a portion of their DC plan balance

Take the time to revisit your DB pension plans future within the context of the three Cs outlined above—cost, confidence, and control—and with a critical eye to see if a pension risk transfer is actually maximizing your shareholders' return when compared to hitting the PAUSE button and pursuing pension hibernation. The answers could very well surprise you.

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