Defined benefit (DB) plans have come to symbolize an all but vanished era of graduation-to-retirement employment, wherein companies reward lifetime employees with the promise of a stable and guaranteed retirement income. Due mostly to two coinciding trends—the shifting nature of work and over a decade of suppressed interest rates—these plans, while still worth trillions in aggregate, are tantamount to high-risk debt for many companies. Though a legacy DB pension fund could be in surplus, it may also be the case that it’s in deficit, meaning that the sponsoring company would need to step in and top up the fund in order to achieve the projected funds needed to meet its pension obligations.
Most companies have opted to shift from DB to defined contribution (DC) plans such as 401Ks, which are less difficult and costly to maintain. But some still retain their legacy defined benefit plans. Because only an estimated 5 percent of corporate DB plans have been bought out to date, many companies and schemes still face an important choice of whether or not to de-risk by transferring their pension fund to another party.
The $3+ trillion currently in private sector U.S. DB pension plan assets represents a massive two-way opportunity: Pension Risk Transfer (PRT), which I can discuss from the perspective of a 183-year-old insurance firm with deep experience in these transactions both in the U.S. and U.K. Transferring risk in this way helps companies deliver on their promises and advances the financial security of its employees, both former and present, who are enrolled in the plan.
The Many Types of Pension Risk Transfer: Buyout or Buy-In, Termination or Lift-Out
There are a number of ways CFOs can go about transferring the potential risk from their existing plans. We are going to discuss buyouts and buy-ins, plan terminations and lift-outs, and the respective characteristics of each.
Buyouts and buy-ins are the two main categories under which a PRT transaction might fall. In a buyout, plan sponsors can remove a certain segment of participants in a ‘lift-out’—or they can transfer all obligations of the plan to an insurance company in a ‘termination.’ The latter action closes the plan. Given the stringent regulatory and government approval processes, a termination can take between 12 and 18 months to complete. At that point, the insurance company is responsible for the administration of the terminated plan’s liabilities and payment of the benefits promised to the participants.
A CFO who wants to transfer the risk completely might consider a straight-on plan termination—if they can afford it and are financially prepared to do so. But CFOs could also consider taking a more gradual approach with a series of lift-outs, weighing the cost of producing the requisite returns over the life of the plan versus the associated costs of totally and immediately offloading it. Their options for a partial approach then range from a buyout—transferring administrative and financial responsibility of the selected segment of the plan to an insurance company—to a buy-in, which requires retaining the administration of the plan.
First, let’s look more in-depth at lift-outs, which we defined earlier. These partial offloads can stop right at that point or be the first step toward an eventual full termination. A CFO might specify, for example, that the lift-out include all retirees who are receiving less than $1,000 a month. This would be a good option for a CFO dealing with a plan that is not fully funded or a company that is not financially prepared to fund a full termination right away. The lift-out will enable a reduction of the overall costs associated with the selected segment of participants, such as PBGC premiums and other administrative charges per capita. And it can typically be accomplished faster than a full termination. As lift-outs don’t usually require the same level of legal preparation or regulatory oversight, in some cases they can be accomplished in as little as 4 to 6 months. Additionally, pricing parameters for retirees who have already made their pension choices are narrower than for other categories, such as deferred participants.
The other category of PRT transaction is a buy-in, in which the company sponsoring the plan purchases a contract from the insurer to cover the benefits payable but retains the administrative responsibility. In this approach, two facets of the plan are transferred to the insurance company: generating the returns and matching the longevity that will be needed to meet the total obligation of all future benefit payments owed to the participants who are covered. The company is relieved of the financial risk but retains all other functions of the plan, from the paperwork and administrative control of the participants to sending the payments. This is the road currently less traveled by U.S. companies, though it is gaining in popularity here. In the UK it is already a very popular full or partial alternative to buy-out. To date, U.S. buy-ins have only taken the form of lift-outs, the first of which occurred in May 2011.
Companies also have another option to reduce their DB pension liabilities, a tactic commonly taken in the U.S., especially for former employees with a vested benefit: offering a lump sum to their plan participants. This approach could lower the number of deferred participants in the transferred population, making the plan more appealing to insurance companies bidding on it.
Why Consider Pension Risk Transfer, and How?
Companies have various reasons for pursuing PRT. A company’s goals may have shifted so that it no longer wants the responsibility for ongoing contributions or administrative costs of a DB plan, or the PRT transaction might stem from a change in employees’ goals with a population that could value DC plans more. A PRT transaction might occur when the company that originally formed the plan has been acquired or has simply ceased to exist. And of course, the existing plan might also no longer make financial sense for the company that originally sponsored it, albeit at one time, it did.
The low interest rate environment that has typified the last decade has only served to increase pension deficits, and some companies lack the liquidity to sufficiently fund them. Further increasing the financial strain, the original DB plan might have failed to sufficiently take into account the increasing longevity of the participants, or the plan sponsor might lack the expertise or efficiency to manage the investments and administration.
Understandably, the considerations of most CFOs relate to the market, and in the case of PRT, they are focused first and foremost on the cost of removing pension obligations from their books. Will the price go up—should I pull the trigger now?—or down—should I wait to execute? How competitive is the market? CFOs and their advisors should weigh the risks one by one in order to optimize the aggregate cost of paying an insurance company to take the plan off their hands. Administrators of larger plans especially might want to consider a stepped route, which could hold more potential benefits than going straight to a full termination—but this all depends on market conditions and the level of funding. Overall, there is no one-size-fits-all answer for CFOs trying to decide whether, when, and how to transfer that risk.
In all cases, however, the plan sponsor is paying to: a) transfer the financial risk of meeting pension promises to its plan participants to another entity, and b) remove or reduce the risks associated with funding and running the plans.
Taking PRT a Step Further
How the transferred assets are re-invested could render the process more socially beneficial than if the money had just remained where it was. In a PRT transaction, which is a transfer of both assets and liabilities, the pricing is partly influenced by how the purchaser of the pension plan redeploys those assets. In our own PRT transactions, we’re increasingly looking at alternative investments such as real assets and urban regeneration which deliver the long-term returns needed to pay long-term pension commitments. These deals hold the potential to create a virtuous cycle of benefits, from reducing or entirely removing the associated risk, to ensuring that retirees receive their benefits, to reinvesting in assets that can generate a broader societal benefit.
I’ll close with a story that illustrates the creativity and ingenuity that can be involved in PRT transactions—in execution itself, as well as in the eventual societal benefit. This is a story about one of the U.K.’s largest PRT transactions: the recently completed £4.6 billion ($5.5 billion) Rolls-Royce deal. Around the same time, we had also signed a £4 billion ($5 billion) real estate investment deal with Oxford University to fund the development of housing for postgraduate students and support staff, tech centers, and other income-producing assets. How, you may ask, could these two deals be related?
Due to the multifaceted financial ecosystem we’ve built, we estimate that 50 to 70 percent of the assets created by the Oxford real estate deal will eventually end up funding the bought-out Rolls Royce pension plans. In effect, this means it’s highly likely that Oxford’s engineering grad students may soon be living and working in facilities that are also paying the pensions of their predecessors who went on to work at Rolls Royce. Of course, not every PRT transaction will be tied up in such a neat package—the point is that there are many ways to deliver on funding pensions. Why not aim for an option that is going to benefit the broadest swath of people?
Nigel Wilson is Group Chief Executive of Legal & General.