3 pension risk transfer strategies

What’s the best way to transfer DB risk?

The financial pain that started in the early 2000s was sufficiently acute for many DB plan sponsors to take action to mitigate risk in the following years. They did so by first reviewing plan design, leading to a wave of plan freezes and terminations.

Later in the decade, the focus shifted to traditional investment strategies as plan sponsors reviewed their asset mix, seeking the right balance between investment risks and rewards. Liability-driven investment strategies came next, as plan sponsors also tried to mitigate liability risks in an environment of declining rates.

But these strategies still weren’t reducing risk sufficiently for many plan sponsors. That’s why, more recently, pension risk transfer strategies have started to emerge and gain momentum. Annuity purchases and lump sum transfers address the full spectrum of DB plan risks, while longevity hedges focus exclusively on the ever-elusive longevity risk.

These strategies are proving valuable to plan sponsors that wish to take the next step in retirement risk management. Eliminating more risk by trading away some rewards helps insulate the plan and the plan sponsor from the financial consequences of uncertainty.

Are these strategies right for your plan? If so, which route should you choose?

Strategy No. 1: Annuity Purchases

These are agreements between plan sponsors and insurers to transfer the financial responsibility of plan members’ monthly pension payments. The chart below shows the two types of group annuity purchases: buyout and buy-in policies.

The fundamental difference between the two approaches resides in the party responsible for the administration and actual payments to retirees each month.

The volume of group annuity purchases has recently soared to new heights, surpassing the $2-billion level in recorded sales in each of the last two years. In the 10 years preceding 2013, the annual sales average was less than $1 billion. The real game changer has come from ongoing plans (those that have not been closed to new entrants and don’t have frozen accruals), which accounted for 68% of the sales volume in 2014. An increasing number of plan sponsors that wish to maintain their DB plans but manage their retirement risks closely are now using an annuity purchase strategy.

Looking ahead for the next couple of years, the market is not showing any signs of slowing down. More than half of respondents to a recent Towers Watson pension risk survey declared their interest in annuity purchases in the medium term. Jumbo transactions are just around the corner, and new alternatives in go-to-market approaches and process refinements abound, such as slicing strategies, limit orders, mortality profile assessments and transfers-in-kind.

In the current low interest rate environment, the question remains: Aren’t interest rates too low to purchase annuities? The answer is no, if the funds to purchase annuities come from selling fixed income investments. Here’s an analogy: buying a house following a sharp rise in the property market is not as much of a concern if the transaction is also accompanied by the simultaneous sale of a property of the same value in the same market.

Such an approach has the advantage of mitigating the effect of prevailing interest rate levels in the decisionmaking process. In more than 90% of the $850 million of annuity purchase transactions for which Towers Watson acted as advisor in 2014, the premium was paid to insurers by either liquidating or transferring fixed income securities.

Since annuity purchases can involve significant financial transactions for the pension plan, they deserve attention from governance, readiness and execution standpoints. Here are the key steps.

1. Clearly define your plan’s guiding principles

  • Are you exiting DB or right-sizing your plan?
  • Are you trying to diversify your pension assets?

2. Select the right strategy

  • What’s your go-to-market approach?
  • What are your strategies for cash sourcing and asset mix?

3. Get ready to execute

  • How prepared are you to execute the transaction?
  • Do you have approval from all of the decision-makers involved?

4. Identify and monitor triggers

  • What are the metrics you want to track?
  • Do you have appropriate access to market insights?

Strategy No. 2: Lump Sum Transfers

Lump sum transfers are offers to deferred vested (DV) members to voluntarily receive a one-time lump sum instead of a lifetime pension. A lump sum campaign is an effective de-risking strategy, as it transfers all risks to members and therefore helps reduce the plan’s financial volatility. These campaigns have become prevalent in the U.S. over the past three years and can also be useful in Canada to address concerns related to DV members.

Over time, the build-up of DV members in a pension plan results in a material obligation for former employees, along with significant ongoing and future administrative costs. As a deferred pension is usually the default option upon employment termination, many former employees end up in DV status due to a lack of understanding of their pension options. A well-explained reminder that there’s still an opportunity for them to take a lump sum might resonate well.

Lump sum transfer campaigns can be appealing to plan sponsors with DV populations of any size—especially when a significant number of DV members are under the small benefits threshold (i.e., the amount of commuted value below which the plan sponsor can pay the money directly to the participant, without offering the option of a deferred pension).

A lump sum campaign can achieve a favourable return on investment by eliminating future administration expenses for members who accept the offer and take the lump sum. Essentially, it frontloads fees for these members that would have been incurred anyway.

Paying a lump sum can also be cheaper than buying an annuity, as insurers are often risk averse to pensions due to begin in a long time because of the uncertainty surrounding the future payments. Conducting a lump sum campaign prior to an annuity purchase can actually help obtain more favourable annuity purchase pricing. Some insurers may charge a risk premium for DV members or even decline to quote if the proportion of DV members in the population is too large.

For the lump sum transfer campaign to be successful, meet with key stakeholders early in the process to review the project’s objectives and financial implications. Then, develop an effective communication campaign so members fully understand their options. Figure 1 (left) shows a typical transaction process for a lump sum transfer campaign.

Strategy No. 3: Longevity Hedges

A longevity hedge is a contract in which a third party exchanges payments based on an expected longevity assumption with payments based on actual longevity experience. The chart below shows the typical transaction process for a longevity hedge.

By committing to a fixed stream of payments for the future, the plan sponsor can eliminate any risk related to members living longer than expected and better manage the plan’s cash outflows. Members are unaffected by the transaction.

Unlike investment risk, plan sponsors typically don’t expect a reward from taking on longevity risk. This doesn’t mean they can’t benefit from longevity risk—but if they could opt out of taking that risk for free, they would.

Longevity hedges facilitate de-risking in situations where a group annuity purchase may be more difficult to complete, such as when pension obligations are very large or pension benefits are indexed to Consumer Price Index increases.

This strategy enables de-risking without locking in low bond yields. It also allows plan sponsors to continue managing assets, so sponsors can still invest in returnseeking assets to generate additional investment returns or fixed income assets to match liabilities. In addition, no upfront premium is required as part of the longevity hedge, nor is a one-time contribution required at the time of transaction.

But a longevity hedge transaction usually leads to an increase in future contributions, as the plan sponsor is paying an ongoing premium to eliminate longevity risk. Whenever possible, many plan sponsors would rather use annuity purchases as a risk transfer strategy, as it offloads all of the pension risks to the insurer. Others prefer to transfer the unrewarding longevity risk while keeping other risks from which they can expect a reward.

Acting on Risk Transfer Strategies

Here are four considerations when adopting risk transfer strategies.

1. Financial impact

  • P&L impact
  • Balance sheet impact
  • Accelerated cash requirement

2. Economic factors

  • Level of interest rates
  • Potential upside of equity risk premium
  • Source of assets for transaction

3. Market factors

  • Providers’ preferences
  • Transaction costs
  • Legislative constraints
  • Counterparty risk

4. Transaction readiness

  • Awareness and education
  • Enterprise philosophy
  • Data readiness
  • Monitoring of defined triggers

In the current economic environment, plan sponsors want to manage retirement risks as much as they can, whether to ensure DB plan sustainability or achieve a smooth transition toward plan termination. Now that risk transfer strategies are an integral part of the retirement risk landscape, plan sponsors have more tools at their disposal in their fast-evolving toolbox.

Mathieu Tessier is the retirement risk management leader – Montreal, with Towers Watson.

Get a PDF of this article.