Market Pulse: Q&A with Glenn O'Brien, Managing Director, U.S. Distribution
Perspectives, November 2017
Q: What can plan participants expect regarding consumer protections, service delivery, and participant communications when a PRT transaction is executed?
In 1995, the U.S. Department of Labor (DOL) published guidelines to help plan sponsors and fiduciaries evaluate and choose the safest available annuity provider. Companies must choose an insurer with strong financial strength ratings, and they are required by law (the Employee Retirement Income Security Act of 1974, or ERISA) to make careful decisions that are solely in the interest of plan participants and their beneficiaries.
When a pension risk transfer (PRT) transaction is executed, participants move from an ERISA pension framework to an insurer framework. An insurance company is governed by each state’s guaranty association, while the plan sponsor pays premiums to the Pension Benefit Guaranty Corporation (PBGC) for its safety net. While both offer great protection, it is worth noting that insurer insolvency is far less likely than a pension plan needing protection from the PBGC.
Service delivery and timely communication is particularly important because insurers are making multi-decade commitments to the plan sponsors and their participants. As insurers, we commit to providing retirees with a dependable stream of payments for the duration of their retirement years. But just as importantly, we commit to being there every step of the way, delivering the assistance, information, resources and support that participants need.
Q: With the increasing level of market volumes we’re seeing in 2017, do you see the potential for capacity constraints among insurers?
I think we need to look at two different types of capacity: market capacity and human capacity. In the market, there is likely capacity for billions of dollars of transactions. We have seen heavy competition in all segments of the market, even for the larger transactions. As demand increases, we’ve seen both new insurers enter the market and more capacity come to the market through existing insurers expanding capabilities. The larger issue has been human resource capacity—not only with insurance companies but also intermediaries, actuaries and plan administrators. As a workaround, we are seeing advisors pushing plans to transact earlier in the year instead of waiting until the fourth quarter.
Q: What may cause a plan sponsor to think risk transfer is too expensive, and if they do, how is this influencing their consideration of risk transfer?
The typical plan sponsor is sitting at 80% funded right now, and the thought of having to fund up their whole plan seems very expensive. The idea of doing a risk transfer for a part of the plan is a very viable solution for most plan sponsors as they can dollar cost average their way out of plan liabilities and—over time—can move a significant amount of risk and pick the most efficient groups to move first.
There are also misconceptions about how expensive it is to transfer risk to an insurer. Plan sponsors tend to compare insurer costs with GAAP liability and, frankly, GAAP liability is not an economic measure of pension liability as it does not include future payment of administrative expenses or the PBGC premium expenses, and it may not be calculated using a plan-specific mortality assumption. It isn't therefore a good economic measure of the plan liability. When plan sponsors evaluate risk transfer based on economic liability, they will see that it is not as expensive as they may think.
Ironically, as you point out, although it seems expensive many are still considering risk transfer because they no longer want to manage large legacy insurance obligations—which have become expensive to retain. We have seen drastic downturns of funded status repeatedly over the past 15 years. Those downturns result in real pain—cash funding requirements, reduced income, and an increase in balance sheet liabilities at the same time the underlying business is suffering. Managing pension risk is difficult. Many sponsors would like to transfer at least some of their pension liability to reduce pension risk and focus on their core businesses.
Q: Economically, it seems logical to borrow to fund pension plans to reduce variable premiums, but why would plan sponsors want to enter into a PRT transaction?
Due to continued lower interest rates, borrowing to fund the pension plan deficit remains a viable strategy that can be used alongside any de-risking solution. We’ve seen a large trend emerging for companies taking advantage of this arbitrage opportunity, including FedEx, DowDuPont and Valvoline. Many companies have simply issued debt to make contributions to their plan, which in turn reduces the amount of variable PBGC premiums they pay as their deficit is reduced. Some sponsors are taking it one step further and have either employed LDI strategies or transferred risk through a pension buy-out.
International Paper is another recent example of a company that issued debt and contributed to their pension plan in conjunction with executing a buy-out for $1.3 billion. Companies in the U.S. have become increasingly mindful of the risks and volatility involved with managing pension plans. As interest rates lag peoples’ expectations, we see plan sponsors looking at the long-term economic impact of holding a large pension liability. The carrying costs of a pension have increased significantly over the last few years, making a very compelling argument to move these liabilities to an insurer.