The 5 Myths: Myth No. 3, Full Funding

The 5 Myths Holding Back Plan Sponsors

While many people think of a pension “Buy-out” as the only PRT solution, there are many options available regardless of funded status.

Myth Three Funding Status Requirements

Some pension plan sponsors may believe that risk transfer is only possible when their plans approach fully funded status.

    • Myth Risk transfer solutions can only be executed once a company reaches or exceeds full funding.
    • Fact Pension Buy-In and Longevity Insurance are options for transferring risk regardless of funding status.

A recent survey indicated that 59% of pension plan sponsors believe that risk transfer is only possible when their plans approach fully funded status.1 This belief is likely based on the awareness of the challenges underfunded plans face in executing the most prevalent risk transfer transaction—the pension buy-out.

However, there are solutions that enable sponsors to transfer risk even if their plans are not fully funded—most notably, the pension buy-in, and a robust LDI strategy along with longevity insurance.

A buy-in is an insurance contract that enables sponsors to transfer longevity, investment, and interest rate risk to an insurer for a subset of a plan’s participants. A buy-in differs from a buy-out in that the contract is retained as a plan asset. Furthermore, a buy-in leaves the plan ultimately responsible for providing pension benefits. These distinguishing features enable buy-ins to overcome some plan specific issues associated with executing buy-outs.

Pension Buy-In

A buy-in significantly narrows the projected range of future contributions a plan sponsor will have to make, because the insurer providing the buy-in assumes the risks associated with the plan’s liabilities.

A buy-in allows plan sponsors to lock in insurance capacity today while it is readily available.

A buy-in will not materially impact the overall funding ratio of the plan since a buy-in contract remains a plan asset. A buy-in also does not trigger settlement accounting, as the plan remains the benefit obligor and, in turn, collects benefit obligations from the insurer. A buy-in additionally provides plan sponsors with a phased approach to transferring DB risk, as sponsors can eventually convert to a buy-out. After execution, the value of the buy-in contract is expected to closely track the value of the plan’s liabilities addressed by the contract.

Exhibit 2 illustrates the impact a buy-in would have on covering the retirees of the hypothetical DB plan introduced earlier in this paper. As shown in Exhibit 2, executing a buy-in increases the lower end of the projected range of plan contributions by approximately $15 million. This is due to the costs associated with completing the buy-in transaction (including recognition of revised longevity assumptions implicit in pricing) and the reduction in the plan’s equity exposure.

Exhibit 2: Impact of a Buy-in Solution

Buy-in increases lower end and decreases upper end of projected range of contributions. Following table provides more details.
Exhibit 8: Range of required plan contributions
Lower End Required Plan Contributions Upper End Required Plan Contributions
Current Strategy (additional longevity risk, not modeled) Retiree Buy-in (no additional longevity risk) Current Strategy (additional longevity risk, not modeled) Retiree Buy-in (no additional longevity risk)
$24 million $39 million $1,275 million $728 million

Current strategy:

  • 65% equities
  • 30% fixed income (Barclays Aggregate Index)
  • 5% cash
  • 95% funded status

Buy-in:

  • Retiree liability buy-in
  • Remaining assets (non-retirees) invested 65% equities, 35% fixed income (Barclays Aggregate Index)

Notes: Analysis based on 1,000 Monte Carlo simulations of equity returns and interest rates to determine how the plan’s funded status would change in 10 years. Lower end (10th percentile plan contributions) captures scenarios where a rise in equity markets and high interest rates positively impact funded status and lower contribution requirements. Our upper end (or 95th percentile of plan contributions) reflects bad outcomes (or tail risk) where significant decline in equity markets and a fall in rates negatively impact funded status and contribution requirements. Source: Prudential Analysis

Conversely, the upper end of the projected range of contributions decreases by approximately $547 million because of the risks assumed by the insurer, and the replacement of a significant portion of the plan’s equities. The significant downside protection with modest loss of upside highlights that the buy-in is a very attractive de-risking option for well-funded plans in current market conditions. The buy-in contract is retained as a plan asset and its value closely tracks the value of the plan liabilities covered by the contract.

LDI + Longevity Insurance

As discussed earlier, a robust LDI strategy can significantly reduce DB risk by ensuring that a plan’s assets and liabilities respond similarly to changes in interest rates. However, LDI strategies still leave sponsors exposed to longevity risk—the risk that a plan’s participants will live longer than expected—resulting in higher benefits payments. One way for sponsors to enhance an LDI strategy is to complement it with longevity insurance, thereby achieving certainty as to the amount they will have to pay each plan participant.

Exhibit 3 illustrates the benefits this solution offers the hypothetical DB plan sponsor introduced earlier in this paper. As Exhibit 3 indicates, the LDI-plus- longevity insurance solution increases the lower end of the projected range of plan contributions by $7 million, but lowers the upper end by approximately $541 million. The upper end decreases significantly due to the replacement of a portion of the plan’s equities exposure with fixed income assets that match the plan’s liabilities. These results highlight the significant benefits of de-risking for a well- funded plan.

Exhibit 3: Impact of the LDI and Longevity Insurance Solutions

LDI with longevity insurance increases lower end and decreases upper end of projected range of contributions. Following table provides more details.

Exhibit 9: Range of required plan contributions
Lower End Required Plan Contributions Upper End Required Plan Contributions
Current Strategy (additional longevity risk, not modeled) LDI with Longevity Insurance (no additional longevity risk) Current Strategy (additional longevity risk, not modeled) LDI with Longevity Insurance (no additional longevity risk)
$24 million $31 million $1,275 million $734 million

Current strategy:

  • 65% equities
  • 30% fixed income (Barclays Aggregate Index)
  • 5% cash
  • 95% funded status

LDI with Longevity Insurance:

  • Retiree liability LDI
  • Non-retiree liability invested 65% equities, 35% fixed income (Barclays Aggregate Index)

Notes: Analysis based on 1,000 Monte Carlo simulations of equity returns and interest rates to determine how the plan’s funded status would change in 10 years. Lower end (10th percentile plan contributions) captures scenarios where a rise in equity markets and high interest rates positively impact funded status and lower contribution requirements. Our upper end (or 95th percentile of plan contributions) reflects bad outcomes (or tail risk) where significant decline in equity markets and a fall in rates negatively impact funded status and contribution requirements. Source: Prudential Analysis

In addition, longevity insurance protects the plan sponsor from a longevity shock, a scenario in which actual lifespan of a participant is different (higher or lower) than expected. Prudential uses up-to-date mortality tables when calculating pension liability and required contributions. Thus, a longevity shock would result if actual lifespan exceeds the estimate described above, and would adversely impact liability valuation, funded status and required contributions. As shown in Exhibit 3, if the plan sponsor executes its current investment strategy, the sponsor remains exposed to the possibility of a longevity shock and the higher plan contributions this would demand—even beyond the forecasted upper end of the range of projected plan contributions. However, with longevity insurance, the plan sponsor mitigates this risk exposure.

Analysis

Our analysis shows that both a buy-in solution and LDI along with longevity insurance are effective strategies for significantly reducing risk without negative accounting or funded status implications. However, the buy-in solution could offer some advantages over LDI, in particular for smaller plans that lack the ability or desire to implement and monitor sophisticated asset/liability management strategies. LDI strategies can be difficult to implement, and investment basis risk often remains, because it is extremely difficult to create an asset portfolio that perfectly matches the movement of the GAAP liability. In contrast, a buy-in presents no residual risk, and can be converted to a buy-out at any time. A buy-in allows plan sponsors to lock in insurance capacity today while it is readily available.

REFERENCES

  • 1"Pension Plan De-risking, North America," by Clear Path Analysis, May 2016.