Pension Risk Transfer on a Budget: Plan Sponsors Take Aim at Targeted Buy-outs

Perspectives, October 2016

by Margaret (Peggy) McDonald and Peter Kahn

The Buy-out Market in 2016

A growing number of pension plan sponsors are choosing to de-risk their plans through buy-out transactions with insurers.  The reasons for this heightening activity are numerous, with ongoing market volatility, increasing longevity and escalating PBGC premiums being chief among them.

Nonetheless, many sponsors are finding it difficult to complete the scale of transaction they desire, as the average plan-funded status is currently less than 80%, straining transaction budgets.1  Consequently, a trend has emerged that addresses this shortcoming: Sponsors are now completing transactions that settle the obligations of a particular group of plan participants.  When executed properly, these “targeted” buy-outs enable sponsors to de-risk their plans with maximum benefit, while respecting their limited de-risking budgets.

1 Milliman 100 Pension Funding Index as of June 30, 2016

Evaluating the Most Efficient Transaction

Pricing Efficiency

Identifying the set of plan participants that can be transferred with the best economic benefit begins with clarifying the definition of “efficiency.”  In a majority of transactions, the sponsor’s primary objective is to de-risk and maintain the plan’s pre-transaction funded status, and achieving this goal may require a plan contribution as part of the buy-out agreement (for the remainder of the paper we assume that a sponsor would maintain pre-transaction funded status).  When viewed through this lens, an efficient transaction is one that maintains a plan’s funded status, with minimal to no plan contribution required.  Accordingly, the most important aspect of the transaction becomes how close the insurer’s premium is to the plan’s liability—a comparison commonly measured as the ratio of the buy-out cost to the plan’s GAAP liability. 

The cost of a buy-out will usually exceed GAAP liability for the relevant group of participants because the insurer takes on the administrative and investment expenses associated with managing the pension, and holds capital in excess of the expected value of the liability, which protects the security of pension benefits, should experience vary from underlying assumptions.  Generally, the cost of a retiree buy-out transaction is about 104% of GAAP liability.  It is important to note, however, that this often-quoted percentage is derived from the “baseline” valuation of the GAAP liability, which may differ from the plan sponsor’s calculation.  The variation between the sponsor’s calculation of GAAP liability and the baseline valuation is largely driven by two dynamics. 

Discount Rate

GAAP liability is calculated by discounting expected future benefit payments by discount rates that reflect yields on AA-rated corporate bonds.  The baseline valuation of the GAAP liability relies on the use of one of the publicly available Citigroup Pension Discount Curves.  However, many sponsors instead rely on yield curves constructed by their actuarial consulting firms—curves that often result in higher discount rates and thus a lower GAAP liability.  In these instances, the buy-out cost will be a higher percentage of the GAAP liability calculated by the sponsor, as compared to the buy-out cost as a percentage of the baseline valuation of the GAAP liability.

Mortality Assumption

The second dynamic is the mortality assumption used in the baseline valuation relative to that employed in the plan sponsor’s calculation.  If the plan sponsor uses a mortality table that assumes a lower longevity rate than that of the pricing insurer, the sponsor’s view of the GAAP liability will be “understated,” and the cost of the buy-out will appear higher as a percentage of GAAP liability. 

Plan sponsors are well served to recognize and measure the difference between their own GAAP liability and the baseline valuation early in the transaction analysis. Doing so will help them avoid the unwelcome surprise of a greater buy-out cost than originally anticipated.

The Disaggregated Costs of a Retiree Buy-out with RP-2014 Base Table
and MP-2015 Improvements

 Sample Plan Illustrative Retiree Buy-out Pricing


1 GAAP liability reflects RP-2014 mortality table with MP-2015.

2 Costs not included in the GAAP retiree obligation include per person administrative expenses of $40 per year and PBGC expenses per person of $64 in 2016, $69 in 2017, $74 in 2018, $80 in 2019 and indexed after 2019.  PBGC variable rate premiums assumed to be 3.0% in 2016 and indexed after 2016.  Funded status for variable rate premium assumed to be 87% (PBGC basis) and 80% (GAAP basis).

3 GAAP liability is discounted using rates unadjusted for investment management fees and the risk of credit defaults and migration.  These are estimated at 30 and 24 basis points per annum, respectively.

Percentages represent present value of estimated future costs. For illustration only.

Ongoing Plan Costs

In addition to pricing efficiency, most plan sponsors aspire to save on PBGC premiums and other ongoing plan expenses.  They do this with good reason, as PBGC premiums have risen three times in recent years, and the annual fixed premium will increase to $80 per participant in 2019.  This represents a more than 225% increase over 2012 levels. 

What’s more, the annual variable premium will increase to 4.1% of unfunded plan liabilities—an escalation of more than 400% since 2013—with a cap of $500 per participant.  Both the fixed and variable premiums (including the cap) will be indexed for inflation thereafter.  Once these increases are fully phased in, pension buy-out transactions will enable plan sponsors to save between $80 and $580 per year for each participant included in the transaction.


PBGC Premium Increases

PBGC Premium Increases

Source:, May 2016.

Framework to Narrow Down Plan Population Segments

The First Cut—The Retiree Population

In recent years, plan sponsors have focused on transferring the liabilities associated with their retiree populations.  Sponsors have taken this approach because retirees are the most efficient population to buy out.  From an insurer’s perspective, the shorter life expectancy of retired versus non-retired participants denotes less long-term longevity risk, and a reduced need for future asset reinvestment.  Further, there is no behavioral risk associated with these participants, because they have already retired and elected their form of annuity. 

The cost to settle the retiree liability—about 104% of the baseline GAAP liability—is significantly less than the cost to settle the not-yet-retired liability (i.e., the deferred population liability).  For deferreds, the expense of a buy-out transaction would likely be in the 110–120% range to account for additional longevity, reinvestment and behavioral risks.

Fortunately, retirees are typically the largest pool of plan participants as measured by plan liability, offering plan sponsors the opportunity to settle a significant amount of liability for an attractive price. 

The Second Cut—Narrowing Down the Retiree Population

Once the transaction has been narrowed down to the retiree population, plan sponsors can work with consultants to evaluate the efficiency of various cohorts within this select group.  This step is best accomplished by partnering with an insurer who can provide insight on current market pricing for the cohorts within the retiree population.  The retiree cohorts generally offering the greatest efficiency are those with the smallest benefits, those who have been in retirement the longest, and/or those who worked in blue-collar positions.

Participant Benefit Size

The most common approach to setting a population target is to start with retirees having the smallest benefits.  There are two reasons why this is so efficient.

First, various studies, including the most recent mortality table published by the Society of Actuaries (RP-2014), show that longevity is directly correlated with benefit size.  Those with small benefits tend to have shorter life expectancy than those with larger pension benefits, as benefit size is indicative of wealth and access to quality healthcare.  Therefore, an annuity for a small-benefit participant will almost certainly be less expensive per dollar of pension benefit than an annuity for a large-benefit participant. 

Secondly, the small-benefit cohort not only offers pricing efficiency, it provides opportunity for significant savings on PBGC premiums, which are slated to rise considerably.  Hence, transferring the payment obligation for these small-benefit individuals represents a sizeable reduction in PBGC premium due.


Comparison of PBGC Premiums for a Plan with $1,000M Liability, 80% Funded and 40,000 Employees

Comparison of PBGC Premiums for a Plan with

$1,000M Liability, 80% Funded and 4,000 Employees

PBGC Premiums




Flat Rate Premium




Variable Rate Premium




Total PBGC Premium (per year)




Premium Per Participant




Increase Over 2013




Participant Retirement Date

Sorting retirees by date of retirement often reveals that those who have been in retirement longer can be annuitized somewhat more efficiently than those who have more recently retired.  The pricing advantage emerges from the reduced longevity and reinvestment risk associated with this group.  Of course, this may not always be the case, as very old populations may have a duration that is too short to invest efficiently.  

Other Options

There are several other areas for possible exploration, which primarily recognize any conservatism in the sponsor’s longevity expectations for the plan.  For example, it is not unusual for a plan—even one with a large percentage of blue-collar participants—to use a mortality assumption derived from a blended table that reflects both blue-collar and white-collar populations.  In these instances, the cost of buying out blue-collar participants may be several percentage points lower than the marketplace norm, based on the shorter life expectancy of these individuals.  Additionally, there may be groups of retirees who worked in geographic locations where longevity expectations may be lower than average.  This, too, may produce an efficient premium to GAAP ratio. 

Of course, these scenarios will be unique to each sponsor, but they are worth considering.  Your plan consultant can help you explore these options, and examine whether a change in mortality assumptions is prudent for the group that remains after a transaction.

Determining an Optimal Transaction Using the “Second Cut”

Once a plan sponsor has determined which cohorts to analyze for potential annuitization and collected insurer pricing, it can then determine how to optimize a buy-out transaction.  This process starts with a contribution budget.  A sponsor would want to determine whether a complete retiree population buy-out could be completed within budget, and if not, begin analyzing a buy-out starting with the most efficient cohort.  If the sponsor has budget remaining after selecting this cohort, it can then use the remaining budget to annuitize all or a part of the cohort with the next-lowest cost to annuitize.  In selecting the optimal population cohorts to annuitize, the sponsor should consult with their plan’s fiduciary to ensure the selection process was conducted in accordance with applicable laws and regulations.

The following chart illustrates this optimization exercise.  In our example, we assume a sponsor’s plan has a $1 billion baseline GAAP pension-benefit obligation that is split evenly between retirees and non-retirees.  The plan has $800 million of assets, making it 80% funded.  This sponsor wants to transfer the maximum amount of plan liability given its contribution budget of $50 million, while maintaining its 80% funded status after the transaction.  The sponsor has decided to evaluate retirees for potential buy-out by both benefit size and retirement date.

Example of a Targeted Buy-out Optimization

($ millions)

Full Retiree Population
GAAP Liability $500
Premium to GAAP Ratio 104.00%
Contribution to Maintain Funded Status $120
(Exceeds $50M budget)


Retirees by Benefit Size Retirees by Retirement Dates
GAAP Liability $300 GAAP Liability $250
Premium to GAAP Ratio 105.30% Premium to GAAP Ratio 105.00%
Contribution Required to Maintain Funded Status $76 Contribution Required to Maintain Funded Status $63
Remaining Budget $– Remaining Budget $–
GAAP Liability $200 GAAP Liability $250
Premium to GAAP Ratio 102.00% Premium to GAAP Ratio 103.00%
Contribution Required to Maintain Funded Status $44 Contribution Required to Maintain Funded Status $58
(most efficient)
Remaining Budget $6 Remaining Budget $–

Premium to GAAP ratios are for illustrative purposes only.

This sponsor started with a desire to transfer all retiree liability, but upon analysis realized that the contribution required to maintain the plan’s funded status would exceed the $50 million budget.  Accordingly, the sponsor started analyzing subsets of the retiree population to find the best opportunity for economically transferring liability.

The analysis proceeds by analyzing the most cost-efficient cohort—in this case the retirees with small benefits.  The required contribution to maintain 80% funded status would be $44 million, leaving $6 million in the budget.  This sponsor would then evaluate the remaining cohorts and identify the group with the next-lowest cost to annuitize—in this case those individuals with the earliest retirement dates. After carving out the retirees in this cohort who are already part of the small-benefit group, the sponsor determines that using its remaining $6 million of budget, it can annuitize an additional $25 million of GAAP liability at a premium to GAAP ratio of 103%.  The combination of these two transactions allows the sponsor to settle nearly half of its total retiree obligation at 102.1%, while maintaining an 80% funded status for its residual plan.

Plan Funded Status 

    Optimized Buy-out  
Initial Funded Status Annuitization Contribution After
GAAP Liability $1,000 ($225) $– $775
Plan Assets 800 ($230) $50 $620
Funded Status ($) ($200) ($5) $50 ($155)
Funded Status (%) 80%     80%

Retiree Liabilities Settled


    Optimized Buy-out  
Premium to GAAP Ratio Contribution Premium Liability % of Total
Retiree Liability
Small Benefits 102% $44 $204 $200 40.00%
Early Retirement 103% $6 $26 $25 5.10%
TOTAL 102.10% $50 $230 $225 45.10%



By executing targeted buy-outs, plan sponsors can cost-effectively de-risk specific segments of their pension plans, while remaining within the confines of their restricted de-risking budgets. Those who proactively de-risk their plans today can gain a significant edge over those who do not. Pension de-risking—even in targeted amounts—offers the certainty plan sponsors want, and the benefit security plan participants need.

This article first appeared in the 2016 Institutional Investor Journals' Guide to Pension and Longevity Risk Transfer for Institutional Investors.