Cost Considerations in Pension Risk Transfer

Preparing for Pension Risk Transfer

Whether or not a buy-out is imminent, there are preparations a plan sponsor can undertake to make a future transaction easier and to shorten the timeline for execution. Prudential delivers a comprehensive roadmap for the buy-out process. Download the full paper here.

In considering a buy-out, plan sponsors should weigh the cost of the transaction against the cost of maintaining the plan, measured not only by the cash cost associated with the plan for a given year, but the impact to the core business—in terms of cash flow, earnings volatility, and ultimately, the ability to grow.

In a recent survey, 46% of senior finance executives indicated that their DB plan placed a constraint on the company’s cash flow, 47% indicated an impact on earnings due to volatility of plan funded status; and 34% indicated an impact on their ability to invest in growth opportunities.1

When evaluating the cost of a transaction, it is common to compare buy-out pricing to accounting liabilities. However, the calculation of pension liabilities for accounting purposes understates the true economic value of plan liabilities that an insurer would consider in pricing a buy-out. There are two reasons for this:

  • First, accounting liabilities do not include the present value of certain costs that a plan sponsor bears, such as administration costs, investment management fees, and PBGC premiums.
  • Second, historically, accounting liabilities had typically been based on outdated longevity assumptions which underestimated the true value of the liability by 6–7%. Now, as more corporations have adopted the new mortality assumptions, the accounting view of mortality more closely aligns with the insurer view. 
The common rule of thumb had been that, for a retiree population, the cost of a buy-out would be about 110% of the accounting liability. However, with the adoption of new mortality assumptions, accounting liabilities have increased, while the cost of a buy-out from the insurers’ perspective has remained about the same. As a result, the estimated cost of a buy-out as a percentage of the accounting liability has decreased from about 110% to about 104%. Of course, these cost estimates will vary for every transaction.

REFERENCES

    • 1.Prudential and CFO Research Services survey of senior finance executives, August 2015.