DB Plan Sponsors Might Want to Press Pause on Pursuing PRT

Corporate defined benefit plan sponsors can keep plans stable and manage investment risks as well as Pension Benefit Guaranty Corporation premium costs instead of executing a pension risk transfer, investment managers suggest.

A Cambridge Associates report, “Pension Risk Transfers Have Several Downside Risks for US Plan Sponsors,” examined the effects under two scenarios—85% and 100% funded—of performing a PRT on DB plans’ funded status, risk reduction and future costs.

PRT can be done through buyouts, buy-ins, lump-sum offerings and partial annuity purchases. Plan sponsors use pension risk transfers to lower the risk and cost of the plan by shrinking its size. But, in many cases, they might achieve the opposite result, the paper says. Cambridge finds that most plan sponsors would be better served by maximizing plan return potential through generating alpha and managing beta. 

“For those seeking to reduce risk, this can be achieved by concentrating on the proportion of risky assets in their plan, coupled with optimally hedging the liabilities in the plan; after all, even a 5% adjustment from equities to fixed income can achieve the same risk reduction as a PRT,” the paper says. The report was written by Jacob Goldberg, investment director, Pension Practice, at Cambridge Associates and Serge Agres, managing director, Pension Practice, at Cambridge Associates.

PRT Impacts

While PRT appears to plan sponsors as a de-risk mechanism, the paper explains that the juice is not worth the squeeze for many.  

Agres and Goldberg advise that before implementing a transfer, sponsors should examine every implication to funded status, risk reduction, and future costs for their plan. “For many plans, a better option lies within the asset allocation and in tailoring portfolio strategy to effectively navigate liability-specific risks and market conditions,” the paper says. “Without this understanding, the hidden cost of these transactions may go unnoticed.”

Cambridge finds that “while a PRT transaction can reduce PBGC premiums in the short term, two of the most overlooked downsides are the impact on funded status and long-term PBGC premiums.” Pursuing a partial annuity purchase can negatively affect funded status for an underfunded plan. “The inverse relationship is true for overfunded plans; these risk transfers would increase funded status, which can assist a plan in decreasing risk and PBGC premiums,” the paper says. “Regardless of funded status, the question remains as to whether the PRT is worthwhile on an after-fee, long-term benefit basis.”

The paper concludes that for plan sponsors who want to terminate the pension, a risk transfer is “necessary,” while for other circumstances “caution and thorough evaluation is advised.”

“Completing a PRT for an underfunded plan will more likely be at the detriment of a plan sponsor’s goal of achieving a fully funded plan,” the writers say. “For more well-funded plans, a one-time partial annuity purchase for participants that either are preferred by insurers or receive small benefits has value-add potential. However, continually performing these transactions or settling all retirees only diminishes this value and could hinder future opportunities.”

Pension Plan Burdens

Plan sponsors look to offload the plan’s risk and retirement liabilities to former employee beneficiaries to de-risk a pension plan in a PRT. Plan sponsors can de-risk by offering vested participants lump-sum payments to exit the plan early or by negotiating with an insurance company to assume the responsibility for paying out guaranteed benefits by executing a PRT.   

Plan sponsors also pay premiums, which charge the plan based on any unfunded liabilities for the year. The Cambridge paper explains that since 2012 legislation was enacted for pension funding relief, premiums have climbed almost 200% per participant in 10 years. “Finding a way to reduce these costs has led many to believe PRTs are a solution,” according to the paper.

Premiums for single-employer plans are calculated by the sum of a flat-rate premium—$86 per participant in 2021—plus a variable-rate premium, which was 4.6% of unfunded liabilities in 2021. Per-participant premiums were capped at $582 for 2021. The per-participant cap for 2022 is $598.

A Better Option?

Plan sponsors have at their disposal better options to keep the plan afloat and lower their risk and PBGC premiums, the paper says. 

Rather than pursue a PRT, Agres and Goldberg recommend pensions pursue several strategies:

• Diversifying risk premia across growth asset classes, including—but not limited to—global equities, high-yield bonds, real assets, hedge funds, private equity and private credit;
• Managing the beta of the portfolio to an appropriate level of risk and excess return over the liabilities;
• Focusing on asset classes with higher alpha generation properties; and
• Employing a thoughtful liability-driven investing design that uses an optimal blend of credit and treasury securities and capital-efficient asset classes to optimize interest rate and credit spread hedge ratios.

PRT Cost Trends

J.P. Morgan’s “Corporate Pension Peer Analysis 2022” report included insights on pension buyout activity, which decreased in 2020 but rebounded in 2021. “After a quiet 2020, the annuity buyout market came roaring back in 2021, likely reflecting pent-up demand and the improved funding position of plan sponsors,” the report says.

J.P. Morgan finds that in Q3 2021, there was almost $16 billion of PRT transaction volume, of which more than half was from large retiree annuitizations—HP and Lockheed Martin. Lump-sum costs, measured as the lump-sum payment relative to GAAP [Generally Accepted Accounting Principles] liability, were elevated throughout the year. “It would have cost more than 100 cents on the dollar to offload GAAP pension benefit obligations through the lump-sum channel,” the paper says. “If discount rates continue to rise during 2022, lump-sum offers will become even less economically attractive to sponsors.”

Like Cambridge Associates, J.P. Morgan also encourages DB plan sponsors to rethink their endgame. “Reaffirm the plan sponsor’s endgame in light of a shifting interest rate environment and more forgiving funding regulations,” the report says. “Relatively new asset classes, such as private credit and real assets, can form part of the substrate of a low-risk stabilized portfolio.”

The investment manager also suggests that plan sponsors take solace in pension relief. “The passage of [legislation] has fundamentally altered the risk profile and viability of defined benefit pension plans,” it says. “Plan sponsors now have the flexibility to tolerate increased levels of volatility and deploy an expanded toolkit of alternative asset classes, enhancing the value proposition of maintaining plans on corporate balance sheets.”

Finally, J.P. Morgan recommends that pension plan sponsors manage plan costs holistically. “The most cost-efficient way to minimize PBGC premiums can often be to maintain and grow a pension surplus,” the report states. “Some pension risk transfers will continue to offer undeniable economics but be wary of the opportunity cost of the associated assets forfeited in the process.”