Forces Come Together to Make PRTs More Attractive

The effects of the COVID-19 pandemic slowed pension risk transfer (PRT) activity early last year, but the market made up ground in the fourth quarter.

Michael Clark, managing director and consulting actuary with River and Mercantile, says the two most common PRT transactions are annuity purchases, which tend to be more focused on in-pay retirees, and lump sum windows, which, in general, focus on terminated, vested participants.

As it relates to lump sum cash-out windows for calendar year plans, the basis used to calculate the present value of lump sump paymentsis the interest rate at the end of the prior calendar year, Clark explains.

“Looking at the November/December 2020 rates, on an effective basis, rates are about the same now as then,” he says. “So when lump sums are calculated and compared to the plan’s liability on the plan sponsor’s balance sheet on mark-to-market basis, they are about same—the amount of the lump sums will be the same as the liability that is released from plan sponsors.”

Clark says plan sponsors should look out for periods of increasing interest rates, like what’s happening now, when determining whether to implement a lump sum window. “When rates are rising, liabilities don’t go down as much as assets go down, so it effectively builds in funded status losses,” he says.

If interest rates maintain their current status through the end of the year, implementing a lump sum window makes sense, Clark says.

Mark Unhoch, partner at October Three, says the rates used to calculate lump sums for terminated, vested participants are not as attractive this year as they will likely be next year, because the higher rates will decrease plan sponsor’s unfunded liabilities and a lump sum window is likely to eliminate a greater proportion of liabilities than it would this year. However, he says getting participants with small benefits to take a lump sum will save on Pension Benefit Guaranty Corporation (PBGC) premiums—and savings on premiums take precedent over what rates have done.

“Rates are up about 70 basis points [bps] this year. A terminated, vested participant has a duration of about 15 years. If you multiply that duration by the interest rate, you will get the change in cost. For a 70 bps increase in rates, if a terminated, vested participant with a duration of 15 years takes a lump sum, the plan sponsor’s cost, or liability, should decrease by 10%,” he explains. “So, with lump sums, it becomes a question of whether increasing costs is worth the savings plan sponsors will get on PBGC premiums.”

However, some plan sponsors don’t have the luxury of waiting. Clark says those that are considering offering a lump sum window in 2021 probably still have a few months to decide, but would need to make a decision by the summer.

As interest rates have come up compared to last year, annuity purchases have become more economically viable—higher interest rates translate to lower annuity purchase prices, Clark explains.

An article on River and Mercantile’s website says: “Many plan sponsors saw strong asset returns in 2020, which, along with rising interest rates, will make buyouts more attractive in 2021. In addition, annuity pricing remains very competitive. For retiree-only cases, pricing continues to average 98% of the economic liability, while plan termination cases, which include in-pay and deferred annuities, average approximately 100%. Another new insurer is also entering the marketplace this spring, which will help ensure pricing remains competitive.”

Clark explains that deferred annuities tend to be more expensive because the insurance company is taking on more risk as the liability stretches out longer. While pricing for deferred annuities is approximately 100% of the plan’s economic liability, the ultimate level will depend on the plan’s complexity.

Plan sponsors should consider whether implementing a PRT transaction will require additional contributions. Unhoch says if the plan is funded at greater than or equal to 80% or the plan sponsor is willing to fund it to 80% or greater, then the plan may enter into a PRT arrangement. “It’s important because plan sponsors need to decide whether they have cash to contribute or whether they should shrink the scope of the PRT transaction,” he says.

When deciding whether to contribute more, plan sponsors might consider what taxes are going to do. “The [presidential] administration is saying it is going to raise corporate taxes. Do I contribute when corporate tax rates are lower, or do I wait to see if taxes do increase and contribute then for a larger tax deduction?” Unhoch explains.

In a “Perspectives” article on October Three’s website, Unhoch says many plan sponsors perceive annuity purchases as too expensive when they compare their generally accepted accounting principles (GAAP) liability to the cost of an annuity purchase, where the annuity purchase price is typically a couple percentage points higher. However, when the present value of future PBGC premiums are added to GAAP liabilities, he says, the annuity purchase price tends to be the lower number and the annuity purchase would result in improved overall costs of the plan. “This is especially true for retirees with small benefit amounts, as PBGC premiums do not vary with the size of a participant’s benefit.”

Unhoch set out to identify a “break-even” point, which is the monthly benefit amount for a given retired participant whereby the annuity purchase price is equivalent to GAAP liabilities with PBGC premiums included. For retirees with benefit amounts below the break-even point, the annuity purchase will be cheaper than retaining participants in the plan and continuing to pay PBGC premiums, the article explains. For retirees with benefit amounts above the break-even point, the annuity purchase may be more expensive than retaining participants in the plan.

October Three conducted an analysis on two hypothetical plans, one of which is subject to the PBGC variable rate premium (VRP) cap, and one of which is not. The analysis found the break-even point for plans not subject to the PBGC VRP cap is approximately $300 and for plans subject to the cap the break-even point is approximately $900.

Unhoch explains that the only administrative cost component assessed was PBGC premiums, but incorporating other administrative costs (e.g,. the cost of processing monthly checks) would drive break-even points even higher, identifying additional savings sponsors could attain from an annuity purchase.

The bottom line is that it’s a good time for small retiree balance buyouts if plan sponsors can afford it. “The average plan has increased funding by about 11% due to the upswing in the stock market and rising interest rates, so we suggest taking some of that gain off the table and using it to save on PBGC expenses,” he says.

PRT transactions take DB plan obligations off plan sponsor’s hands, and sponsors reap savings in PBGC premiums. For plans subject to the VRP cap, the savings is approximately $668 per participant, Clark says, and the savings goes on in perpetuity, as long as those participants would have been in the plan. “PBGC premium savings is a compelling argument for PRT, especially for those at the VRP cap,” he adds.

PRT transactions also relieve some administrative burdens for plan sponsors, Clark explains. “Most plan sponsors would say the most challenging issue is terminated, vested participants not keeping in touch and updating their information, making it hard sometimes to track them down. It requires additional work from plan sponsors to find missing participants. Plan sponsors should make efforts annually to update participant information or to track down those considered ‘missing,’” he says.

Clark says many plan sponsors have already done from one to three lump sum windows over the past six to eight years, but they still have participants who haven’t elected to take one. He says he is now seeing plan sponsors looking at folding those people into retiree buyout transactions, especially ones with smaller benefits. “They can get favorable pricing with the right mix of retirees and deferred annuities. This strategy is economically advantageous on the annuity purchase side, especially with the competitive pricing of deferred annuities,” Clark says.

Another benefit of a PRT transaction is that it will reduce the size of the plan. Unhoch recalls how GM’s pension plan was larger than its market capitalization when it initiated PRT transactions. “Most DB plans are 30 years or more old. They build up over the years and are now a large part of company balance sheets,” Unhoch says. “This can affect decisions companies are making because of pension contribution requirements or the time and attention the plan takes away from other points of business. If you shrink the plan, you will shrink those elements.”