Transferring Pension Risk through Buyout and Buy-in Arrangements

Companies seeking to reduce costs continue to offload pension liabilities at a record pace. Pension buyouts swelled to $23 billion in 2017, a 68 percent increase over the prior year. With rising interest rates and lower corporate taxes, an increasing number of companies are seeing their pension funding levels rise enough to make transferring their pension liabilities to an insurance company through terminal funding and other pension risk transfer strategies.

With the liability transferred, the insurance company assumes the risk of future payment obligations. However, the premium cost is prohibitive for companies with low funding levels because they still have to make contributions to close the funding gap while paying annual premiums to the Pension Benefit Guarantee Corp (PBGC). Rising interest rates and lower taxes, companies have been able to close that gap through improved investment performance and higher contributions to the pension plan.

 

Pension Funding Gaps Continue to Widen

The last period of time when pension funds were 100 percent (or more) funded was 2007, just before the financial meltdown and the stock market crash. As interest rates declined over the next 10 years, pension funds the gap between required payouts and the resources available to fund them widened significantly. The median funding level for the largest companies had fallen to 82 percent in 2016. During that same period, the annual premiums payable to the PBGC have also increased adding to the heavy cost burden of maintaining the growing liability.

 

Cutting the Cord with Terminal Funding Buyout

Many companies are choosing to freeze all or parts of their pension plans but they are still liable for future payouts to all employees, current and retired, covered under the plan. One of the strategies employed by companies is to transfer that obligation through a pension buyout terminal funding strategy. A company makes an arrangement with a large insurance company to purchase a group annuity in exchange for a large premium. The liability is transferred from the balance sheet of the company to the books of the insurance company which then guarantees the payouts. This arrangement may also discharge the company of its future obligation to the retirees because the pension plan is terminated and the insurance company contracts with retirees individually to guarantee their payout.

For most companies, this strategy may not be a viable option if there is a significant funding gap because the company would have to put up a significant contribution to close the gap prior to transferring the risk. Some companies with a solid cash position might make the necessary contribution just to be rid of the costly obligation.

When Terminal Funding isn’t an Option

In recent years the terminal funding strategy has morphed into a variation that doesn’t require complete plan termination. Using the same principle of risk transfer, companies may now choose a buy-in over a buyout because it may offer more flexibility in how the company chooses to wind-up its pension plan. In addition, having a funding gap does not necessarily preclude a company from executing a buy-in.

The major difference between a buyout and buy-in strategy is that, instead of transferring the pension liability to the insurance company, the company purchases a group annuity to insure its future obligation to retirees while maintaining the annuity as an asset on its books. The company maintains the financial obligation of ensuring future payouts, but the insurer assumes the risk associated with the plan’s liabilities.

The buy-in arrangement may be preferable for companies that would like to take a more strategic approach to terminating its plan. For instance, plan termination can be phased in over a period of time. The buy-in can be targeted at a specific range of employees or retirees that present the company with greater risk exposure. With greater risk exposure and plan volatility mitigated through the buy-in, the plan can take advantage of increasing interest rates and lower tax rates to focus on getting the remainder of its plan to overfunded status or construct a more cost efficient cash buyout of the remaining employees covered under the plan.

Summary

With increasing PBG premiums and expanding life spans, an increasing number of companies are looking for relief from the ever increasing costs of providing pension benefits. Improved investment performance along with lower taxes should enable some companies to close their funding gap, which would make terminal funding through a buyout arrangement a viable option. Companies with underfunded pensions looking for immediate relief or more flexibility in terminating their plan could consider a buy-in arrangement, which would enable them to transfer longevity, investment and interest rate risk to an insurer for certain segments of their plan’s participants.