What Is a Pension Risk Transfer?
A pension risk transfer occurs when a defined benefit pension provider offloads some or all of the plan’s risk (e.g., retirement income liabilities to former employee beneficiaries). The plan sponsor can do this by offering vested plan participants a lump-sum payment to voluntarily leave the plan early (buying out employees' pensions) or by negotiating with an insurance company to take on the responsibility for paying those guaranteed benefits.
- Pension risk transfer is when a defined-benefit (DB) pension provider seeks to remove some or all of its obligations to pay out guaranteed retirement income to plan participants.
- Defined pension obligations represent an enormous liability to companies that have guaranteed retirement income to its current and past employees.
- The pension provider may alternatively seek to transfer some risk to insurance companies via annuity contracts or through negotiations with unions to restructure the terms of the pension.
How Pension Risk Transfer Works
Companies transfer pension risk to avoid earnings volatility and enable themselves to concentrate on their core businesses. The total annual cost of a pension plan can be hard to predict due to variables in investment returns, interest rates, and the longevity of participants.
Large companies had been holdouts on the trend of transferring pension planning responsibility to employees, but that began to change in 2012 when a range of Fortune 500 players sought to transfer pension risk. They included Ford Motor Co., Sears, Roebuck & Co., J.C. Penney Co. Inc., and PepsiCo Inc. (which offered former employees an optional lump-sum payment), as well as General Motors Co. and Verizon Communications Inc., which purchased annuities for retirees.
Types of risks addressed in risk transfer transactions include the following:
- The risk that participants will live longer than current annuity mortality tables would indicate (longevity risk)
- The risk that funds set aside for paying retirement benefits will fail to achieve expected rates of investment return (investment risk)
- The risk that changes in the interest rate environment will cause significant and unpredictable fluctuations in balance sheet obligations, net periodic cost, and required contributions (interest rate risk)
- The risks of a plan sponsor’s pension liabilities becoming disproportionately large relative to the remaining assets and liabilities of the sponsor
Companies have historically adopted pension plans for a variety of reasons, such as attraction and retention of qualified employees, workforce management, paternalism, employee expectations, and favorable tax policies.
In light of the voluntary nature of sponsorship, plan sponsors generally believe that the ability to close a plan to new entrants, reduce or freeze benefits, or completely terminate a plan (after providing for all accrued benefits) has been and remains necessary to encourage adoption and continuation of plans.
Types of Pension Risk Transfers
There are several ways that a pension provider can go about transferring the risk it has incurred through its obligations to pay guaranteed retirement income to employees:
- The purchase of annuities from an insurance company that transfers liabilities for some or all plan participants (removing the risks cited above concerning that liability from the plan sponsor)
- The payment of lump sums (buyouts) to pension plan participants that satisfy the liability of the plan for those participants
- The restructuring of plan investments to reduce risk to the plan sponsor