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Charlie Clark: Okay. Hello and welcome to Critical Point, presented by Milliman. I’m Charlie Clark, a principal at Milliman, and director of the firm’s Employee Benefits Research Group. With the passage of COVID-19 stimulus legislation this year, many CFOs and plan sponsors are likely seeing in the waning time of 2021 an opportune time to de-risk their company’s defined benefit pension plan liabilities. Now, historically, the pension risk transfer market tends to see increased activity in the second half of the year, which is only compounded today by a low interest rate environment and a likely rise in the PBGC premiums. The PBGC, by the way, being the Department of Labor’s insurer of private company pension programs. But for corporate financial officers who are considering any annuity buyouts, there’s an opportunity cost to a 100% pension risk transfer. It could be viewed as quote “Leaving money on the table.” So here to discuss pension risk mitigation versus risk transfer are Zorast Wadia, a principal with Milliman. Good afternoon, Zorast.

Zorast Wadia: Good afternoon.

Charlie Clark: And Bret Linton, the Employee Benefits Practice director at Milliman. Hi, Bret.

Bret Linton: Hello, Charlie.

Charlie Clark: Okay, so Bret and Zorast are joint authors of a paper that evaluates DB plan pension risk mitigation, and for you out there if you wanted to read it, it was just posted to Chief Investment Officer’s website. So let’s start a discussion on this. Conventional wisdom today in September of 2021 touts that annuity buyouts to a third-party insurer are quote “safer,” and quote “less costly risk mitigation strategy.” But the third-party insurers certainly have incentives to promote these transactions, but in your paper you talk about opportunity cost. Can you provide us with some details on this, please?

Zorast Wadia: Sure. Along with the significant cost involved with annuity buyouts, including risk premiums and built-in profit margin for insurers, plan sponsors also need to consider the opportunity cost of losing the future asset returns. For instance, a plan sponsor that engaged in a pension buyout would’ve missed out on double-digit plan asset returns over the past two years. This forgone asset growth can represent a significant opportunity cost that may even outweigh the risk reduction goal of the transfer itself.

Bret Linton: That’s a great comment, Zorast, and I would also add I have a certain client that maybe I’ll talk about in just a little bit. But in their situation, they had a sizeable pension plan, and when they see the material, and they talk to brokers for annuity placements, basically, the brokers are comparing the present value of all the administrative expenses, versus the ongoing expenses. And from that point of view, ignoring the assets, it appears to make sense financially, even though it can be a big one-time up-front cost initially. But when you look at the opportunity cost with the assets and what those can do for you, it can be a completely different story.

Charlie Clark: So both to Bret and Zorast, if not pension risk transfer, what then? What options should the CFOs and the CIOs be looking at this time?

Zorast Wadia: Well, I’m glad you asked, Charlie. As an alternative to risk transfer, a plan sponsor can explore risk mitigation. With pension risk mitigation, a company can reduce and manage risk according to its risk tolerance. This is normally done via plan design and risk management strategies, including moving assets into safer investments, such as fixed income assets instead of equities. With a glide path or similar strategy, a plan sponsor can shed equity risk and take on more fixed income assets as their funded status shows improvement. Now, the ultimate goal of any risk management strategy is to balance assets and liabilities, and ensure that they move in lockstep as the plan goes forward.

Bret Linton: One of my clients that has a pension plan that has about a billion dollars in liabilities several years ago was approached by an annuity placement broker. They did this expense analysis, and from a present value it seemed to make sense that it would be cheaper over the long term to just pony up some money right now to terminate the plans. But as Zorast mentioned, there’s a lot of expenses that the insurance companies add as well. And so what they did not take into account were the opportunity cost of the assets, and what those might do for them, as well as the opportunity cost for assets of the current plan’s sponsor that could be used elsewhere instead of the pension plan. So in this case, this company decided to implement strategic hibernation policy that would allow them to reflect and capture the asset returns on the pension plans, and allow that to help fund the pension plan liabilities. And at the time, I think the estimate was that going through a pension plan termination, they were about 80%, close to 80% funded, and they would’ve had to put in about $220 million into the pension plan just to terminate it. Like I said, they were considering it because it seemed to make more sense when you look at the long-term cost of the pension plan. However, after putting into place the hibernation strategy, instead of spending the $220 million, they kept that in the corporate asset account, used that money for acquisitions and other ventures. And over the last several years, that pension plan has, with those investments, closed that funding deficit for plan termination by the tune of almost $200 million. And with that hibernation strategy, they took some risk off the table, they did a few other things we might talk about a little bit later. But the assets helped fund about $170 million of that deficit over the last several years, and that was huge for the company for allowing them to focus assets elsewhere, and letting those assets continue to grow. Because the growth of those assets were much more in excess of any expenses on the plans, including PBGC premiums, attorney fees, actuarial fees, etc. And so they’ve only had to put in, I think, $30 million over the last seven years or so. And so very beneficial for them to have those other assets, and they’re going to continue with this policy until the plan actually is fully funded, at which time they can terminate without much assets at all.

Charlie Clark: Okay, so the listeners will forgive me for this kind of cheeky comment that hibernation is just not for polar bears, huh? But besides the plan hibernation, transferring pension risks to the plan participants in the form of a lump sum payment, could make some economic sense for some companies when the annuity buyout would not. How can a plan sponsor assess forgoing future of asset returns with a lump sum window strategy, Zorast?

Zorast Wadia: While plan sponsors are forgoing future asset returns with a lump sum window strategy, there can be advantages of offering these windows over an annuity buyout for some participants. For example, by transferring mortality risk to the plan participant rather than a third-party insurance company, the plan sponsor can avoid paying risk premiums and additional fees based on a profit margin for the insurer. Now this could be a significant savings. Additionally, a plan sponsor can offer lump sum payouts based on an interest rate that was in effect at the beginning of a plan year. Now, depending on how interest rates subsequently move during the year, plan sponsors can potentially release more in plan liabilities than they would release in plan assets. This in particular would result in a balance sheet gain, and would not be possible under an annuity buyout transaction.

Bret Linton: Great point, Zorast. One thing I’d like to add on that, Charlie, as well, is when plan sponsors do these lump sum sweeps, there’s the question of the paternalistic aspect of a pension plan, or fiduciary responsibility that plan sponsors have. And with these lump sum sweep windows, like Zorast said, there might be financial opportunities, but also it’s opportunities for the plan participants as well, especially for the benefits that are smaller in nature. So, for example, if a plan participant has accrued only $100 a month in annuity benefits, and a lump sum is a minimal amount, that’s beneficial for both potentially the plan sponsor and the participant in the following ways. One, the cost of administering those plans relative to the benefit value doesn’t make economic sense for the plan sponsors. So they can get out the benefits that have—that are smaller, that as a percentage of cost are higher. But in addition to that, the participants are usually happy to get those lump sum sweeps, or payouts, because they’re not really counting on that money anyway for retirement. It’s so small that they would rather have it now as a lump sum and do what they would like with it.

Charlie Clark: And I guess, Bret, that might even include rolling it over if they decide to do that to their own personal IRAs? And we’re not talking about personal IRAs here, but I imagine that that would be a consideration, any type of lump sum window design?

Bret Linton: Correct.

Charlie Clark: Okay. So as we get to the end of this //

Charlie Clark: // Can you just do a wrap-up for us on what your main messages are to the plan sponsors, the CIOs and the CFOs, about the true economic value?

Zorast Wadia: Well, with the passage of funding relief under the American Rescue Plan Act, a targeted hibernation strategy, as Bret discussed earlier, can make more sense financially over a risk transfer strategy. And that’s because plan sponsors now have a longer period of time to pay off their deficits and accumulate plan assets in a far less risky manner. With funding relief, CFOs now have time on their side. The assets in their pension plans can be put to work for them, ultimately putting plans in a more favorable position to terminate when it makes more economic sense.

Charlie Clark: Bret?

Bret Linton: Yeah, in closing, Charlie, and thank you for leading us in the discussion, I would just add a quote from the Textron CIO, Charles Van Vleet, who said “Why give away perfectly good capital?” And I think this plays into here with the pension plans as well when you’re thinking about wrapping up and terminating a pension plan. Putting in a hibernation strategy that can reduce risk but allow the plan to help you fund itself to plan termination is a financially viable method of managing a pension plan, one that I think is gaining more attention with the passage of new pension relief that Zorast just described.

Charlie Clark: Thanks so much, Zorast, thank you, Bret. Appreciate your time for joining me in this interesting discussion. Everyone, you’ve been listening to Critical Point, presented by Milliman. To listen to other episodes of our podcast, visit us at Milliman.com. And you can also find us on iTunes, Google Play, Spotify, and Stitcher. See you next time on Milliman’s Critical Point.