Reducing Pension Risk with Buy-Ins

Most corporate treasurers are all too aware of the investment losses their pension plans suffered in the global financial crisis, and of the connection between those losses and a shift in attitude toward pension risk. In 2008, after two decades of reliable investment gains, many plans were overfunded and plan sponsors didn't have to worry much about their asset/liability mix. However, as the financial crisis materially impacted the funded status of most large defined-benefit (DB) pension plans, plan sponsors became much more aware of their liabilities, and many began considering pension risk-transfer strategies. Although most corporate pension plans' funded status has rebounded, few plan sponsors have shifted back to the carefree mentality of the 1990s.

The combined effects of the sustained low-interest-rate environment, market uncertainty, regulatory changes, planned increases in Pension Benefit Guaranty Corporation (PBGC) premiums, and recent changes in mortality assumptions from the Society of Actuaries (SOA) are prompting most plan sponsors to spend more time evaluating their plan's investment performance relative to its liabilities. As a result, increasing numbers of companies are shifting to an investment approach focused on balancing assets and liabilities, and some are employing pension risk-transfer strategies to more fully mitigate their liabilities.

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One such strategy is a pension buy-in. Simply put, a buy-in involves the purchase of a group annuity contract, which is then held as an investment in the pension plan. The goal of a buy-in is to mitigate funded-status volatility, longevity, and other risks. A buy-in can be used by plans that are fully funded, or by plans that are currently under-funded, to ensure that ongoing cash flow requirements are met for a specific portion of plan participants. In a recent MetLife poll, 15 percent of respondents who are DB plan sponsors and are considering pension risk-transfer options said they are likely to opt for a pension buy-in.

The decision to employ a buy-in is usually part of a phased strategy to reduce plan risk. Because there are several ways to mitigate pension risk, it's a good idea for plan sponsors to think of de-risking as a series of steps, with a spectrum of possible choices at each step, rather than as a "once-and-done" transaction. At one end of the spectrum is a liability-driven investment strategy in which asset allocations are generally intended to match plan liabilities. On the other end is the pension buy-out, through which the liabilities and assets are transferred to an insurer. A pension buy-in, which shares aspects of both, lies between the two on the spectrum.

Buy-ins have become the most common form of pension de-risking in the U.K., and they are starting to gain traction in the United States as well. The most recent—and largest—U.S. buy-in transaction to date was secured this summer, for almost $100 million.

Buy-ins vs. Buy-outs

Both pension buy-outs and pension buy-ins involve the transfer of risks associated with a plan's liabilities to an insurance company. However, there are some fundamental differences between these approaches to risk transfer.

With a pension buy-out, the plan's assets and liabilities are irrevocably transferred to an insurance company. Each plan participant whose benefit is "bought out" has a right to an annuity payment, enforceable against the insurer. The insurance company assumes the financial and administrative responsibilities of paying the benefits, thus relieving the plan sponsor of its contractual obligation to participants. If a participant's entire benefit is "bought out," he or she ceases to be a participant in the pension plan.

By contrast, a buy-in is the purchase of a group annuity contract from an insurance company. The contract is held in the plan's name as an asset within the pension plan. Buy-ins can cover all plan participants (and beneficiaries) or a defined subset of participants. Through this distinct asset class, the insurer guarantees the plan's ongoing cash flow needs for future benefit payments as projected for the participants identified in the contract, but the plan remains responsible for ensuring that the pension's benefits are paid; the plan is not discharged from its contractual obligation to participants. A buy-in can also be thought of as a precise type of liability-driven investing (LDI) strategy in which assets specifically match the liability cash flows, on a guaranteed basis.

Pension buy-ins can significantly reduce market, interest rate, and longevity risk for a portion of a plan's liabilities. Thus, buy-ins can be a powerful investment tool through which a plan literally reshapes the risks associated with its liabilities. If a plan sponsor finds that it is becoming increasingly difficult to justify retaining long-term pension liabilities on its balance sheet, a buy-in can accomplish the financial effects of transferring risk, while preserving the plan sponsor's right to execute a buy-out in the future, if the funding, accounting, and business considerations are acceptable.

How a Buy-in Works

When a plan sponsor secures a buy-in for its plan, the plan makes a premium payment to an insurance company to cover the projected future benefit payments of a group of plan participants. Unlike other investment products that rely on proxies, such as market benchmarks that offer rough duration matches, a buy-in provides a level of precision that cannot be matched by other products. This type of strategy can be used to cover the obligations for all plan participants or customized to cover a defined segment of the population.

Generally companies pay their premiums in cash, but a plan sponsor may also be able to structure a buy-in as an asset-in-kind (AIK) deal. This is possible when the plan has similar investments to those that the insurer would use to back the plan's benefit liability, such as corporate or government bonds. An AIK arrangement can provide additional value to both the pension plan and the insurer, as assets can be transferred from the plan to the insurer at a price between the bid and offer prices available in the market. An AIK deal may also transfer assets that the insurer does not expect to hold in its portfolio, but usually at the price at which the insurer can sell them immediately in the open market. Asset-in-kind arrangements have been a popular means of funding both buy-outs and buy-ins in the U.K. for some time, and we are likely to see AIK arrangements become more commonplace in the United States.

Regardless of the method of payment, the insurance company issues a group annuity contract to the plan on receipt of a single payment or premium. (See Figure 1, below.) Then the insurance company makes a monthly bulk payment to the plan, representing the monthly benefit amounts projected for those covered by the contract. Note that there is no relationship between the insurance company and the plan participants. The plan continues to make benefit payments to its participants, and it retains the liability for those benefits. The purpose of the contract is to ensure that the sponsor has the funds to meet the plan's projected cash flows.

Since the plan retains the obligation to pay all benefits to plan participants, PBGC protection continues, as do PBGC premiums. Additionally, the plan continues to administer the participant data and benefits, so administrative expenses continue as well. The plan also retains responsibility for making all required regulatory filings.

In calculations of asset allocation and expected return on assets for a plan with a buy-in, the plan sponsor may view the insurance contract as a fixed-income alternative. Plan sponsors must keep in mind that this is not a liquid asset. The annuity contract purchase should be viewed as a long-term asset allocation decision. That said, the contract can be discontinued at any time with a reasonable notification to the insurer. The plan will receive the value of the annuity contract less an unwind charge. Alternatively, the buy-in can be converted at any time to a buy-out (with the same insurer) without assessment of an unwind charge.

Accounting and Funding Status Implications

From an accounting perspective, a buy-in does not trigger a settlement accounting charge. U.S. GAAP requires immediate gain or loss recognition if a transaction "… (a) is an irrevocable action, (b) relieves the employer (or the plan) of primary responsibility for a pension benefit obligation, and (c) eliminates significant risks related to the obligation and the assets used to effect the settlement."¹ Since the plan sponsor continues to be responsible for payments to participants under a buy-in, and since the plan sponsor may discontinue the contract, a properly designed buy-in arrangement does not meet the requirements necessary for ASC² settlement accounting, nor will it have the related effects on financial statements.

However, a buy-in may support tying the accounting of assets to that of liabilities. Changes in interest rates over time will impact the plan's liabilities and the value of the contract. MetLife believes that, for accounting purposes, the value of the liability may be set equal to the contract value of the annuity contract. Although both are based on long-term, high-quality corporate bond yields, differences may exist between the contract value and the funding liability value as calculated under the Pension Protection Act (PPA). And since the assets and liabilities remain in the plan, the funded status of the plan should not change upon the purchase of the annuity contract.

As with any pension asset or liability, plan sponsors should consult with their accounting advisers to determine liability values for financial reporting purposes; each plan's accountant needs to make those decisions individually in the context of the plan's unique circumstances. Also, of course, the plan's accountant must determine the impact of any risk-transfer strategy to a particular plan's funded status.

1. Financial Accounting Standards Board, Summary of Statement No. 88, December 1985.

2. FASB Accounting Standards Codification.

Buy-in Decision-Making

Plan sponsors that are seriously pursuing pension risk mitigation—whether via LDI or via a buyout—should consider the buy-in as an option in their de-risking toolkit. With a buy-in, the sponsor can enjoy the virtues of a buy-out while awaiting the appropriate business conditions to execute such a transaction. Note, however, that if a plan is on a formal termination track, a buy-in may not be appropriate.

Figure 2 outlines several factors that pension plan sponsors need to address when considering a buy-in.

Plan sponsors that decide to move forward with a buy-in, or a buy-out, should consider several additional criteria in selecting an insurer to work with. First, it is important to select an insurer with pension risk transfer as a core competency. It is also extremely important to select an insurance carrier with strong financial strength ratings, to ensure that the insurer will be able to meet all of its payment obligations well into the future. Another consideration is the insurer's willingness to offer flexible options for transferring pension obligations, including structuring arrangements with assets in kind (full or partial).

Buy-ins and other pension risk-transfer solutions are worthy of consideration by plan sponsors. Despite a decline in the number of defined-benefit pension plans being offered in the United States, U.S.-based companies are currently managing $3 trillion of defined-benefit liabilities³. These liabilities will extend a long way into the future, until all of the plan's participants (and their dependents) retire and live out their lives.

In some cases, companies will decide that they are prepared to retain pension liabilities on their balance sheets and will manage them internally through careful investment and risk management. Others will pass these liabilities on to an insurer, formally or informally, if they can do so at an acceptable cost. Key to making this decision is ensuring that there is sufficient protection of participants' promised benefits. To ensure they're selecting an acceptable insurance carrier, plan sponsors may follow the guidance concerning fiduciary standards provided by the Department of Labor's Interpretive Bulletin 95-1.

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Wayne Daniel is senior vice president, U.S. Pensions, for MetLife. He has over 25 years of global insurance experience in pension risk transfer, re-insurance, and longevity markets. Prior to joining MetLife in 2011, Daniel was managing director of Longevity Markets at Credit Suisse, London.