Pension risk transfer (PRT)is a process where a company transfers its defined benefit pension liabilities to a third party, typically an insurance company. This transfer can involve part or all of the defined benefit pension plan's obligations. The main goal is to reduce or eliminate the financial risks of managing a defined benefit pension plan.
Pension risk transfer has been popular in recent years. This shift has moved hundreds of billions of dollars in defined benefit pension liabilities from employer sponsored plans to insurance companies.
Risks of pension fund management
Defined benefit pension plans come with significant financial risks for a company. Examples include:
- Investment risk: The possibility that the investments made by the company may not yield the expected returns, potentially leading to funding shortfalls.
- Longevity risk: The risk that retirees will live longer than expected, resulting in longer than-anticipated pension benefit payouts.
- Interest rate risk: The risk that changes in interest rates will affect the value of the company's investments and liabilities.
To manage these financial risks, companies often use Pension Risk Transfer (PRT) programs.
Pension risk transfer explained — How does it work?
The two main types of pension risk transfer transactions are buyouts and buy-ins.
- Buyouts: In a buyout, a company transfers its defined benefit pension responsibilities to an insurance company. The insurance company converts these pension plan liabilities into annuities representing the pension plan participants’ vested benefit and pays the benefit due to each of those individuals ensuring that they receive their earned benefits. This transaction effectively removes the pension plan liabilities from the company's balance sheet.
- Buy-ins: In a buy-in, the company buys an annuity contract from an insurance company to cover their defined benefit pension plan liabilities. However, unlike a buyout, the liabilities remain on the company's balance sheet. The annuity serves as an asset that matches the pension plan liabilities, providing a hedge against the associated risks.
Why do companies choose pension risk transfer?
In addition to those listed above, several factors drive companies to opt into including pension plan risk transfer in their strategy:
- Financial stability: Pension liabilities can introduce significant challenges when reviewing a company's financial statements. By transferring these liabilities, companies can stabilize their financial outlook and focus on their core business operations.
- Regulatory compliance: Pension plans are subject to stringent regulatory requirements. By transferring their liabilities, companies can lower their regulatory burden. They can do this without managing the costs of an in-house compliance program and team.
- Cost savings: Managing assets of a pension plan can be costly. Pension risk transfer can save money by cutting administrative costs. It also removes the need for ongoing payments to the pension fund.
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The role of insurance companies in pension risk transfer
Insurance companies play a crucial role in pension risk transfer transactions. They possess the expertise and resources for pension risk management associated with financial liabilities.
When a company transfers its pension plan liabilities to an insurance company, the insurer assumes responsibility for paying the benefits to the plan participants. In return, the company pays a fee to the insurer. This fee usually depends on the current value of the pension plan liabilities.
Insurance companies benefit from these transactions by acquiring assets that they can invest to generate returns. They use their investment knowledge and size to manage the assets. This helps them meet their obligations to the plan’s participants. After the pension plan liabilities are transferred to the insurance company and annuities purchased, the pension plan participants whose benefits were transferred are no longer participants in the company’s pension plan. They are annuitants of an annuity representing their former vested pension plan benefit. In most cases, it’s a win-win situation for both the company and the insurer.
Pension risk transfer is a powerful approach that enables companies to manage their pension liabilities more effectively. Alight has over 40 years of experience in the pensions/defined benefit plan space and is an experienced partner. We understand the intricacies of these pension de-risking transactions and can help navigate the process successfully.
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