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Freezing your plan is often the first step to address pension risk, but it is certainly not the last. From changing the plan's investments or transferring obligations to an insurer, to terminating the plan altogether, there are many ways to mitigate and/or eliminate risk. And they often work together.
However, they are not all the same. Risk can be reduced, transferred, or eliminated. The right approach depends on where a plan stands today, how well funded it is, and your organization's business goals.
In this article, we break down the differences between pension terminations and pension risk transfer and the factors that influence when each strategy might be appropriate for an organization looking to reduce or eliminate its pension risk.
Pension risk transfer is a strategy for transferring some or all of a plan’s financial and longevity risk from the plan sponsor to another party, typically an insurance company.
One common example is an annuity purchase, where an insurer assumes responsibility for making future benefit payments to participants in exchange for a premium paid by the plan. But PRT is not an all-or-nothing decision. Sponsors have options for how and when they approach a transaction, and funding plays an important role.
Plans less than 80% funded: Reviewing plan design, commissioning pension forensic studies, and starting plan hygiene improvements are the initial steps to reduce risk at this stage, largely to locate problems and reach funding.
Plans 80% - 100% funded: Offering lump-sum distributions, initiating lift-outs, and preparing for plan termination are the best routes to reduce risk, ongoing costs, and ultimately eliminate it at this stage.
Plans over 100% funded: There are limitations on how surplus assets can be used. For organizations that would like to retain the advantages of a pension plan, these assets could be used to fund a new design with reduced risk. October Three offers specialized plans for that exact scenario.
When a plan is terminated, the sponsor's goal is to satisfy the plan’s obligations and bring the plan to an end. Depending on the circumstances, that may involve settling benefits through lump-sum distributions, an annuity purchase, or a combination of approaches.
This means the strategies discussed above don't necessarily compete with termination but can be steps along the way.
For example, a sponsor may use investment strategies to improve the plan's funded position. Once the plan is sufficiently funded, it may pursue an annuity purchase to transfer the remaining pension obligations. And once all plan obligations have been satisfied and the required benefits have been settled or distributed, the plan can be terminated.
Like freezing a pension plan, risk transfer serves as a way to reduce risk in the plan, but termination remains the only way to remove risk all together.
There isn't a single de-risking strategy that makes sense for every plan. The right approach depends on the sponsor's objectives and the plan.
Consider the following:
What is your final objective? Are you looking to reduce pension risk or eliminate the plan altogether?
How well funded is the plan? Does the plan have enough assets to support the strategy you are considering?
How much risk are you comfortable retaining? Even a well-funded plan can remain exposed to market, interest-rate, longevity, and operational risks.
What is your desired timeline? Is termination something you want to pursue soon?
How much ongoing work can your organization support? A frozen plan may have fewer moving parts than an active plan, but it still requires ongoing oversight and administration.
What opportunities does the plan's current funding position create? A plan that is approaching or exceeding full funding may have options that were not available previously.
Your answers can lead sponsors down very different paths. To put these questions into action, below are a few common scenarios, and how a plan sponsor might respond.
In this case, immediate termination may not be practical. The sponsor could instead focus on improving the plan's funded position through additional contributions, investment positioning, or other risk-reduction strategies.
For example, the sponsor could use a lift-out to transfer the pension obligations of a subset of participants, such as retirees, to an insurance company. This can reduce the plan's overall liabilities and ongoing risk while allowing the sponsor to address the remaining population over time. The objective may be to put the plan in a stronger position so that termination becomes more achievable later.
In this situation, the sponsor may have opportunities to reduce pension risk while evaluating its longer-term options. For example, like scenario A, a lift-out could transfer the liabilities to an insurance company. The sponsor could also use an LDI strategy to better align the plan’s investments with its liabilities and reduce exposure to market and interest-rate risk. These approaches can provide a middle ground, allowing the sponsor to reduce risk without committing to a full plan termination.
In this situation, the focus becomes getting the plan into the right financial and operational position to complete the termination process. That could include improving funding, positioning assets appropriately, evaluating PRT opportunities, and preparing for the administrative work required to settle benefits. Unlike the scenarios above, individual de-risking strategies are steps in the process to reach termination.
As long as a plan remains in place, the sponsor must continue to oversee it. That responsibility may be manageable, especially for a well-funded frozen plan. But, as mentioned in our prior article, the risk remains.
Satisfying the plans obligations and terminating the plan are the only way to completely remove the risks.
If termination is your desired endpoint, the right approach can help shorten the termination timeline and reduce your organization's workload and risk.
However, there are still potential advantages and disadvantages if you'd prefer to reduce risk but maintain your plan. In our next article, we'll cover exactly that by looking at the pros and cons of maintaining a frozen pension plan and what sponsors should consider as they navigate de-risking their plan.
Or, if you’re ready to jump in today, let’s connect to discuss your plan and explore how we can help you reduce risk for your pension.