Prelude to pension risk transfer

Neil Drzewiecki

By Neil Drzewiecki
Head of the Institutional Longevity business for Massachusetts Mutual Life Insurance Co.’s Institutional Solutions.
Posted on Oct 30, 2019

Classical music fans are familiar with preludes as an introductory set of music played before the main concert. German composers Johann Pachelbel and Johann Sebastian Bach, for instance, are famous for their organ-inspired preludes.

The pension world has preludes of its own in the form of cost and risk management strategies that are sometimes employed before a permanent exit strategy such as a pension risk transfer (PRT) or pension risk buyout is consummated. Two of those preludes are often plan hibernation and investment hedging strategies. Both approaches have upsides as well as downsides, the latter primarily being the inability of these approaches to completely remove all financial risks over the long term. MassMutual’s recent white paper, Key Decisions for De-risking Your Pension Plan , takes a deeper dive into these strategies.

A defined benefit plan is hibernated by closing or “freezing” the plan to any new entrants or participants, and stopping accruals for existing participants who are still eligible for benefits. Freezing the plan protects against the risk of unanticipated benefit increases. However, the plan remains exposed to many other risks, especially interest-rate risk. Plans that are placed into hibernation typically reallocate investments to hedge the exposure to a plan’s liabilities.

A plan adopting a hibernation strategy will typically establish a “glide path” in which investments are increasingly allocated toward fixed income as the plan’s funded status improves. This is done for two reasons: assets can’t revert to the plan sponsor, so as a plan approaches 100 percent funded, the risk/reward trade-off associated with equities starts to diminish. Additionally, fixed income assets (bonds) offer a hedging effect on pension liabilities; when interest rates decrease, the value of bonds increases (and vice versa).

Traditional Glide Path Strategy

The chart below illustrates what a sample glide path might look like. In this example, the plan would be targeting a fixed-income allocation of 40 percent when the plan is 80 percent funded. Once the plan becomes 85 percent funded, 10 percent of the total assets would be reallocated from equities to fixed income to bring the fixed-income allocation up to 50 percent.

chart 1

For illustrative purposes only.

Advocates of hibernation promote the tactic as a way to save money and reduce risks over a period of time before eventually executing a pension buyout, pension risk transfer or combination of both. However, hibernation may not be a panacea for every pension plan or pension risk management objective.

Once in hibernation, the pension must continue to be managed to some degree and therefore continues to incur costs, including investment management expenses. Other costs continue such as actuarial consulting, recordkeeping and reporting, not to mention the consumption of time from management.

The fixed-income assets in which a plan invests can be allocated to match the liability’s sensitivity to interest-rate movements (called “duration”) to offset changes in the plan’s liabilities. When interest rates decrease, the asset portfolio will increase in value in an amount close to the increase in liabilities.

This strategy — known as hedging — is typically pursued in a plan that has progressed along its glide path and can work well in reducing the investment risks associated with pension plans. Hedging can work well in reducing the investment risks associated with pension plans but does not eliminate the risk. It’s impossible to hedge every risk and therefore some market risk remains, albeit lower and less volatile than an investment strategy with no hedging. Even interest rate risk isn’t fully hedged in a fixed income investment strategy that matches the plan’s asset and liability durations.

Interest rates on assets (referred to as yields) aren’t all created equal. The yield on assets can vary significantly due to two main components: The term of the asset (1-30 years) and the market’s view of the creditworthiness of the bond issuer (more risky companies have higher yields than less risky companies, all else being equal).

The duration of a plan’s liability indicates its relative sensitivity to interest rate risk assuming all interest rates move by the same amount. In reality, that rarely happens; rates at different terms and credit ratings tend to move differently. This means that even a “fully hedged” (assuming 100 percent fixed income with a duration matching that of the plan’s liabilities) plan is still exposed to interest rate risk. This can be managed through more sophisticated hedging strategies but those become much more difficult (and possibly more expensive in terms of investment fees) to execute as a plan sponsor.

Meanwhile, the assets and liabilities of the DB plan remain on the sponsor’s balance sheet. The goal of many pension risk transfers is in part to extinguish the long-term financial obligations and potential impact from a company’s profit-and-loss statement.

The management of interest rate risk (and other risks), administration of pension-like liabilities, and development and execution of investment strategies that appropriately back those liabilities are all strengths of insurance companies and can be accomplished through a PRT.

While a PRT may be considered a symphony of risk management, many employers seek preludes in the form of hibernation, hedging or other strategies. Ultimately, the goal is a happy tune for both plan sponsors and their participants.

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