The Prodigal Series Returns

Welcome back to the Pension Series everyone! I hope you didn’t interpret my several month hiatus (from the series) as a lack of interest in the intersection between pensions and Financial Independence (FI). If you did, then let me assure you that I remain committed to the topic. In fact, my Facebook Group members can attest that I typically post one or two articles a week to prompt discussion on the topic of pensions and FI. That said, I must admit after the rush to write and publish parts 11 through 13 of the Pension Series, it took me a while to find more content that met my standards. At this point in the series, I look for topics that I haven’t already addressed; that help my readers navigate the Golden Albatross decision; and/or enable planning for FI using a pension.

The Search Is Over

Luckily, I recently found a few more topics which deserve examination. Several of the latest topics stem from articles I posted in my Facebook Group. In fact, it wasn’t until I posted an article about FedEx transferring a large portion of its pension fund to Met Life in my Facebook Group, that I realized the topic of pension risk transfer deserved an entire article itself.

In the past few months I’ve noted several stories from both the U.S. and U.K. about companies transferring some or all of their pension funds to insurance companies. The FedEx story started a conversation in my Facebook Group about winners and losers in risk transfer scenarios where a pension fund transfers obligations to an insurance company. Between the company who owns the pension fund, the insurance company, and the plan participants; most of the respondents from my group seemed to think the plan participants (i.e. current and future pensioners) lost. I must admit that I agreed.

However, after reflecting on the conversation, I realized that neither I nor the respondents from my group actually knew the answer. We opined that in the zero-sum world of pension finance, the pensioner probably lost; but we actually didn’t cite any facts. Thus, I felt compelled to research the issue in order to determine whether or not our premise was true. The remainder of this article constitutes my attempt to prove or refute the that the pensioner loses if/when their pension is transferred to an insurance company. I hope you find it useful.

Pension Risk Transfer

The concept that drives companies or their pension funds to transfer some, or all, of their pension liabilities to an insurance company is called “pension risk transfer”. My longtime readers might recognize the concept since I addressed it at the individual level it in my Pension Lump Sum article. I touched upon it again in my Pension Lump Sum Case Study article as well. However, I want to briefly revisit the issue for those who didn’t read, or don’t remember, those articles.

My standard online repository of definitions for all financial topics, Investopedia, describes pension risk transfer in the following terms:

When a defined benefit pension provider offloads some or all of the plan’s risk – e.g.: retirement payment liabilities to former employee beneficiaries. The plan sponsor can do this by offering vested plan participants a lump-sum payment to voluntarily leave the plan, or by negotiating with an insurance company to take on the responsibility for paying benefits. Companies transfer pension risk to avoid earnings volatility – they no longer have to pay for unfunded pension obligations – and to free themselves to concentrate on their core businesses.

What the above definition above doesn’t explain is that insurance companies turn the pension liabilities into annuities for current or future retirees in frozen pensions. The pension fund, or company backing it, typically funds these annuities by transferring a large chunk of pension fund assets to the insurance company. In other words, the pension fund pays the insurance company to take the pension liabilities off their hands. After that, insurance companies use their actuarial wizardry (which I believe most actuaries call actuarial science) to keep these annuities funded.

Why do companies, or their pension funds, transfer their liabilities? While the Investopedia definition pointed out two reasons (concentrate on business and avoid earnings volatility); it didn’t lay out all the reasons. Fortunately, in October 2016 the American Academy of Actuaries (AAoA) produced an excellent Issue Brief which addressed the five Ws involved in pension risk transfer, specifically the “why”. Since I don’t expect anyone to read it, I summarized the major reasons from the article below:

1. • longevity risk — plan participants (pensioners) living too long
   • investment risk — under-performance by the invested assets that fund the pension
   • interest rate risk — fluctuating interest rates cause pension fund balance sheets to swing wildly; which obligates pension fund sponsors to cough-up more money to keep pensions funded
   • bankruptcy risk — pension obligations create doubt in a pension fund sponsor’s (i.e. a company’s) ability to continue as a going concern

Winners and Losers: The Insurance Companies

Based on my research, the insurance companies are clear winners in the institutional game of pension risk transfer. As the Wall Street Journal pointed out in March of 2017:

Prudential has emerged as the leader in U.S. pension-risk transfer. The insurance giant, which traces its roots to the Widows and Orphans Friendly Society in 1873, has signed 10 jumbo deals through which it has assumed nearly $45 billion of corporate pension obligations, involving more than 320,000 people.

As the article goes on to point out, part of Prudential’s lead in this market stems from a 2006 decision by the company to re-invigorate an oft-ignored part of their business. It was an area called pension closeouts, “in which insurers assumed the liabilities of organizations that wanted to shut down their entire pension plan.“. Apparently Prudential proved so good at this obscure part of the insurance business that they still administer Cleveland’s Library Pension (which they assumed in 1928) for two old ladies in their 100s.

Prudential isn’t the only insurance company in the business of pension risk transfer though. Plenty of other large insurance companies, both in the U.S. and overseas, now provide the service. This includes MetLife and U.K. company Legal & General. As Investment News noted in March of 2018, “Pension risk transfers swelled nearly 70% in 2017”. A point emphasized in their article by this graph:

That isn’t to say that assuming some, or all, pension liability from a company is risk-free for insurance companies. As Investment News recently noted, MetLife currently finds itself in the midst of a scandal involving their mishandling of 2 percent, or 13,500, pension clients’ accounts — clients brought-in through pension risk transfers. Bad publicity aside, I can’t find any historical evidence regarding what I would consider the obvious downside risk for insurance companies: bankruptcy due to the assumption of too much liability from pension risk transfer. Nor can I find any literature discussing that risk on the internet.

Now, part of that may be due to newness of the pension risk transfer market. As the bailout of AIG showed, the insurance industry is just as capable as the financial industry of creating financial instruments that blow-up in their face when the economy takes a turn for the worse. However, the annuities part of the insurance industry is fairly old and stable. And as the WSJ article showed, this part of the business is simply a new twist on an old part of the industry. In other words, it’s not some new-fangled market-swap derivative device meant to juice bottom lines.

Another explanation for a lack of concern over pension risk transfer within the insurance industry may be how these deals are structured. As the 2016 AAoA Issue Brief notes, insurance companies only take on the liabilities for current pensioners (i.e. those already getting paid a pension), or for future pensioners in frozen plans (i.e. workers whose pension benefits no longer grow). Thus, they don’t assume the dynamic, uncertain, and volatile risk for active pension plan participants who are still working towards a pension. That potential explanation is further reinforced by the AAoA Issue Brief. It doesn’t even list insurance companies as one of the concerned parties impacted either positively or negatively by pension risk transfer.

Winners and Losers: Companies and Their Pension Plans

The winner/loser case is a little less clear-cut when it comes to a company that offloads its pension liability through pension risk transfer to an insurance company. From what I can tell by looking at the issue, it varies depending on the specific set of circumstances surrounding the company’s decision. That shouldn’t come as a surprise to my long-term readers since everything related to pensions comes down the specific pension fund, or company, and its issues.

The most favorable conditions for a company to transfer its pension risk include a high interest rate environment, and a complete closeout of a frozen pension. This specific set of circumstances allows a company to shift all future pension liability at a low(er) price to an insurance company — since a closeout is a complete shutdown of the pension, and high interest rates translate to steady long-term returns for the insurance company. This basically means a company pays an insurance company less to take away all of its pension problems.

Following this logic, the least favorable conditions under which a company could transfer pension liabilities to an insurance company include a low interest rate environment with a large ongoing number of active plan participants. The second part, a large number of active participants in the pension plan, is non-consequential to the insurance company, but absolutely vital to the company which transfers a part of its pension liabilities.

Why? Well as I pointed out above, a company pays an insurance company to assume its pension liabilities. It typically does this with assets from the pension plan itself. However, by doing so, it leaves the remainder of participants contributing to a potentially weaker pension plan with a far smaller risk pool, and far less assets to secure its future liabilities. As the Issue Brief from the AAoA points out, it means a company could potentially trigger its benefit restriction threshold for the remaining participants.

However, other than potentially weakening the ability of a pension plan to pay for future liabilities, the only other drawback for a company looking to engage in pension risk transfer activity appears to be expense. Some companies may choose to wait out low interest rates, in order to reduce the long-term costs of the pension liabilities they hope to transfer. Other companies may choose to move forward and transfer the liability no matter the cost. Either way, any company that transfers pension risk to an insurance company, shifts a large potential future unknown cost, into the present. In doing so, they may lose in that quarter (in terms of share price) or even for that year (for the same reason), but in the long term they probably win. The only potential loser in this situation from the corporate side is the pension fund itself.

Winners and Losers: Plan Participants

Given the relative newness of the pension risk transfer industry, it’s too soon to definitively judge whether or not pension plan members end up better or worse off when their pension is transferred. Currently, the winning and losing conditions for the individual plan participants appear to mirror those for the companies; but only to a certain extent. That said, a lot depends on the financial particulars of the insurance company acquiring the pension obligation, and the individual circumstances of the plan participant.

Early indications are that retirees already drawing a pension appear to be safe. While we lack enough data to call them winners, they certainly haven’t lost. During my research, the only negative article I found was the MetLife article I noted above. The MetLife issue centers on how hard (or not) MetLife tried to track down owners of unclaimed pensions. To me, this indicates the pensions weren’t of a high enough amount for their rightful owners to keep track of themselves. However, that doesn’t excuse MetLife for what several state insurance regulators perceive as a lack of effort.

Other than the MetLife story, I found no other negative results in the news from pension transfers. Insurance companies don’t appear to be shorting plan participants. Or at least, no one has complained to the press about it. On the contrary, a January 2018 Plan Advisor article noted that when they followed up on the impact of the 2015 Verizon pension risk transfer to Prudential, the chairman for the Association of BellTel Retirees admitted that Prudential “has so-far effectively served his fellow retirees well”. This is significant since the BellTel Association fought the Verizon to Prudential transfer all the way to the 5th Circuit Court of Appeals on the basis that their members would be worse off.

Obviously, the BellTel Association lost in court; but they don’t seem to have lost in the aftermath. From a certain point of view, they may even be in better hands. The responsibility for their pension’s financial future was transferred from a company whose primary business is providing wireless telecommunications services, to an insurance company with a 143-year-old track record of successfully pooling risk for uncertain future events based on actuarial science. As the 2016 AAoA reported noted:

Most group annuity products are funded well in excess of 100 percent on a statutory basis and, thus, are less at risk of default in the first place.

Federal vs. State Protections

Although they lost, the BellTel Association argued that by transferring the pension obligations to an insurance company, their members would lose the Federal protections afforded by the Employee Retirement Income Security Act of 1974 (ERISA). That’s true. In place of the protections delineated in ERISA, and backed by the Pension Benefit Guarantee Corporation (PBGC); annuity regulation and protection rests with state insurance regulators. I assume this means the state in which an insurance company, like Prudential, is headquartered; but I haven’t verified that yet. That’s important because maximum reimbursement amounts vary from state-to-state for an annuity policyholder should their insurance company go bankrupt.

While losing Federal protections and the PBGC’s backing might sound bad, a lot of that depends on the type of pension plan that a participant belongs to. The PBGC runs two different types of insurance schemes meant to protect pension plan participants: the Multi-Employer Program, and the Single Employer Program. The Single Employer Plan provides insurance coverage for corporate pension plans owned by a single company. The Multi-Employer Plan covers collectively bargained pensions “maintained by more than one employer, usually within the same or related industries, and a labor union“.

It’s extremely important to note that the Single-Employer Program is close to full solvency; while the Multi-Employer Plan is within 10 years of insolvency … if not sooner. Not only that, but when the Multi-Employer Plan assumes responsibility for a defunct pension fund, payments to participants are reduced to somewhere between 6% and 50% of a person’s promised pension. Payout percentages ultimately depend on the gap between a pensioner’s promised amount, and the current maximum amount that the PBGC pays from the Multi-Employer Plan ($12,870). No matter what though, reductions like this devastate any pensioner’s retirement budget.

President Trump recently tasked Congress with sorting out the Multi-Employer Program’s problems. As of May 2018, joint Senate and House hearings are ongoing. However, I hold little hope they will result in significant improvements to the Multi-Employer Plan. As the head of the PBGC recently testified, the funding issues associated with the Multi-Employer Plan are decades old. So old in fact, that they outlasted multiple presidential administrations from both U.S. political parties. Also, since multi-employer pensions are synonymous with union pensions, and the Republican party is the traditional antagonist of organized labor; it doesn’t require a genius to conclude that there’s probably little appetite for a Federally financed solution in a Republican-controlled Congress.

Winners vs. Losers: Multi-Employer vs. Single Employer Plan Participants

Ideally then, multi-employer pension plans, or more specifically their participants, stand to benefit the most from pension risk transfer; especially since the PBGC’s Multi-Employer Plan won’t be there to protect them by the mid-2020s. Conversely, participants in single-employer pension plans, backed by the PBGC’s well-funded Single Employer Plan, benefit far less. Although I must point out that currently the Single Employer Plan tops out their guaranteed pension coverage at $65,045; so there’s some risk of pension reduction involved for single employer participants too.

With that in mind, it’s worth noting that the PBGC studied risk transfer activity from 2009 to 2013. As a result, they found that 947,000 out of 1.1 million plan participants affected by pension risk transfers (either lump sum offers or annuities), came from non-collectively bargained plans. In other words, single employer plans. Needless to say, the trend continues to this day.

Why do single-employer plans with the better Federal pension insurance scheme transfer more of their participants to insurance companies? It saves them money. For each participant enrolled in a pension plan; the plan, or the corporation that sponsors the plan, must pay insurance premiums to the PBGC. While the premiums for the PBGC’s Multi-Employer Plan failed to keep up with expenses and inflation; the premiums for the Single Employer Plan did. This means it’s expensive for companies to pay those premiums. When combined with the other economic reasons I outlined above, it often makes a lot of fiscal sense to unload as many participants as possible to an insurance company — even if it’s not entirely in the best interest of the plan’s participants.

Finally, I’d be remiss if I didn’t point out that the October 2016 AAoA Issue Brief addresses the potential that participants left behind by pension risk transfer activity stand to lose the most. As you recall, when a pension plan or a company transfers pension liabilities to an insurance company, it transfers assets along with the liabilities. As noted above in the company section, the AAoA fears that these asset transfers could leave current workers (who can’t be transferred since they are still working) contributing to severely weakened pension funds.

The AAoA foresees a number of unintended consequences as a result, such as workers leaving a company, or otherwise healthy pension funds running into fiscal difficulties. While I’ve yet to come across any documented evidence of this scenario playing out, based on the fact that multi-employer plans are under much greater financial strain than single-employer plans, I’d expect to see this issue arise under the multi-employer plans first. It’s something that bear watching in conjunction with the PBGC’s trials and tribulations.

The Bottom Line

I began the research for this article with the premise that the pensioner loses when a pension fund transfers their pension liability to an insurance company and purchases an annuity. Other than the MetLife story though, I didn’t find any documented evidence which proved my premise. As a result, it’s plausible to conclude that my premise was incorrect. Maybe the pensioner doesn’t lose in this scenario. Or maybe I should state that the pensioner who’s already receiving a pension, or whose pension is frozen, doesn’t lose.

It’s far less clear as to whether or not the workers left behind (i.e. still working and contributing to a pension fund) win or lose. They may find their pension fund was fatally weakened through the proportional transfer of its risk pool and asset base to an insurance company. This weakness could trigger benefit reductions, or the freezing of the pension altogether. Based on the significantly weaker financial circumstances of multi-employer pension schemes, it’s plausible to expect the first signs of negative effects to appear there.

Conversely, if any entity is the winner, it currently appears to be the insurance companies engaged in the pension risk transfer business. Insurance companies receive the easiest to predict pension cases in which pensioners are already retired, or pension funds are frozen. In either case, it means the final pension amount is no longer growing. The ability to pool risk and effectively predict annuity payouts over decades is a well-documented capability for most major insurance companies. Considering that insurance companies receive a large amount of assets from pension funds to cover the initial cost of the annuities, it’s probable to assume that the insurance companies are making a lot of money from this activity.

Non-frozen, active pension funds retain a certain level of risk; the active worker who still contribute to the fund. This dynamic creates an ever-increasing final pension value and ever larger future financial liability for the pension fund. However, the pension funds, or the companies that sponsor them, get something out of pension risk transfer industry in return. That’s the ability to shift hard to define future financial liabilities into the present in the form of a one-time cost. In other words, they can pay insurance companies to get rid of their problem. As a result, they can forget about investment return and longevity risk. If it’s a single employer pension fund, pension risk transfer also frees up future working capital, and allows a company to concentrate on its core business.

I suspect that’s not the full story though. The pension risk transfer industry is too new for any article or issue brief to act as the definitive word on the issue. I suspect many a twist and turn yet to come. With that said, I no longer fear for the small guy whose pension gets transferred to an insurance company. As long as the pension fund, or its parent company, contracts with a reputable insurance company to administer the annuity; the current pensioner and/or frozen pensioner will be OK.