The De-Risking Spectrum
Before delving into the pros and cons, it will be helpful to briefly summarize the three broad pension risk management paradigms outlined in our recent paper, Defining the De-Risking Spectrum1. These three modes, “return-seeking”, “hibernation” and “buyout” will be the reference points for our comparison.
- Return-Seeking: The allocation of plan assets is designed to out-earn the liability at an acceptable level of risk. The asset allocation choice is generally the largest contributor to overall risk. Tactical views on interest rates may also be taken to leave some portion of the liability unhedged. Annual funded status volatilities in this mode can range from as low as 4% to higher than 25%.
- Hibernation: Plan assets are predominantly committed to fixed income-based LDI to limit funded status volatility. Volatilities in this range can potentially be reduced to about 1% annually.
- Buyout: Purchase of annuity contracts to completely remove the obligation from the sponsor’s books. Pension funded status volatility is eliminated from the sponsor’s perspective.
Components of Annuity Buyout Pricing
Pros and Cons
Contributions and liquidity
Sponsor health and credit rating
Longevity risk and mortality assumptions
Separately, the question of whether the plan’s current liability value is based on outdated mortality assumptions is relevant. A plan will be forced to immediately recognize any “stale” assumptions in a buyout transaction, but may be able to delay this recognition for accounting and funding purposes in hibernation mode.
Conflicts of interest in insurer selection
Ongoing plan costs
Insurer profit margin and pricing opaqueness
Counterparty and litigation risk
A related type of counterparty risk may also exist in the selection of an annuity provider. In the event of an insurer failure, will the sponsor and fiduciary be entirely insulated from liability? Additionally, recent lawsuits show that sponsors should be prepared to defend their decisions in court even prior to the buyout transaction (though this issue could become less relevant if lawsuits continue to be settled to the sponsor’s benefit).