Transferring Pension Risk
Why Insurance Companies are Bailing Out Some Defined Benefit Plans
“To date, only insurance solutions can address the longevity risk in large pension funds.” Prudential, The Pension Risk Transfer Market at $260 Billion
Over the last decade, the extraordinary convergence of historically low-interest rates and increasing longevity has wreaked havoc on defined benefit pension (DB) plans. Despite strong market returns, many pension plans are still underfunded and in crisis mode. Increasingly, plan sponsors are looking more intently than ever at unloading their pension liabilities through a risk-transfer strategy.
Where do those pension liabilities go?
Increasingly to an insurance company, which then assumes the liability and the responsibility for paying all future benefits to the plan participants covered by the agreement. The number of companies that have transferred their DB pension liabilities to an insurance company has doubled in each of the last three years. Most recently, the international financial giant HSBC transferred more than $8 billion of pension liabilities to Prudential Financial, Inc. to reduce its “longevity risk.” It’s expected that trillions of dollars of pension liabilities will be transferred to insurance companies over the next decade.
Established, well-capitalized insurance companies offer one solution to corporate pension plan dilemmas. They also offer a lesson to those of us on an individual level who are thinking about how to manage the risk of outliving savings. Having weathered more than a century of depressions and recessions, the best insurance companies know how to handle longevity.
The Strain of Longevity Risk
Traditionally, global pension funds have held on to the longevity risk associated with having thousands of former employees and DB plans that guaranteed those retirees’ lifetime income. Such companies seek to be one step ahead of asset risk through investment results, but that led to uneven and sometimes unsustainable outcomes. Now companies like Bristol-Myers Squibb, Verizon, FedEx, and Sears are among those offloading their pension liabilities to insurance companies.
Although fewer companies currently offer DB pension plans, many organizations are still on the hook for the millions of Americans lucky enough to have participated in legacy plans. When a company transfers its pension liabilities to an insurance company, it can purchase a group annuity to guarantee that the plan’s assets will always match its liability cash flow and prevent underfunding. Or that the company can pay a premium to the insurance company to settle the liability. Plan participants can still expect to receive the pension payout they have earned.
Throughout their history, life insurance companies have been among the most stable financial institutions. They are regulated by the states, which impose strict reserve requirements to ensure they have enough liquidity to cover their claims and dictate the quality of investments that insurers can include in their portfolios.
Generally, only the largest and strongest life insurers participate in pension risk transfers. Companies such as Prudential, a clear leader in risk transfer transactions, have earned “excellent” and “very strong” ratings from AM Best and Standard & Poor’s, respectively.
As people on an individual basis think about how to handle the financial uncertainty associated with living too long, they might borrow a page from some of the biggest pension funds around. Longevity can be a risk. Insurance companies may be an excellent solution to it.