Understanding Pension De Risking and Its Impact

Pension de-risking is a strategy used by companies to manage their pension liabilities and reduce their financial risk. This approach involves transferring or hedging pension obligations to other parties, typically through insurance contracts or annuity purchases.

Companies with defined benefit pension plans often engage in pension de-risking to alleviate their financial burden. According to a recent study, 75% of companies with defined benefit plans have implemented de-risking strategies.

By transferring pension liabilities, companies can free up capital to invest in other areas of their business. This can be particularly beneficial for companies with underfunded pension plans, where de-risking can help to reduce the financial strain.

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A pension risk transfer is a way for a defined benefit pension provider to offload some or all of the plan's risk to an insurance company or by offering a lump-sum payment to participants.

This can be done by negotiating with an insurance company to take on the responsibility for paying guaranteed benefits.

The plan sponsor can also buy out employees' pensions by offering vested plan participants a lump-sum payment to voluntarily leave the plan early.

This approach allows the plan sponsor to transfer the risk of paying retirement income liabilities to former employee beneficiaries to someone else.

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Offering a lump sum window is a strategy to reduce the obligations of a pension plan. This can be done during a plan termination or while the plan is ongoing.

A lump sum window allows terminated vested and active participants to elect a lump sum payment, reducing the plan's future obligations. Those who don't elect a lump sum will be included in the PRT annuity purchase.

The most common ways to transfer risk are via lump sum settlement, annuity buy-out, and annuity buy-in. These methods can help mitigate financial risks associated with a pension plan.

A lump sum settlement involves paying a single lump sum to a participant, reflecting the present value of all future expected benefit payments. This can be a straightforward way to transfer risk.

An annuity buy-out provides an irrevocable commitment from an insurer to make all future pension payments to plan participants. The pension plan no longer has any obligation to the participants.

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An annuity buy-in is a transaction where an insurer provides a revocable commitment to fund future pension payments. This can be an asset of the pension plan and includes the option to convert to a buy-out.

Here are the three common ways to transfer risk:

Pension risk transfer transactions can benefit an organization by mitigating financial risks, including fluctuating interest rates, earnings volatility, participant longevity, investment return, and administrative demands and expenses.

Aon has advised on over 488 annuity placements covering over $147 billion of premium since 2012.

Their team provides plan sponsors with project management expertise to help navigate the pension de-risking process.

Aon's Pension Administration team offers custom-tailored participant communications, notices, and internally processed participant elections for lump sum settlements.

Aon has strong relationships with every annuity provider, which is crucial for executing an annuity purchase.

Here are some of the asset/liability management techniques Aon utilizes to develop a plan-specific strategy:

Aon's analysis focuses on providing plan sponsors with the information they need to assess the merits of acting, including education, financial outcomes, investment strategies, and a detailed review of data readiness.

Pension risk transfer is a common practice among defined-benefit pension providers. They seek to remove some or all of their obligations to pay out guaranteed retirement income to plan participants.

Defined pension obligations can be a significant liability for companies. This is because they have guaranteed retirement income to their current and past employees.

Companies have historically adopted pension plans for various reasons, including attraction and retention of qualified employees, workforce management, and favorable tax policies.

Defined-benefit pension providers may transfer some risk to insurance companies via annuity contracts. Alternatively, they may negotiate with unions to restructure the terms of the pension.

Here are some key reasons why companies adopt pension plans:

The potential impact of these pension de-risking cases is significant. If they move past a motion to dismiss, there's a high risk that similar cases will follow, particularly if the annuity provider is not a traditional insurer.

This could lead to a surge in class actions targeting non-traditional annuity providers. The Courts of Appeals or even the Supreme Court may need to weigh in before Article III standing in these new pension risk transfer transaction cases is resolved.

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If the lower courts rule that allegations of an annuity provider being "too risky" or "non-traditional" are enough to satisfy Article III standing, it's likely that additional annuity providers will be targeted, and additional large pension risk transfer transactions will be challenged in class actions.

Here are some potential consequences of this ruling:

The European Union has implemented a directive to harmonize pension de-risking strategies across member states, requiring pension funds to disclose their de-risking activities and outcomes.

Pension funds are now required to conduct regular stress tests to assess their ability to withstand market volatility and economic downturns.

In the UK, the Pensions Regulator has introduced new guidelines for pension de-risking, emphasizing the importance of trustee oversight and member communication.

Pension de-risking strategies must be carefully considered to ensure they align with the pension fund's overall investment objectives and risk tolerance.

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ERISA's fiduciary standards are often at the center of class action lawsuits, as seen in complaints against AT&T and Lockheed Martin.

The Department of Labor's Interpretive Bulletin 95-1 provides guidance on ERISA's fiduciary standards, specifically regarding the selection of an annuity provider for defined benefit pension liabilities.

Choosing a risky annuity provider can put plan participants at risk of losing their pension benefits, as alleged in complaints against Lockheed Martin and AT&T.

The complaints focus on the fact that Lockheed Martin and AT&T chose a non-traditional PRT annuity provider, Athene, which is owned by a private equity firm and has a subsidiary with a far riskier asset base than other conventional annuity providers.

There is no allegation that participants are not receiving their vested benefits, but rather that the shift to Athene put their future pension benefits at risk of default.

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The European Union's General Data Protection Regulation (GDPR) has been a game-changer for data protection laws, with many countries adopting similar regulations.

One notable development is the rise of artificial intelligence (AI) regulations, with the EU's AI Act aiming to establish a framework for the development and deployment of AI systems.

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The US has also seen significant developments in AI regulations, with the Federal Trade Commission (FTC) issuing guidelines for the use of AI in consumer-facing businesses.

The California Consumer Privacy Act (CCPA) has been a model for other states to follow, with many adopting similar consumer data protection laws.

The future of data protection laws will likely be shaped by the ongoing debate over the balance between individual rights and business needs.

The use of AI in healthcare is expected to continue growing, with many countries investing in AI-powered diagnostic tools and personalized medicine.

Courts may determine the future of PRT transactions, with the Piercy, Schloss, and Lockheed complaints potentially trying to get around Lee v. Verizon and Thole.

The complaints allege that PRT transactions concluded in the transfer of affected participants out of their retirement plans to a risky annuity provider, accompanied by the loss of two ERISA protections.

Two ERISA regulatory features are always lost when a defined benefit pension plan is terminated in a "standard termination" that ERISA expressly authorizes.

The only real question for the courts should be whether the "risky" and "non-traditional" annuity provider allegations are sufficient to move these cases out of the "too speculative" category discussed in Lee v. Verizon and Thole.

If the courts rule in favor of the complaints, it could have significant implications for PRT transactions.

To mitigate potential litigation risks, it's essential to assess potential litigation risks in advance of any deal activity.

Here are some key considerations:

To obtain a DOL prohibited transaction exemption, you'll need to meet certain requirements. The Department of Labor (DOL) has established a series of conditions that must be met to grant relief.

The DOL requires the use of an independent fiduciary to confirm several key points. These include verifying that the insurer is licensed to underwrite the proposed risks.

An independent firm must review the captive's reserves for the past two years. This is to ensure that the captive is financially stable and able to meet its obligations.

The DOL also requires that the captive has undergone an examination by an independent certified public accountant for its last complete taxable year. This is to provide assurance that the captive's financial statements are accurate and reliable.

To qualify for a prohibited transaction exemption, the proposed transaction must confer an immediate benefit on the plan's participants. This can take the form of lower cost for employee contributions, enhanced benefits, or both.

The premiums charged under the program must be reasonable and within the range of rates charged by competitors for similar coverage under comparable programs. This is to ensure that the plan is not overpaying for the reinsurance.

The plan must not pay any commissions with respect to the reinsurance transaction. This is to prevent any conflicts of interest that could compromise the plan's interests.

Finally, the reinsurance agreement must be "indemnity reinsurance." This means that the fronting insurer remains liable for the risk if the reinsuring captive is unable or unwilling to pay.

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Large companies like Ford Motor Co. and General Motors Co. started transferring pension risk in 2012 to avoid earnings volatility and focus on their core businesses.

The total annual cost of a pension plan can be hard to predict due to variables in investment returns, interest rates, and the longevity of participants.

Plan sponsors believe that the ability to close a plan to new entrants, reduce or freeze benefits, or completely terminate a plan (after providing for all accrued benefits) has been and remains necessary to encourage adoption and continuation of plans.

Types of risks addressed in risk transfer transactions include longevity risk, investment risk, interest rate risk, and the risk of a plan sponsor's pension liabilities becoming disproportionately large relative to the remaining assets and liabilities of the sponsor.

A pension risk transfer transaction can benefit an organization by mitigating financial risks such as fluctuating interest rates, earnings volatility, participant longevity, investment return, and administrative demands and expenses.

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These risks are addressed through risk transfer transactions, which can help organizations redirect resources to their primary business activities while upholding legacy obligations to plan participants.

Here are some of the financial risks that a pension risk transfer transaction can help mitigate: