A comparison of the risk management options for defined benefit plans: liability- driven investing, annuity buy-outs, and annuity buy-ins.
Besides the usual suspects, there鈥檚 another, lesser-known risk mitigation method that deserves attention now: annuity buy-ins. Why? Because funding levels may have changed and the strategy for a defined benefit (DB) retirement plan might be ripe for another look, too.
The surprisingly strong performance of return-seeking asset classes in 2023 has left DB funding ratios for many plans at the highest levels in memory. Plan sponsors accustomed to years of chasing net returns to close funding gaps suddenly find themselves with surpluses to conserve, which typically leads to strategic thoughts that are more conservative.
Historically, pension plan risk reduction has generally led plan sponsors down one of two paths:
- Liability-driven investing (LDI): reducing interest rate risk using duration-matched bonds.
- Traditional annuity buy-out: transferring out the assets and liabilities of a plan to an insurance company. In this case, this is the permanent transfer of liabilities and assets from the DB plan to an insurance company; the insurance company pays beneficiaries directly.
The annuity buy-in may be a good third option because better funding makes it attractive鈥攁nd one to consider if funding is good and risk management is in focus.
What鈥檚 the difference between an annuity buy-in and an annuity buy-out?
Annuity buy-ins start very much like annuity buy-outs; an asset is transferred to an insurer to fully guarantee all interest rates and mortality risks of a defined population. (For simplicity, we鈥檒l assume all annuities mentioned cover only retirees and beneficiaries already in payment鈥攁s annuity pricing is complex for employees not yet receiving payments.)
Unlike the annuity buy-out, assets and liabilities in an annuity buy-in contract continue to be reported in key ongoing plan measures. The market value of the buy-in contract remains an asset of the plan, and liabilities for covered participants are included in annual calculations of minimum funding, accounting, and Pension Benefit Guaranty Corporation (PBGC) premiums. Monthly benefits are paid from the buy-in contract by the insurance company/issuer into the pension plan鈥檚 investment portfolio and then forwarded to covered retirees. In an annuity buy-out, the insurance company/issuer makes benefit payments directly to the retirees. (See the chart below for a comparison.) Annuity buy-in contracts hedge related risks associated with the corresponding liabilities without transferring assets or liabilities out of the plan, and therefore wouldn鈥檛 trigger settlement charges. They can be thought of as 鈥減erfect LDI鈥 in helping to solve these concerns.
Plan sponsors may convert annuity buy-ins to traditional annuity buy-outs in the future within the provisions of their contracts.
Annuity buy-ins compared to LDI and annuity buy-outs
Buy-ins fill a hybrid space between LDI and buy-outs, solving two problems of the more traditional risk management tools: risk hedging and reporting impacts.
Annuity buy-ins and risk-hedging
While LDI is a powerful tool that can reduce interest rate risk, it can never perfectly hedge associated obligations. There鈥檚 always some degree of tracking error associated with a mismatch of duration and quality of LDI bonds vs. the liabilities themselves. Other risks like longevity are tough to address through investments.
The annuity buy-in hedges the settlement liability of the covered pensioners. Once the premium is paid, future changes in interest rate, yield curve shape, credit spreads, inflation, mortality improvement, or benefit election have no impact on the net position of the contract. The cost of settling the obligations of covered participants is always deemed to be fully funded, effectively walling off that risk from the plan sponsor.
But this hedging forfeits the potential upside of demographic experience and investment net performance. Future investment flexibility is also somewhat compromised as assets have been invested in an insurance contract. Buy-ins are revocable, but material forfeitures make the buy-in decision effectively permanent for most plan sponsors, whereas LDI holdings are much easier to liquidate.
| Risk management method | |||
|---|---|---|---|
| Attribute | LDI | Annuity buy-out | Annuity buy-in |
| Hedging ability | Strong but incomplete | Complete* | Complete** |
| Accounting settlement expense timing | N/A | Immediate | Deferred until transition to annuity buy-out |
| Investment flexibility | Total investment flexibility | No investment flexibility | Partial investment flexibility (revocable with a contractual forfeiture penalty) |
| How are benefits paid? | Directly from plan assets | Directly from insurer | Indirectly from insurer through plan assets) |
*Buy-outs may impact a plan鈥檚 funding ratio
**Through the use of a 鈥減erfect LDI鈥 strategy
Annuity buy-ins and the impacts on plan reporting
A major impediment to executing buy-outs is the impact these purchases have on the valuations of the residual pension plan. Premiums are often higher than the associated funding and accounting liabilities for the purchase group, potentially increasing contributions, balance sheet liabilities, and accounting expenses. In addition, U.S. pension accounting rules also require recognition of additional accounting 鈥渟ettlement charges鈥 when buy-outs are executed.
Buy-ins do not trigger settlement charges, so risks can be hedged without booking large one-time accounting costs. Funding ratios under Pension Protection Act rules and balance sheet disclosures are also unaffected since assets and liabilities are still included in those calculations.
Pension Benefit Guaranty Corporation (PBGC) premium payments are still required for participants covered under annuity buy-ins since the contract is technically revocable. DB plan sponsors also need to understand that buy-ins only hedge the cost of settling obligations. Buy-ins can effectively reduce the volatility of funding, accounting, and PBGC liabilities measured at market values, just not perfectly. Liabilities based on non-market averaging methods could mismatch significantly, as they would also for LDI.
When is an annuity buy-in a good fit?
Buy-ins typically work best for plan sponsors seeking maximum hedging of settlement obligations with minimum disruption of ongoing actuarial reporting. Two common examples fitting this description come to mind:
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Terminating plans wanting to lock in cost: Unlike annuity buy-outs, there are no restrictions on purchasing an annuity buy-in between a plan鈥檚 termination date and completion of the PBGC termination filing review鈥攁 process that can take about a year. Plan sponsors can lock in costs while waiting to complete the termination process and convert to a buy-out.
An additional advantage is that group annuity pricing tends to be better earlier in the calendar year when insurers have more capacity to quote risk transfer business. A February buy-in converted to a buy-out in December can cost much less than waiting to execute a buy-out in December. Sponsors should be aware of minimum holding periods of buy-in contracts prior to buy-out conversions when considering this strategy.
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Well-funded or hibernating plans sensitive to settlement charges: Many pension plans are now well-funded but may also carry large unrecognized accounting losses that can trigger significant settlement charges with buy-outs. Annuity buy-ins with use of a 鈥減erfect LDI鈥 can provide risk hedging while allowing DB plan sponsors to implement more gradual loss recognition methods. The profile for this type of DB plan sponsor likely includes financial services companies, such as banks, credit unions, and insurance companies.
Executing an annuity buy-in for pension risk management isn鈥檛 a solution for everyone. Many plan sponsors get what they need from the classic LDI and buy-out options. But for those looking to hedge without disturbing their financials, the annuity buy-in offers an interesting option that may be worth consideration now.
