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Lump-sum payments and annuities
There are two main types of risk transfers:
- Lump-sum payments to deferred vested participants, often made through a onetime, voluntary distribution.
- The purchase of a group annuity contract from an insurance company, often for the plan’s retiree population.
Both types reduce the pension plan’s size by settling participants’ liability and paying out the assets associated with that liability. The illustration below shows how, after a risk transfer, a pension plan’s assets may be allocated among lump-sum payments to participants, premiums paid to an insurance company for annuities, and assets retained by the plan to manage against the liability of the remaining participants.
The plan that remains
“If plan sponsors aren’t careful,” says Vanguard Senior Investment Strategist Val Dion, “a risk transfer can end up costing the organization money instead of saving it.”
Likewise, a risk transfer can also increase risk rather than reducing it. “Too often, plans make risk transfer decisions based on an incomplete analysis,” Val says. “They don’t analyze the plan that remains, so they don’t account for factors like an increase in the required rate of return to cover annual accruals, a longer liability duration that is more interest rate-sensitive, or whether they need to reallocate assets to address those factors.”
“Get a second opinion”
Jim and Val have written a Vanguard research paper, Evaluating Pension Risk Transfer, that covers all the dimensions of the risk transfer decision. Jim’s advice for plan sponsors considering a pension plan risk transfer?
"We tell our clients, ‘Talk to an expert first. Get a second opinion,’” he says. “Our analysis may agree with their assessment, in which case they’ll feel even more confident about their decision. But in many cases, our analysis can help them uncover hidden risks of transferring liabilities.”