Perspectives : Asset Management | July 07, 2023

Consider the risks of a pension risk transfer

Updated April 5, 2024

Read time: 8 minutes

If you’re the sponsor of a corporate pension plan who wants to reduce the plan’s size, costs, or risks—or some combination of the three—you may consider a risk transfer.  As the name suggests, a risk transfer looks to shift some of the plan’s financial risk from the sponsoring corporation to a third party. It also tries to reduce the administrative costs or Pension Benefit Guaranty Corporation (PBGC) premiums, amounts that are often related to the number of plan participants.
Analyzing a prospective risk transfer, however, might be more complicated than some pension plan sponsors suspect and often more complex than the standard analysis typically shows. If handled improperly, a risk transfer may pose its own risks in the form of increased costs or financial risk.

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.

But the label “risk transfer” itself may be something of a misnomer. “Think of it as a ‘liability transfer,’ " says Jim Gannon, Vanguard senior investment strategist and lead actuary. “Plans transfer the pension liability to an insurer or to participants. ‘Risk transfer’ implies that risk is also being transferred, but we’ve found that’s not always the case. ”

The plan that remains

As Jim suggests, thorough analysis is key when plan sponsors are deciding whether to transfer liabilities. He outlines the four-step process that Vanguard applies to pension plan liability transfer decisions:
Calculate the plan’s costs and risk before any liability transfer, both current and projected year by year (using probability models) into the future.
Analyze the proposed transaction by comparing the total liabilities transferred with the total assets transferred to remove those liabilities plus the transaction’s costs (in fees and time).
Analyze the remaining pension plan and the plan’s costs and risk projected year by year into the future.
Compare step 1 to steps 2 and 3 to see whether the transaction reduces cost and risk, not only at the time of the transaction (step 2) but also into the future (step 3).

“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”

Vanguard recommends that plan sponsors perform a comprehensive asset-liability study to analyze both the transfer transaction and the plan that remains. “We believe that both assessments must occur as part of the decision-making process,” Val says. “If step 2 shows that the transaction saves money, but step 3 shows that the ongoing plan’s future contribution requirements will increase, the plan sponsor needs to know that before making a decision.”

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.”