Current Thinking

“De-Risking” Your Defined Benefit Plan

For decades—before the 401(k) plan came on the scene—defined benefit (DB) pension plans ruled the retirement plan world. If an employer offered a retirement plan, it was quite likely a DB plan. Certainly governmental and union plans were almost always DBs. And many private sector companies also maintained DB plans. But times have changed. Many entities, including governmental agencies, have moved away from DB plans and towards defined contribution (DC) plans. In many cases, the sheer cost of DB plans tipped the scales in favor of a different retirement plan. Without even considering administrative costs, many organizations simply determined that the weight of ongoing funding obligations in DB plans was too great.

To be sure, defined benefit plans can still provide an excellent way for businesses to offer retirement benefits. And many employers with DB plans want to keep them. But even those employers with no intention of terminating their DB plans may be seeking ways to offload some of their ongoing funding and distribution obligations. A growing trend for reducing these pension obligations involves transferring them to an insurance company through what is known as “pension risk transfers.” This process can relieve employers of plan liabilities while protecting pension benefits for plan participants and beneficiaries.

Pension Risk Transfer in a Nutshell

Understanding pension risk transfer (PRT) requires more information than can be covered in a brief article. But the basics are pretty straightforward. In short, rather than retaining full responsibility for current and future pension payments, a plan sponsor may transfer plan assets to an insurance company that will assume payment responsibility going forward. Of course, there are numerous variations on this concept. For example, a plan sponsor may prefer to transfer the payment risk only for a select portion of participants (e.g., current payees or future payees), while retaining responsibility for another group. This decision could coincide with an amendment to revise future benefit accruals or to terminate or freeze the plan. More typically, however, a plan sponsor would divest all their pension plan liabilities, usually over the course of several years. And this process could involve multiple strategies and stages, including a combination of transferring obligations along with offering lump-sum payouts to participants instead of monthly annuity payments.

With such concerns as market volatility, interest rate uncertainty, and inflation, more and more plan sponsors are considering their PRT options. Sponsors can meet their de-risking goals by transferring plan liabilities to appropriate and reputable insurers. So rather than having their plans pay out monthly benefits to individual participants indefinitely—or purchase individual annuities each time a participant retires—plan sponsors can arrange with an insurance company to assume this obligation. As you would expect, insurance companies see this as an opportunity, as well. They stand to profit from this risk-shifting trend. And the good news is that it might not cost as much as plan sponsors imagine.

Plan Sponsors Must Remember Their Fiduciary Duties

At Pentegra, we discuss fiduciary responsibility and liability—a lot. So you probably know that plan sponsors and other fiduciaries must exercise the highest degree of care in plan operations. Under ERISA, this high standard of care also applies when delegating duties to other service providers. This means that in selecting an insurer to assume pension payments, for example, the plan sponsor must use a reasonable process that a “prudent man acting a like capacity and familiar with such matters would use.” As with selecting an investment manager or a third-party plan administrator, the plan sponsor should vet the insurer rigorously.

Fortunately—at least in this regard—insurance companies are highly regulated, mostly by state authorities. But this doesn’t mean that all of them are created equal. Although insurers must meet capitalization and reserve requirements, there can be stark differences in solvency, experience, and reputation. It may be hard for plan sponsors to assess the relative strengths (and weaknesses) of providers in an apples-to-apples comparison. And even between two seemingly equally matched competitors, one may have more experience specifically working in pension risk transfer situations. To get connected with qualified insurers, plan sponsors should enlist financial professionals for recommendations and guidance. But ultimately, plan sponsors are responsible for making prudent decisions for their plans. So they must decide whether transferring their pension risk to an insurance company is in the best interests of their plan participants and beneficiaries. And if so, then they must decide on the best path forward.

Defined Benefit Plan Sponsors Are Not Alone

Making a big decision such as transferring pension liabilities to another entity can seem daunting. And just because this trend is growing doesn’t mean that it’s right in all cases. Or maybe it is worth pursuing, but perhaps not right now. Whatever your situation, it’s still good to know that there may be alternatives—even if you implement them down the road. Any alternative, including staying on your present course, involves fulfilling your responsibilities as a plan fiduciary. Pentegra’s retirement plan experts are available to discuss your fiduciary duties and how we can help you fulfill them.

 

The information, analyses and opinions set out herein are for general information only and are not intended to provide specific advice or recommendations for any individual or entity. Nothing herein constitutes or should be construed as a legal opinion or advice. You should consult your own attorney, accountant, financial or tax advisor or other planner or consultant with regard to your own situation or that of any entity which you represent or advise.