In recent years, the US Pension Risk Transfer landscape has been dominated by a single type of transaction: the annuity buy-out. Annuity buy-outs have been a tremendously successful tool for companies to reduce pension risk and manage rising pension costs. But there is another, similar type of transaction, which accomplishes many of the same goals but has been utilized far less: the annuity buy-in contract. This less common but closely related pension risk management solution can be a compelling strategy for pension plan sponsors in many situations, and those opportunities are poised to increase as the majority of plan sponsors continue to de-risk and progress their pension plan exit strategies.
Many annuity buy-ins have been transacted in the UK in recent years, and while only around a dozen buy-ins have been executed in the US, we expect to see a significant increase in that number going forward. While plan sponsors may not view a buy-in as a replacement for a buy-out, it should be considered as an intermediary step when transacting immediately is not possible (e.g. plan termination) or desirable (e.g. delaying or minimizing an accounting settlement charge or if union support is needed).
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What is an annuity buy-in?
An annuity buy-in is like an annuity buy-out in that it is a transaction in which a plan sponsor insures its pension obligations and eliminates risk. In a buy-out, a pension plan sponsor segments a portion of their pension plan and transfers both the assets and liabilities for the covered population to an insurer. The same is true for a buy-in, except that the plan sponsor retains the ultimate responsibility for administering pension payments to the covered individuals. Thus, two main differences arise:
- The buy-in contract counts as a plan asset, which can be favorable from a funded status and required contributions perspective.
- The plan sponsor will continue to be responsible for PBGC premiums and other administrative expenses.
The two contracts typically cost the same at inception. At any point in the future, a buy-in can be converted to a buy-out with the same insurance company, typically at no additional cost1.
Why utilization will increase
The number of plans within striking distance of full plan terminations has increased due to rising interest rates. However, the plan termination process is involved and requires a minimum execution timeline of several months. Board and/or senior management level approval is often needed, and these approvals typically hinge on financial estimates that are based on market pricing at the time of the estimate. As a result, the time gap between the decision to proceed and the transaction closing can be as much as a year or more.
During this gap, plan sponsors have very few options to mitigate the financial risk related to insurer pricing. Material differences in relative pricing can occur based on even mild market changes. Based on an analysis of indicative insurer prices, the ratio of insurer price to accounting benefit obligation can change by as much as several percentage points over a given month, let alone over a longer period. This is driven by basis risk between an insurer portfolio and the AA-rated corporate bond approach used to determine pension discount rates.
An annuity buy-in, in contrast, is the perfect hedge, as it is convertible to a buy-out at little, or no, additional cost. A plan sponsor can use a buy-in to lock-in pricing and reduce exposure to both capital market conditions and insurer capacity during the plan termination process.
The need for hedging financial and insurer capacity risks is not limited to plan sponsors considering full plan termination. There are many reasons why plan sponsors considering a large buy-out transaction may not be able or willing to transact immediately and will face the same risks as those considering full termination.
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1 Depending on the agreed terms, conversion to a buy-out may require a one-time expense to cover future administrative costs the insurer would bear. Aside from the potential exception of administrative costs, the annuity buy-out price covers all benefits already covered by the buy-in, which results in zero cost at conversion.