The question of what kind of investment risk underfunded pensions pose is hotly debated. Limited disclosure and murky accounting make it challenging for investors to assess this risk. The following concerns about pension risk and the way investors should address them
What is Pension Obligation Risk?
Pension obligation risk, as defined by the National Association of Insurance Commissioners (NAIC), refers to the financial risk a company faces due to its contractual obligations to a pension scheme. This risk arises from the potential for the company’s pension liabilities to exceed the assets available to cover those liabilities, leading to financial strain and potential impact on its earnings and financial health.
Understanding Pension Risk Transfer (PRT)
One strategy companies employ to manage pension obligation risk is Pension Risk Transfer (PRT). PRT involves transferring the financial responsibility and administrative burden of a defined-benefit pension plan from the company to a life insurer. This transfer mitigates the company’s exposure to various risks associated with pension liabilities, including:
- Longevity Risk: The risk that participants live longer than anticipated, leading to higher-than-expected payouts.
- Investment Risk: The risk that investment returns fall short of expectations, jeopardizing the ability to meet future pension obligations.
- Interest Rate Risk: Fluctuations in interest rates can significantly impact the present value of future pension obligations, leading to volatility in the company’s financial statements.
- Proportionality Risk: The risk that pension liabilities become disproportionately large relative to the company’s overall assets and liabilities, potentially impacting its financial stability.
Types of Pension Risk Transfer Strategies
There are four main types of PRT strategies:
- Longevity Reinsurance: This strategy involves transferring the longevity risk to a reinsurer, who assumes the responsibility for covering longevity-related costs.
- Buy-in: Under this approach, the insurer pays the monthly annuity amount to the plan, while the plan continues to make pension payments to participants.
- Buy-out: In a buy-out, the insurer takes on a direct and irrevocable commitment to make the specified annuity payments to each covered participant.
- Paying in Lump Sums: This strategy involves making a lump-sum payment to the insurer, who then assumes responsibility for future pension payments.
Accounting and Reporting Considerations for PRT
Pensions transferred to life insurers are typically held in separate accounts, which are legally and financially segregated from the insurer’s general operations. These separate accounts are subject to specific accounting and reporting requirements outlined in the Statutory Accounting Principles (SSAP) No. 56.
In 2021, the NAIC implemented changes to enhance the visibility and reporting of PRT activities. These changes require separate accounts to be individually identified and disclosed, allowing regulators to better assess the adequacy of assets held to cover pension liabilities.
Investing Risk of Underfunded Pension Plans
Underfunded pension plans pose a significant investment risk to companies. When liabilities exceed assets, companies must increase contributions to their pension portfolio, often in the form of cash. This can lead to a reduction in earnings per share (EPS) and equity, potentially triggering defaults under loan agreements and other financial consequences.
Evaluating the risk of underfunded pension plans requires careful analysis of the plan’s funding status, assumptions used to calculate liabilities, and the company’s overall financial health. Investors should be aware of the potential impact of underfunded pension plans on a company’s financial stability and investment returns.
Additional Resources
- NAIC Pension Risk Transfer Page: https://content.naic.org/cipr-topics/pension-risk-transfer
- Investopedia: The Investing Risk of Underfunded Pension Plans: https://www.investopedia.com/articles/analyst/03/050803.asp
- MetLife Pension Risk Transfer Poll: https://www.metlife.com/us/dam/usml/us-metlife/documents/pensions/pension-risk-transfer-poll-2023.pdf
- Wharton Pension Research Council: New Financial Instruments for Managing Longevity Risk: https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3625064
- North American Actuarial Journal: New Solutions to an Age-Old Problem: Innovative Strategies for Managing Pension and Longevity Risk: https://www.naaajournal.org/index.php/NAAAJ/article/download/120/123
- American Academy of Actuaries: Pension Risk Transfer Issue Brief: https://www.actuary.org/sites/default/files/pension-risk-transfer-issue-brief.pdf
- Conning & Co.: Conning’s Corporate Pension Review: https://www.conning.com/research/research-library/conning-s-corporate-pension-review-april-2023
Pension obligation risk is a complex issue with significant financial implications for companies and investors. Understanding the various types of PRT strategies, accounting and reporting considerations, and the potential risks associated with underfunded pension plans is crucial for making informed investment decisions. By carefully analyzing the financial health of companies with defined-benefit pension plans and considering the potential impact of pension obligations, investors can mitigate risks and make informed investment choices.
Pension Risk Defined
From the perspective of investors, pension risk is the possibility that an underfunded defined-benefit pension plan will negatively impact a company’s earnings per share (EPS) and financial standing. Note that pension risk arises only with defined-benefit plans.
A defined-benefit pension plan ensures that retired workers will receive a predetermined (defined) payment. The business must make prudent investments to meet this commitment and ensure that it has the money to pay the promised benefits. Because it guarantees employees a set benefit and must cover any investment losses, the company assumes the risk associated with investments.
Defined-Contribution Plans
In contrast, the employees in a defined-contribution plan—which occasionally doubles as a profit-sharing plan—bear the investment risk. Rather than providing fixed benefits to retired employees directly, the company makes a set amount of contributions to their retirement accounts. Thus, the employees are the ones who own any profits or losses on these retirement investments.
Despite the fact that there are fewer defined-benefit plans now than there were a few decades ago, unionized businesses are still at the highest risk.
Knowing how fully the company’s pension liability is funded is the first step in evaluating risk. “Underfunded” refers to a situation in which the assets (the investment portfolio) that have accumulated to cover those necessary payments are less than the liabilities, or the obligations to pay pensions. These assets are made up of corporate contributions that have been invested in as well as the profits from those investments.
Pensions may be funded by cash contributions and company stock under the current Internal Revenue Service (IRS) and accounting rules; however, the amount of stock that may be contributed is restricted to a percentage of the entire portfolio. In order to reduce their cash contributions, businesses typically contribute as much stock as they can. However, because it leaves a fund that is “overinvested” in the employer, this is poor portfolio management. For both upcoming contributions and strong returns on the employer’s stock, the portfolio is unduly reliant on the employer’s financial situation.
In the event that the value of a pension’s assets is less than the 2095% funded amount at the start of the plan year, or if the assets are less than the 80% funded amount at any point during the year, the employer is required to increase its contribution to the pension portfolio, which is typically made up of cash. The requirement to make this cash payment could significantly lower equity and EPS. A default under corporate loan agreements can result from a decrease in equity and have major ramifications, such as increased interest rates or bankruptcy.
That was the simple part. Now it starts to get complicated.
What Are Defined Contribution and Defined Benefit Pension Plans?
FAQ
What is the meaning of pension obligation?
What is the pension risk?
What is defined pension risk?
Are pension obligations considered debt?
What is a pension risk transfer?
A pension risk transfer is when a defined-benefit pension provider seeks to remove some or all of its obligation to pay guaranteed retirement income or post-retirement benefits to plan participants.
What are defined pension obligations?
Defined pension obligations represent an enormous liability to companies that have guaranteed retirement income to its current and past employees. The pension provider may alternatively seek to transfer some risk to insurance companies via annuity contracts or through negotiations with unions to restructure the terms of the pension.
What is pension risk?
From an investor’s point of view, pension risk is the risk to a company’s earnings per share (EPS) and a financial condition that arises from an underfunded defined-benefit pension plan. Note that pension risk arises only with defined-benefit plans. A defined-benefit pension plan promises to pay a specific (defined) benefit to retired employees.
What is pension obligation risk capital (p2prc)?
Accordingly, the PRA’s basic approach towards pension obligation risk capital (P2PRC) is that it exists to enable a firm to meet its pension obligations throughout a period of stress and beyond. The PRA uses the actuarial funding valuation prepared for a pension scheme’s trustees as a starting point for its own internal assessment of P2PRC.