BMO execs highlight why PRTs have seen growth and increased popularity in recent years as well as the benefits of a PRT transaction
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Pension risk transfers (PRTs) have experienced significant growth globally over the past decade, a de-risking trend that’s allowed defined benefit pension sponsors to transfer their liabilities to an insurer. PRTs have reached historical volumes in North America, the UK, and some continental European countries in the past few years because of higher interest rates and strong market performance.
As companies shift their retirement program focus to defined contribution (DC) offerings, plan sponsors are left with old defined benefit (DB) pension plans that can be volatile and difficult to manage. A PRT transaction can benefit an organization looking to de-risk and redirect resources to its primary business activities while upholding legacy obligations to plan participants.
BMO Insurance president Rohit Thomas explains PRTs essentially remove three risks: market risk or fluctuations in their liabilities due to markets, longevity risk, and expense risk. “They're really hedging – or transferring - their defined benefit obligations,” he says.
There are two different ways to do a risk transfer, Thomas highlights: a buy-in and buy-out. When a risk transfer happens, the plan sponsor transfers the obligation to an insurance company and are then hedging against its defined benefit obligations, including any market risk. “Insurance companies are guaranteeing the income to pensioners. Any changes in markets, any changes in longevity or changes in healthcare, even changes in expenses to manage pension administration, are now transferred to the insurance company. That obligation has been lifted from a plan sponsors’ responsibility,” Thomas explained.
PRTs have seen such tremendous growth over the last decade, mainly because of three reasons. The first of which is a result of negative market fluctuations impacting their solvency ratio, causing plan sponsors to top up their pension.
“A lot of plan sponsors have gone through the financial crisis. They've gone through COVID, we've even had other crises too, like the Euro crisis and oil crisis that have impacted their solvency ratios. Things that have gotten out of their control and when you're dealing with negative markets, you're then having to top up your pension. Because they've lived through it, they're aware of that impact,” Thomas said.
Secondly, as Thomas points out, there’s a level of education that's happening in the industry on risk transfer. Lastly, is due to interest rates being higher.
“We've all seen the cycles and it’s a great time to lock in,” Thomas says. “Higher interest rates mean your liability comes down because the discount rate is higher. Plan sponsors have done a lot of prep to get ready and they are taking advantage of the interest rate environment. There’s also the realization that defined benefit is not part of their core business and this is an opportunity for them to focus on their core business.”
Thomas is quick to point out the few benefits that are associated with transferring a pension. With most insurance companies being publicly traded institutions, from a pensioner’s perspective, “they're taking the risk off the insurance company, given the framework, given the capital and given the regulation,” Thomas said. “It is, of course, depending on who the plan sponsor is, a financially sound decision. Insurance companies are in the business of managing market, credit and longevity risk.”
There’s also a stronger capital position for plan sponsors because insurance companies have a strict capital structure under the Office of the Superintendent of Financial Institutions (OSFI) says BMO Insurance’s CIO François Hélou.
“The Canadian insurance industry is very strong, it's actually one of the strongest in the world,” Hélou admits.
More recently, several pension plan organizations have reached well-funded levels. Hélou highlighted the result is a combination, which is usually rare in an economic cycle, of markets doing very well with interest rates also going up.
“Usually it's one or the other,” Hélou noted. “The two combined have compounded and boosted, to a large degree, the solvency ratio of pension plans that have gone from well below 100 per cent (at the height of the COVID crisis) to levels that are well above 100 per cent.”
Hélou says this combination of market events is what attracts pension plans and consultants to do a pension risk transfer.
“The worst-case scenario would be a combination of markets declining and interest rates decreasing as result of a recession. Then you have a compounded effect that goes the other way, which we saw during March 2020, COVID and in ’08 and ’09. The two combined tend to bring the solvency ratio much lower. Now they're seeing this positive combination and they're saying, ‘Now is a good time to do the de-risking through a pension risk transfer,’” Hélou added.
As for the effect that pension risk transfers can have on inflation, Thomas noted the PRT market mimics what pensioners’ actual benefits would be. For example, if a pensioner’s benefits have inflation, caps, floors or bridge benefits, to name a few, these benefit payments are transferred to the insurance company. What is usually not transferred, however, is the funding risk where they might still be accumulating service.
Noting a few pension organizations who have gone bankrupt over the last decade, Hélou asserts this creates problems for pensioners at these organizations, who also have defined benefit pension plans, citing Sears and Nortel as an example.
“It affects the pensioners at an age where they can afford it the least. When you lose a chunk of your income, and you’re a pensioner in your 70s or 80s, it's not easy to get another job to make up for that income. Having an insurance company guaranteeing that exact pension liability over to the pensioners’ is an extremely important element of risk management. Not only at a corporate level, but also at a society level because pensions usually carry a surviving spouse benefit as well,” says Hélou.