Pensions Reassess Long-Term Outlooks as Volatility and Inflation Remain High

Art by Caroline Barlow

This year is on pace to be a record-breaking one for pension risk transfers. As CIO reported earlier this month, U.S. single premium buyout sales set a second-quarter sales record of $12.3 billion, a 148% jump from the $4.97 billion during the same period last year, according to data from LIMRA’s U.S. Group Annuity Risk Transfer Sales Survey.

The third quarter is already on pace to break those records. On September 13, IBM announced a $16 billion pension risk transfer covering approximately 100,000 retirees. Three days later, food packaging corporation Pactiv Evergreen LLC announced a $660 million pension risk transfer.

These transactions point to a number of converging market forces that have plan sponsors reconsidering their long-term glidepaths. Sources say plan sponsors are rethinking when they might do risk transfer transactions or are repositioning their portfolios to improve funded status with an eye toward risk transfers in the future.

Market Forces Align

Matt McDaniel, a Philadelphia-based partner and U.S. leader of the financial strategy group at global consultant Mercer, says market volatility is causing some plan sponsors to move up timelines.

“Plan sponsors tend to take a closer look at their plans for risk transfers when market conditions get challenging,” he says. “If a plan sponsor is already considering some type of transaction, they may be looking at the state of things right now and asking themselves how long they want to stay on this rollercoaster. That can lead to an acceleration of the overall timeline to a risk transfer.”

Apart from navigating volatility, rising interest rates might make risk transfers more appealing now than they have been over the past few years, McDaniel says. When rates rise, the total cost of doing an annuity transfer goes down, because insurers can use the higher yields they are getting to offer lower prices.

“Many pensions are coming off of a good year, so they could have a higher funded status,” he says. “If you’re looking to do a risk transfer or terminate, it may come at a lower cost now because the plan sponsor won’t have to contribute as much to get to an appropriate funded status to facilitate the transaction.”

Underfunded Plans Face New Pressure

For plans that have had difficulty achieving or maintaining funded status, the market environment is more challenging. Underfunded plans hoping for a long-term rebound didn’t get that in 2022.

“Plans that were exposed to significant equity risk and/or interest rate risk have had a hard time this year,” says Jason Richards, St. Louis-based managing director of the Retirement Risk Management Group at consultancy WTW. “We’re seeing more plan sponsors think about what their desired end state is. If a plan sponsor will be retaining its obligations for at least the next handful of years, it might be worth looking at diversification and thinking through how you can limit risks to the portfolio.”

Reallocations can be beneficial, but they come with some caveats. Richards says plan sponsors are looking at asset classes like bank loans and high-yield bonds to improve the returns they can expect from the fixed-income side of the portfolio. Plans with a longer time horizon to termination might be able to realize an illiquidity premium if they consider private credit or other less liquid asset classes as part of a diversification plan.

“The issue is the time horizon,” Richards says. “Pension plans can typically realize illiquidity premiums because they have a longer time horizon. However, if you’re considering a risk transfer you may need to maintain a certain level of liquidity to support that. If you diversify into asset classes that have a long lockup you can run into trouble. If plan sponsors think they can go to the secondary market to offload some of those investments, they may be surprised by the haircut they have to take.”

Mercer’s McDaniel agrees. He says it’s important for plan sponsors to remember that funded status can change quickly. “If you’re 80% funded and you go into illiquid investments and you hit 100% funded status, you may end up having to wait longer than you anticipated to unwind those investments,” he says.

Inflation Concerns

Rising inflation can also have an impact. Inflation is typically measured year over year in portfolio calculations. That puts the most recent number at approximately 8%. However, the past few months have shown a decline in overall inflation. If that trend continues, year-over-year inflation figures are likely to be lower. That could make the math for what pensions have to pay out and overall funded status harder to handicap, at least over the near term.

“The message we are trying to give everyone is that the returns you got last year are probably not indicative of a typical year,” explains Jay Kloepfer, San Francisco-based executive vice president and director of the Capital Markets Research Group at pension consultant Callan. “The same is true for inflation. If you are looking at year-on-year figures, it’s going to be tough short term. But we do expect conditions to settle, although it’s hard to know exactly when.”

Plans that aren’t frozen or have benefits indexed to inflation may find themselves paying out more now and taking a hit to funded status. But they could make up some of it later if inflation settles lower in the future or investment performance improves.

Richards adds that if inflation remains elevated, plans may need to look at their total-return assumptions. “I think plan sponsors are really struggling with what happens if you were planning for a 7% return when inflation is at 2%, but then inflation ends up settling at 4%, for example. The return profile could look different,” he says. He adds that while any change is likely to have the most impact on underfunded plans, it’s good for every plan sponsor to think through their assumptions when market conditions change significantly.

“If you have a frozen plan you’re not going to be as exposed, but inflation can still impact investment performance,” he says. “Sponsors need to consider portfolio allocations and liquidity with inflation in mind.”

Insurers Adjust

For the insurers taking on new risk transfers, the math for inflation, interest rates and volatility is a bit different. Insurers are heavily invested in the fixed-income market and face tighter controls over how they can diversify than pension plans do. Still, higher yields as a result of current market conditions are making it cheaper to annuitize pension obligations for frozen plans. But, for plans with built-in cost-of-living increases, it could end up being more expensive to do a risk transfer.

“Insurers are going to be looking at the benefits they have to take on and if there is an embedded level of inflation risk that makes everything more expensive,” says Mercer’s McDaniel. “This is more of a problem outside the U.S. where pensions are more likely to be indexed to inflation, but either way, it makes the ideal end state hard to achieve.”

Over time, insurers may also choose to diversify into more illiquid parts of the fixed-income universe to shore up investment returns if inflation and volatility remain persistent. “Insurers are good at navigating across market cycles,” says Richards. “They have the benefit of being able to make decisions based on book value rather than current market value. So they aren’t as beholden to quarter-over-quarter shifts in the discount rate. Their long time horizon gives them some advantages in terms of being able to get an illiquidity premium if they choose to diversify into those parts of the fixed-income universe.”