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For pension risk transfers, it’s safety first

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Mike Clark
Consulting Actuary

Many defined benefit (DB) plan sponsors are likely scouring the internet for an obscure document called “IRS Interpretive Bulletin 2509.95-1” (more commonly known as “95-1”.) That is because 95-1 attempts to clarify the fiduciary responsibilities of plan sponsors when they purchase annuities to permanently transfer pension risk to insurers, an activity that has picked up steam with improving DB funding positions in 2021.

At the core of 95-1 is the requirement that sponsors “must take steps to obtain the safest annuity available” when purchasing. The superlative adjective always bothered me since it suggests there is a single answer to the question. (If you line up all the insurers in the US against the wall in order from safest to least safe, there would only be one at the front of the line.) But we know that the pension risk transfer market has at least a dozen meaningful providers with more joining in as demand grows.

Defining the “safest”

In recognition of this fact, 95-1 quickly backpedals on “safest” (an impressive feat in a two page document) to clarify that “more than one provider is able to offer the safest annuity available”. This can’t be literally true, but it is generally reasonable since more than one insurer could conceivably provide sufficient security to comfortably place an obligation. Factors to use in determining the safest providers include:

  • Quality and diversification of insurer investment portfolio
  • Size of insurer relative to annuity being placed
  • Insurer capital level and surplus
  • Structure of annuity contracts available
  • Availability of state backed guarantees
  • Other business related risks

Introducing ambiguity

Further straying from the “safest” annuity concept, 95-1 then offers this prevaricating tie-breaker: “…there are situations where it may be in the interest of the participants and beneficiaries to purchase other than the safest available annuity.”

The ability to administer the plan’s benefits is one exception. This is particularly important when annuity placements include deferred lives (those not receiving pensions yet) as this service is not available from all insurers. Complexities like cash balance benefits and cost of living adjustments are also relatively unattractive to some from an administrative perspective.

Is the price right?

The second exception granted is, not surprisingly, price. (I really buried that lead!) 95-1 rationally suggests that the safest annuity provider need not be chosen if it is only marginally safer but disproportionately more expensive than other options. It’s important to note, though, that 95-1 does not require that the lowest price always be selected. It actually admonishes that cost considerations should “never justify putting the benefits of annuitized participants and beneficiaries at risk.”

Safety horse vs. price cart

Many sponsors hire search consultants to assist with their annuity placements by soliciting competitive bids. Though this is not specifically required by 95-1, it seems a prudent step to increase fiduciary protection. Most of these competitive bids come down to two main factors: insurer security and price. 95-1 would prefer you keep them in that order: insurer security as the primary deciding factor and price as a secondary consideration. Safety first!

But weighing the financial strength and administrative capabilities of insurers can be a laborious process. Whereas price is easily understandable by all, making it a tempting hook on which to hang buying decisions. Since 95-1 requires precisely the opposite approach, fiduciaries should guard against the temptation to put the price cart before the “safest” horse.

Realistically, the likelihood of any insurer failing to fulfill the annuity payment obligations they take on is exceedingly small. If the worst ever were to occur, however, the first question plan fiduciaries will be asked won’t be, “Did you get a good deal?”

Mike Clark is a fellow of the Society of Actuaries (SOA) and a member of the American Academy of Actuaries (AAA).

Affiliation Disclosure

The subject matter in this communication is educational only and provided with the understanding that Principal® is not rendering legal, accounting, investment, or tax advice. You should consult with appropriate counsel, financial professionals, and other advisors on all matters pertaining to legal, tax, investment or accounting obligations and requirements.

Insurance products and plan administrative services are provided by Principal Life Insurance Company, a member of the Principal Financial Group® (Principal®), Des Moines, IA 50392.