The who and why of pension de-risking

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Double exposure of calculator,account book,bar,house and car key remote on finance and banking concept © Baramee Chongchaeng /123RF Stock PhotosLike Canadian defined benefit plans, many U.S. plan sponsors are purchasing annuities to get out of the pension business. But why are companies choosing the de-risking route versus freezing or winding up their plans?

A new working paper by Brian Silverstein, a PhD candidate at Florida Atlantic University, looked at instances of complete divestitures of plan assets and liabilities through annuity buyouts.

The paper found plan sponsors pay the premium associated with de-risking when their pensions are better funded and large relative to the organization’s size. As well, those choosing risk transfers have growth prospects, which is why they’re willing to pay the premium associated with an annuity purchase, the paper suggested.

“To buy out — to transfer your assets and liabilities out of the plan — you do pay a premium, upwards of 10 per cent,” says Silverstein. “So you’re paying now to avoid future volatility in your income statements, which might take away from core operations. What it seems to be is de-risking associated with plan health and prudent investment decisions overall.”

This is opposed to organizations that choose to freeze their plans, which is actually a sign of constraint and possible distress, rather than freeing up the balance sheet for future growth, according to the paper.

Interestingly, when employers de-risk their pension plans, they increase risk-taking at a corporate level, it found. This suggests organizations remove pension risk from their balance sheets in order to take advantage of future investment opportunities.

More earnings volatility tends to exist after de-risking, on average, over three years, says Silverstein, explaining this is an academic proxy for risk-taking.

After de-risking, organizations are also making investments, but there aren’t any economically significant changes in capital expenditures. However, financing decisions are happening, he adds.

The paper also found that, after a plan sponsor de-risks its pension, less diversification is measured by sales across different units. This suggests that pension items that are off the balance sheet aren’t favoured by lenders, so when a company de-risks, the financial reporting is clearer, Silverstein says.

“By reducing the complexity of the financial statements, in essence, it [should] allow the firms cheaper access to external finance.”

Finally, pension de-risking is associated with better risk-adjusted stock returns, Silverstein adds.

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