New Solutions for Retirement Benefit Obligations
Table of Contents
The DB Plan Buy-in Annuity ......................................................................3
The Retiree Life Insurance Buy-out ..........................................................5
Combining the Use of a VEBA and Captive Insurer
to Finance Retiree Healthcare Benefits ....................................................6
Keeping Promises: New Solutions for Retirement Beneﬁt Obligations 1
Retirement benefit obligations, such as defined benefit (DB) plans and
retiree healthcare benefits, are straining the finances of employers.
Many DB plan sponsors are making larger contributions to their plans
to address sharp declines in plan funding levels and to provide liquidity
to make benefit payments. At the same time, the cost of retiree
healthcare obligations continues to grow due to the significant increase
in healthcare costs over the last decade.
Business leaders and finance executives are focused on ensuring that
their companies have the financial resources to fulfill long-term benefit
obligations, while maintaining the flexibility to conduct core business
activities. Although this is not an easy balancing act, a growing number
of solutions are available to help companies fulfill their benefit
obligations.The goal of this paper is to describe three such solutions:
• DB plan buy-in annuities for an immediate and orderly transfer of
The buy-in annuity enables underfunded DB plans to substantially
reduce pension risk before their plans become fully funded.The
buy-in is an insurance policy that provides for the future benefits for a
subset of a plan’s participants; the policy resides in the plan as a plan
asset. Buy-in policies lower a DB plan’s overall exposure to longevity,
investment, and interest rate risk, thereby increasing the stability and
predictability of future plan costs.
• Retiree life insurance buy-outs to strengthen a company’s financial
This solution enables an employer to strengthen its balance sheet
and streamline benefits administration by allowing it to fully transfer
to an insurer the liabilities associated with providing retiree life
• Combining the use of a VEBA with a captive insurer to more
efficiently fund retiree healthcare obligations.
Employers that are funding retiree healthcare benefits through
a Voluntary Employee Beneficiary Association (VEBA) trust can
enhance this funding strategy by incorporating the use of a captive
insurer to reinsure retiree healthcare benefits.1 This approach
provides companies with tax and funding efficiencies that cannot
be realized solely through the use of a VEBA as a funding vehicle.
The rest of this paper explores each of these solutions in greater detail.
1 While VEBAs are generally used to fund healthcare benefits for retirees, they can also be used to fund
healthcare benefits for current employees.
2 Keeping Promises: New Solutions for Retirement Beneﬁt Obligations
The DB Plan Buy-in Annuity distinguishing features enable buy-ins to overcome the
challenges involved in executing buy-outs:
The challenge for DB plan sponsors
DB plan sponsors are exposed to a number of risks • The buy-in does not trigger settlement accounting,
with respect to managing their pension obligations, as the plan sponsor remains the primary benefit
including longevity risk, investment risk, and interest obligor.
rate risk. Liability-driven investing (LDI) strategies • The buy-in should not impact materially the overall
enable sponsors to mitigate interest rate risk. However, funding ratio of the plan since the buy-in contract
even sophisticated LDI strategies can fall short of their remains a plan asset.
risk reduction objectives, because it is difficult to invest
in a portfolio of securities that replicates pension After execution, the value of a buy-in contract is
liability discount rate benchmarks for funding expected to more closely track the value of the
requirements and financial reporting. For example, liabilities that the contract addresses than the value
a DB plan’s liabilities often extend for more than 30 of assets invested in an LDI strategy would.This is
years, but the high-quality corporate bond market because the value of the liabilities and the value of the
offers limited opportunity to invest in bonds with buy-in contract will respond in parallel to changes in
maturities greater than 15 years. factors including, but not limited to, interest rates and
longevity, whereas the value of the liabilities and the
The most effective way for sponsors to eliminate all of value of assets invested in an LDI strategy will only
the risks they face is to buy an annuity. However, this respond in parallel to changes in interest rates.
option is primarily available to plans that are fully, or
nearly fully, funded. Underfunded plans would need The impact of a buy-in on the future expected returns
to make contributions to their plans to close the funding and risk of a DB plan
gap to enable the purchase of such an annuity. Instead, The buy-in contract is a plan asset that can be thought
the more practical option for underfunded plans is to of as a fixed-income instrument. As a result, a DB plan
purchase an annuity for a subset of a plan’s participants, sponsor can incorporate a buy-in contract into its DB
such as its retirees. Even this option, however, presents plan’s asset allocation in a way that achieves a targeted
challenges for underfunded plan sponsors: level of future expected returns and risk. For example,
a sponsor that wishes to minimize risk can fund the
• A buy-out annuity triggers settlement accounting purchase of a buy-in contract through the sale of
because the sponsor is fully transferring the liability equities. After executing the buy-in, such a DB plan’s
to an insurer. Under settlement accounting, the future expected returns would be lower, but the plan
sponsor must accelerate recognition of any deferred would have effectively increased its fixed-income
losses or gains within its DB plan. allocation, thereby reducing future funded status
• A buy-out annuity lowers the overall funding ratio of volatility. Alternatively, a sponsor that wishes to reduce
an underfunded plan. For example, a plan with $100 the impact of a buy-in on the future expected returns of
million in liabilities and $75 million in assets has a its DB plan’s portfolio could fund the buy-in by utilizing
funding ratio of 75%. If this plan executes a buy-out by current fixed-income securities.
paying a $25 million premium to an insurer to transfer Assessing the benefits of the buy-in solution through
$25 million in liabilities, the plan would be left with a case study
$75 million in liabilities and $50 million in assets.2 As a The following case study demonstrates the benefits of
result, the plan’s funding ratio would decline from 75% a buy-in by analyzing the pension liabilities of the 12
to 67%. A lower funding ratio can have several companies within the Dow JonesTransportation Index
negative implications for a DB plan, including an that have a DB plan.The analysis was conducted by:
acceleration of required plan contributions.
• Adjusting the total net debt of these companies by
The buy-in as a new risk management solution adding to it their unfunded pension and other post-
for DB plans employment benefit (OPEB) liabilities.
The buy-in enables plan sponsors to purchase an
insurance policy to realize the same risk reduction • Quantifying the risk associated with the total
benefits of a buy-out without the negative accounting adjusted net debt by measuring its annual Value at
and funding implications. Like buy-outs, buy-ins enable Risk (VaR),3 or the amount that the adjusted net debt
sponsors to transfer longevity, investment, and interest could increase in any given year.
rate risk to an insurer. However, unlike a buy-out The VaR of both financial debt and benefit liabilities
annuity, the buy-in contract is retained as a plan asset. was measured because factors such as interest
Further, the buy-in leaves plan sponsors ultimately rates impact both types of debt.The limitation of
responsible for providing pension benefits.These VaR analysis is that it understates the impact of
2 The premium cost above the value of the liabilities being transferred has not been shown to simplify the numeric example.
3 Value at Risk (VaR) was modeled in this analysis by measuring the maximum possible annual increase in the total adjusted net debt of these
12 companies in 95% of the modeled scenarios.
Keeping Promises: New Solutions for Retirement Beneﬁt Obligations 3
catastrophic events such as the recent financial billion to $21.3 billion.This analysis assumes that this
crisis. However, with this caveat, VaR analysis can strategy was implemented by replacing bonds from
serve as a useful risk assessment tool. the Barclays Aggregate Index with bonds from the
Barclays Long Corporate Credit Index.4 This strategy
• Sizing the impact of LDI-based risk mitigation
mitigates interest rate risk by better matching the
measures, a buy-out annuity, and a buy-in on the
duration of these companies’ DB fixed-income assets
VaR of these companies’ total adjusted net debt.
and DB liabilities. Alternatively, purchasing interest
The two LDI-based risk mitigation measures that swaps to match the overall duration of these
are modeled are duration extension through the companies’ DB portfolios and DB liabilities reduces
purchase of cash bonds, and duration extension the VaR to $18.9 billion.
through the purchase of interest rate swaps.
Both the buy-out annuity and the buy-in reduce the
The results of this analysis are shown in Exhibit 1. VaR to $17.9 billion.This analysis assumes that both
of these transactions were financed through the sale
As shown inTable A, the total net debt of the
of securities from each asset class within the DB plans
companies in the index increases significantly after
of these companies in proportion to the portfolio
being adjusted to include pension and other benefit
weighting of the asset class. In addition, this analysis
liabilities.The VaR associated with the total adjusted
assumes that after the execution of a buy-out, the
net debt, as shown inTable B, is $22.9 billion. If factors
companies make additional plan contributions to
such as equity market performance or interest rate
maintain their plans’ funding ratios. Additional
swings caused the total adjusted net debt to increase
contributions are not assumed in the case of the buy-in
by this amount in any given year, these companies’
because the buy-in contract is retained as a plan asset.
access to capital, valuation, and cash flow would be
materially impacted. Buy-ins and buy-outs have the most significant impact
on the VaR because they address all of the risks (i.e.,
The impact of each DB risk mitigation measure is also
interest rate risk, longevity risk, and investment risk)
presented inTable B. Buying cash bonds to extend the
facing DB plan sponsors.
duration of the fixed-income portfolios within the DB
plans of these companies reduces the VaR from $22.9
4 Fixed-income assets comprise 35% of the portfolios within the DB plans of these companies.
Impact of the Buy-In on the VaR of the Adjusted Net Debt of the 12 Companies
in the Dow Jones Transportation Index With Defined Benefit Plans
Table A Table B
Total Net Debt and VaR of Total Adjusted Net Debt
Total Adjusted Net Debt ($ Billions)
of any Risk
Mitigation After Execution of Each Risk
Measures Mitigation Measure
80 20 18.9
60 58.1 15
Net Debt Total adjusted Extend Extend Buy-out Buy-in
net debt with duration duration
pension and via cash via interest
OPEB liabilities bonds rate swaps
Note: Analysis based on 2009 financials; impact of each risk mitigation measure is modeled individually.
Source: SEC filings, Prudential analysis.
4 Keeping Promises: New Solutions for Retirement Beneﬁt Obligations
The Retiree Life Insurance Buy-out assuming that the buy-out was funded by deploying
available cash on the employer’s balance sheet.
The challenge for employers
Some employers offer employees life insurance • Future benefit costs cannot increase since the insurer
benefits that extend into retirement. Employers usually assumes all responsibility for providing the benefit.
offer each retiree a relatively modest amount of life • Benefits administration is significantly streamlined
insurance, such as $5,000 to $10,000. However, when because the insurer takes on the responsibility for
multiplied across thousands of retirees, this benefit administering the plan.The employer only retains
can entail a significant obligation for a large employer, responsibility for tax and Employee Retirement
and presents several challenges: Income Security Act reporting.
• Employers must record the net liability for retiree • Moreover, for employers that have set aside assets
life insurance benefit obligations on the balance to fund retiree life insurance obligations, the buy-out
sheet, thereby increasing a company’s liabilities- eliminates investment risk on these assets because
to-equity ratio. the insurer becomes solely responsible for investing
• Employers may have to absorb increases in the buy-out premium and absorbing unfavorable
insurance premiums because of unfavorable investment returns.
mortality experience or increases in the price Executing this transaction does require employers to
of insurance. pay the premium for a buy-out. However, for employers
• Administering retiree life insurance programs can with available cash to pay the premium, the retiree life
require significant overhead because companies must insurance buy-out can be an attractive option, because
service a large and dispersed retiree population. the insurer can price the buy-out premium using a
higher discount rate than the rate the employer is likely
Retiree life insurance buy-outs provide a one-stop earning on its cash.
solution for settling retiree life insurance obligations
Employers can execute a retiree life insurance buy-out An example of the benefits of a retiree life insurance
by paying a single, tax-deductible premium to an buy-out is shown in Exhibit 2.
insurer to completely address their future obligation In this example, the employer pays a $22 million
related to retiree life insurance benefits.This premium to eliminate its unfunded retiree life liabilities.
transaction addresses the challenges discussed above: The premium is slightly more than the net liability
• The retiree life insurance buy-out completely because the premium includes the capitalization of the
removes the liability associated with retiree life insurer’s administrative costs.The buy-out removes the
insurance benefits from an employer’s balance sheet. liability from the balance sheet, thereby improving the
This improves an employer’s liabilities-to-equity ratio, employer’s liabilities-to-equity ratio from 1.50 to 1.46.
Impact of a Retiree Life Insurance Buy-Out
Hypothetical employer with retiree life insurance liabilities ($ Millions)
Assets Liabilities • $20 million unfunded liability on balance sheet
Current assets $500 Retiree life liability $20 • Annual premium expenses of $750,000
Long-term assets $500 Other liabilities $580 after taxes
Shareholders’ equity $400 • Additional costs per year to administer
Total $1,000 Total $1,000
• Liabilities-to-equity ratio of 1.50
Hypothetical employer after executing a retiree life insurance buy-out ($ Millions)
Assets Liabilities • $22 million premium paid to insurer
Current assets $478 Retiree life liability $0 • Retiree life insurance liability is removed
Long-term assets $500 Other liabilities $580 (settlement) from the balance sheet
Shareholders’ equity $398 • Annual premium and administrative
expenses are eliminated
Total $978 Total $978
• Liabilities-to-equity ratio improves to 1.46
Keeping Promises: New Solutions for Retirement Beneﬁt Obligations 5
Combining the Use of a VEBA and Using a VEBA and captive insurer to efficiently fund
retiree health obligations
Captive Insurer to Finance Retiree Companies use captive insurers for a number of
Healthcare Benefits reasons, including insuring risks that may be difficult
The challenge for employers to insure in the commercial insurance markets. Now,
Some employers are using a VEBA to fund retiree in a new application, captive insurers can help
healthcare obligations. VEBAs are trusts that enable an companies maximize the efficiency of funding retiree
employer to make tax-deductible contributions to fund health obligations.
future healthcare expenses, such as medical claims, for An employer providing retiree health benefits can
its retirees. In a typical arrangement shown in Exhibit 3, direct its VEBA to purchase a non-cancellable group
the employer makes tax-deductible contributions to the Accident & Health (A&H) policy from a third-party
VEBA to fund retiree healthcare obligations. Employees insurer.The third-party insurer’s policy would provide
and retirees file claims with a claims administrator.The for the reimbursement of all retiree healthcare claims
claims administrator processes and pays the claims, within an annual corridor of benefits for each
and is then reimbursed by the employer’s VEBA. beneficiary.The third-party insurer then cedes its
Funding retiree healthcare obligations via a VEBA liability under the policy to the employer’s captive
creates a few challenges for employers: insurer.This funding strategy creates several benefits
for the employer:
• Earnings on assets held in a VEBA may be subject to
Unrelated Business IncomeTax. (This tax applies to • The captive insurer receives a premium from
earnings within management VEBAs, not collectively the third-party insurer for assuming the retiree
bargained VEBAs.) healthcare liability, and can accumulate earnings on
a tax-advantaged basis on assets held in support of
• Assets placed in a VEBA are, for all intents and the liability.
purposes, unavailable to the employer, as any
withdrawals from the VEBA for purposes other • The captive insurer can dividend its income to the
than paying benefit expenses are taxed at 100%. employer, thereby providing a conduit for favorable
investment returns or claims experience to flow to
Using a VEBA to Fund Retiree Healthcare Benefits
Employer Plan Contributions VEBA
Claim payments Administrator
6 Keeping Promises: New Solutions for Retirement Beneﬁt Obligations
Exhibit 4 illustrates how an employer can use its efficiencies for the employer. Assets provided to the
captive insurer in conjunction with a VEBA to fund captive to assume the third-party insurer’s liability
retiree health obligations. generate earnings on a tax-advantaged basis. In
addition, the employer gains access to favorable
As shown in the left-hand side of Exhibit 4, the retiree
investment results and claims experience within the
experience remains the same when a captive is used
to reinsure retiree health benefits.The employer
continues to make tax-deductible contributions to Implementation considerations
the VEBA to fund retiree health obligations. Retirees Companies must have already established a VEBA and
continue to file claims with the same claims a captive insurer domiciled in the United States to take
administrator that was in place prior to the reinsurance advantage of this transaction. In addition, companies
transaction. must obtain an exemption from the U.S. Department
of Labor (DOL) to reinsure their retiree health benefits
The right-hand side of Exhibit 4 demonstrates how the
with a captive insurer.The DOL provided approval for
introduction of a captive insurer to finance retiree
the first transaction of this type in March 2010.
healthcare obligations creates tax and funding
Combining the Use of a VEBA and Captive Insurer to Fund Retiree
Employer and Participant View Captive Insurer View
Employer VEBA Captive
Claim payments reimbursements
• Third-party insurer • Tax-advantaged
Claim payments takes on liability investment earnings
for reimbursing within captive insurer
Retiree medical claims within an
• Potential to dividend
claims annual corridor
excess returns to the
of benefits for
Keeping Promises: New Solutions for Retirement Beneﬁt Obligations 7
The solutions presented in this paper provide three potential ways for
companies to address certain aspects of their benefit obligations while
reducing risk, strengthening their financial position, and maximizing
funding efficiencies. In particular, these solutions enable finance
executives to evaluate the benefit risks embedded within their
companies’ balance sheets, and to transfer selected risks to third-party
insurers that may be better positioned to manage these risks over the
long term. By assuming these risks, third-party insurers serve as a
specialized source of funding for companies that need to fulfill benefit
obligations, and thereby help finance executives further diversify their
companies’ funding sources.
For more information,
please contact the contributors:
Vice President, Prudential Financial
Vice President, Prudential Retirement
Vice President, Prudential Financial
Vice President, Prudential Retirement
8 Keeping Promises: New Solutions for Retirement Beneﬁt Obligations
The Prudential Insurance Company of America, Newark, NJ