What Is Pension Risk Transfer?

Pension Risk Transfer Explained

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A pension risk transfer occurs when a company eliminates some or all of its pension benefit obligations for financial reasons. This process is also known as “derisking” and is usually done by offering vested plan participants—those who have earned benefits from their years of service with a company—a lump-sum payout. Companies can also enter an agreement with an insurance company to hand off the responsibility for plan participants’ monthly pension benefits.

Here’s what to know about pension risk transfers, how they work, the different types, and more.

Definition and Examples of Pension Risk Transfer

In a pension risk transfer, sometimes referred to as PRT, companies eliminate the risk of defined benefit plans by transferring or ending their obligations to plan participants.

Defined benefit plans have become less prevalent; far more companies now instead offer 401(k) retirement plans, a type of defined contribution plan. As part of this transition, many companies with pensions have frozen benefits or opted for pension risk transfers to unload the risks associated with funding such plans.

How Does Pension Risk Transfer Work?

Although defined benefit plans with set monthly payouts are on the decline, many companies that offer them experience the pressures of escalating costs and financial volatility that accompany sizable pension benefit obligations. Rather than continue to wrestle with uncertainty about financial markets, interest rates, maintaining sufficient reserves, and the life expectancy of vested program participants, plan sponsors are unloading the responsibility for funding pensions.

The defined contribution plan, the most familiar version of which is the 401(k), was created when Congress passed the Revenue Act of 1978. The 401(k) was originally designed to supplement employer-sponsored pension plans but ultimately replaced most of them as companies came to prefer the reduced risks that came with defined contribution plans.

The Pension Benefit Guaranty Corporation is a government entity that takes over and pays benefits to plan participants of defaulted defined benefit plans.

Types of Pension Risk Transfers

There are a handful of strategies that pension program sponsors may use to eliminate or significantly decrease their amount of financial responsibility for defined benefit plans. All of these can have serious implications for plan participants and retirees.

Freezing Benefits

A pension freeze means some or all of the employees covered by a pension plan stop earning benefits from the point the plan is frozen. In some cases, a freeze may cut off participation in a defined benefits plan to those workers who were not yet participating yet allow the employees who were enrolled in the plan to continue earning benefits. This type is known as a soft freeze. 

Alternatively, a pension freeze may prevent all program participants from earning future benefits under the plan, an option known as a hard freeze. Under federal law, companies may not revoke benefits that employees have already earned under a plan.

Transferring Benefits to an Insurance Company

Some companies transfer pension plan obligations by converting them to annuity contracts that shift benefit payments to an insurance provider. A slew of Fortune 500 corporations took this step following the Great Recession of 2008, including General Motors, Kimberly-Clark, and Verizon Communications. While this changes who pays the monthly benefit, it should not change the amount.

Lump-Sum Payout

A program sponsor may offer participants an option to cash out their pension by receiving a single large payment in lieu of continued monthly payments. The decision whether to accept a lump sum is a complex one (more on that below).

What Pension Risk Transfer Means for Program Participants

A common and important decision that many vested plan participants face when a company opts for pension risk transfer is whether to accept a lump-sum payout offer or continue to receive monthly retirement benefits. 

A plan sponsor cannot force a vested plan participant to accept a payout offer.

For someone who is due to receive or is already receiving a monthly pension payment, determining whether a lump-sum payout is the right option is a complex matter. It’s an exercise that Katie Lewis, an investment advisor representative at Financial Security Management in Lakewood, Colorado, regularly completes with clients. 

Lewis told The Balance in a phone interview that she agrees that these points should be considered when you’re faced with the pension payout dilemma:

  • What do your retirement accounts look like? If you have a traditional IRA, Roth IRA, 401(k), or other savings that will help support you in retirement, accepting a lump-sum payout and bypassing monthly payments may be more attractive than if you’re heavily reliant on pension benefits alone.
  • Do you have other sources of income? If you plan to continue working part-time or have other streams of income, taking a lump-sum payout may be less risky and even a financially savvy move.
  • What is your confidence level in investing? Most pension plans pay a vested participant or surviving spouse the same monthly amount until they die. If you accept a lump-sum payout, however, that money becomes yours to manage. If you are in your 60s, you may need it to last more than 20 years. Thus, you may need to obtain a rate of return that helps the original amount grow so that you have funds to support yourself and possibly a spouse for many years to come.
  • What is your health and family history? If you are healthy and your family has a history of living well into their 80s or beyond, a lifetime monthly pension may be more valuable. Conversely, if you have a shorter life expectancy due to personal or family health reasons, the lump-sum payout could be more sensible. Remember to factor in whether your plan covers a surviving spouse. 
  • Do you aspire to leave money to heirs or charity? Pension plan payments cease either after a program participant or their spouse dies. A lump-sum payment creates the opportunity to pass wealth on if there is a balance left over.

When Lewis talks with clients about the pros and cons of accepting a lump-sum payout, she aims for candid conversations about longevity and family history, she said.

“None of us have crystal balls, but if someone has a lot of preexisting conditions going on, it’s a conversation you need to have” Lewis said, especially before opting for continuing monthly pension payments or accepting a lump sum.

Pension Plans vs. Lump-Sum Payouts

If your company offers a lump-sum payment as part of its attempt to erase some or all of its pension obligations, consider the pros and cons of all your options. Here’s a look at how pension plans stack up against lump-sum payments.

Pension Plans Lump-Sum Payouts
Guaranteed payment for life (and possibly a surviving spouse’s life) Immediate liquidity to use or invest as you wish, with the potential for growth through investments
Predictable amount of monthly income  Risk of losing some principal through market volatility and declines if invested
No adjustment for inflation over time You’re responsible for wisely investing and drawing down funds from the account
Payments cease upon your death or the death of a surviving spouse A remaining balance after your death may allow you to pass money on

If you don't roll proceeds from lump-sum payments directly into an IRA or an employer plan like a 401(k) or a 403(b), the payout will be taxed as ordinary income and may push you into a higher tax bracket.

A Financial Planner May Add Clarity

Clearly, the decision whether to maintain monthly payments from a defined benefit plan or to accept a company’s lump-sum payout can be knotty. For example, one client Lewis worked with had more than 20 different options to review in the pension payout proposal they were given.

“It is a complicated choice to make, and I’ve found that insurance companies or businesses make it really difficult to wade through,” Lewis said.

Regardless, it’s important to make the right decision for your situation if your pension provider opts for pension risk transfer. Financial planners and wealth advisors can help by running calculations and using their expertise to weigh your options so that you have plenty of information before making your choice. 

Key Takeaways

  • Pension risk transfer involves a company eliminating some or all of its financial obligation to vested participants in a defined benefit pension plan.
  • Vested participants may be offered a lump-sum payout or have their monthly payments handled by an insurance company through an annuity contract.
  • Most participants in a defined benefit pension plan cannot be forced to take a lump-sum payout. There are numerous factors to consider before deciding what’s right for you.