What alternative LDI solution can be used tomanage a defined benefit pension plan instead ofmanaging just interest-rate risk?

What will be an ideal response?

Three solutions have been used by sponsors of DB pension plans to mitigate the risks thatthey face. These solutions, referred to as de-risking solutions, areclosing (freezing), termination and risk transference. Below we describe these strategies.Basically, these solutions are a means for dealing with longevity risk, which is the risk that actual life expectancy of plan members beyond their retirement date will exceed the life expectancy assumed in projecting the liabilities.

Closing a fund plan means freezing the plan, not terminating it. The plan remainsinsured by the federal insurer, the Pension Guaranty Benefit Corporation (PGBC). Thereare three types of plan freezes:

• Hard freeze: All employees may not earn any further benefits under the plan but employees become immediately vested in what they have earned.
• Partial freeze: The benefits may not increase for some but not all employees. This typically occurs when an employer does not allow new employees to enroll in the plan, but continues the plan for existing employees.
• Soft freeze: Employees are no longer allowed to obtain pension credit for future years of work under the plan, but they are allowed their benefits to be figured on their pay at the time they leave the plan, rather than at the date of the freeze.

A frozen plan can be unfrozen at the election of the employer.

The termination of a plan results in the plan operations stopping completely and cannotbe "unterminated." What happens to the plan's assets and the payments to the members ofthe plan depends on whether the plan is underfunded or overfunded. For an underfundedpension plan, the assets are turned over to the PBGC. That federal insurer will then makethe promised payments to the plan members (subject to federal restrictions as to the maximumamount a plan member may be paid). If in the unlikely case the plan is overfunded,the plan assets will be transferred to a qualified insurer that will then be responsible formaking the full benefit payments to the plan members.

Pension sponsors can buy out the vested employees with a lump-sum payment. Thisremoves all pension risk associated for that one group of members. This solution transferspension risk to the members who accept the lump-sum payment.

Other risk transference solutions include buy-outs, buy-ins, and longevity swaps. Ina buy-out, the sponsor purchases for a single premium an insurance contract (an annuitycontract) for all employees. This transfers the pension risk from the plan sponsor to theissuer of the annuity (usually a life insurance company). This solution is referred to asannuitization. Although the standard pension risk has been removed, there is still the creditrisk of the counterparty.

With a buy-in, the plan sponsor purchases for a single premium an annuity that doesnot cover the full amount of the projected liabilities. The assets in the fund not used topurchase an annuity are still managed by the plan sponsor, so there is only a partial transferenceof the pension risk. The annuity becomes an asset of the pension plan with the associatedcredit risk like that of any corporate debt obligation.

The hedging of longevity risk can be obtained by the pension plan entering into a longevityswap or a longevity bond. With a longevity swap, the pension plan enters into aswap agreement with a counterparty, usually an investment bank or an insurer. The pensionplan pays in this swap transaction a fixed amount periodically to the counterpartyand the counterparty makes periodic floating payments to the pension plan based on thedifference between actual and expected mortality experience. There are different types oflongevity swaps: customized and standardized (or index-linked instruments). The risk withstandardized longevity swaps is that the contract may not provide precisely the longevityrisk faced by the pension plan.