When purchasing a group annuity, participant benefit security is crucial. The sources for this security change significantly after this transaction. Awareness and analysis are key to preserving and even strengthening the protection of a retiree’s future benefit payments.
Sources of a Secure Pension
Within an ERISA defined benefit plan (covered by the Employee Retirement Income Security Act of 1974, typically private industry plans), participant benefit security is a function of the plan funding, the sponsoring employer’s financial strength and the backing of the Pension Benefit Guaranty Corporation (PBGC). (Some smaller professional group plans may opt out of PBGC coverage.) When benefit payment responsibility is transferred to an insurance company through a group annuity, the participant security comes from the insurance company’s financial strength, the funding of the separate account (if any) and the backing of the state guaranty associations.
When moving participants into a group annuity, plan sponsors have fiduciary obligations that are guided by the Department of Labor’s Interpretive Bulletin 95-1 (DOL 95-1). This bulletin requires plan sponsors to buy the “safest available annuity” determined by the following criteria: 1) the safety of the insurer; 2) the insurer’s financial strength, business lines and quality of investments; 3) the annuity contract structure; and 4) any protections available through state guaranty funds.
Pension Plan or Group Annuity?
This criteria is generally used to select the best carrier in the group annuity marketplace. But let’s take a step back and use it to compare the security of a pension plan versus a group annuity. Why is this important? When participants have the option to take a lump sum equivalent value of the monthly benefit instead of an annuity, the decision must often be made before the annuity carrier is known. The participant may be inclined to choose the lump sum because they feel insecure about the unknown insurance carrier compared to the greater comfort felt with their employer with whom they have had a well-established, proven provider relationship.
Much of the DOL 95-1 criteria deals with the financial security of the entity providing the benefit and the assets set aside to finance the benefit. Corporate pension plans must be at least 80% funded in order to offer lump sums or annuities. Recent funding relief legislation that allows plan liabilities to be measured at higher interest rates will artificially inflate this funding percentage. Insurance companies, on the other hand, are required to hold reserves against all liabilities and have additional capital surplus to back obligations. In effect, they are required to be over 100% funded at all times.
Corporate asset allocation will vary and is not regulated, but rather determined by an investment committee. Fixed income investments may vary from 20% to 80%, depending on company appetite for risk. Insurance company portfolios typically allocate around 85% to fixed income investments. A group annuity, backed by more assets and a more stable portfolio, is generally the more reliable source for future benefit payments.
Pension plan assets are protected from creditors in the event of corporate bankruptcy. Likewise, plan sponsors may have the option to place the group annuity assets into a separate account, inaccessible to creditors in the event of insurance company insolvency. This election is more common among the larger annuity transactions.
When an employer becomes insolvent, the PBGC may provide the pension plan’s benefit amount up to certain limits. For 2018, the maximum covered monthly benefit for a 65-year-old is $5,420. Additional amounts may be recovered from available plan assets.
Similar to the PBGC, state guaranty associations (now established in every state) have coverage limits at the individual participant level when an insurance company becomes insolvent. However, they calculate coverage differently than the PBGC. Annuities are protected against insurance company insolvency up to a specific present value of the benefit. Coverage varies from $100,000 to $500,000, with $250,000 being the most common benefit limit. The guaranty association in an annuitant’s state of residence at the time of the insurer’s insolvency provides the protection. Limits are per person and include all contracts held with the insolvent insurer. The insolvent insurer typically provides a portion of the settlement depending on available assets.
If a significant number of participants’ benefits exceed the state guaranty association limit, the plan sponsor may consider splitting the annuity among two separate insurers. This will provide the total state guaranty association limit for each of the insurers, in effect doubling the amount of coverage.
A Secure Option
The first line of protection for pension plan participants is the financial strength of the entity making their benefit payments. Insurance companies are generally held to stricter financial standards and more intensive oversight than pension plans and their sponsoring companies. In most cases, the creditworthiness of the safest available annuity provider is more reliable than that of the underlying pension plan sponsor completing the risk transfer. Participants can rest assured that their retirement benefits are in good hands with an insurance company annuity.
This article originally appeared in the 2018 | ISSUE ONE of the SilverLink magazine, under the title “Group Annuity Pension Buyout: Impact on Participant Benefit Security.” To receive a complimentary subscription to the SilverLink magazine, sign up here.