Defined benefit pension plans are on the list of financial risks that need regular attention. As a pension plan ages, more retiree-, beneficiary- and terminated-employee liabilities emerge. Eventually, the pension plan obligation may increase to a point where the volatility on the balance sheet and income statement is greater than a company is prepared to absorb. There are several techniques to shrink the pension obligation back down to a manageable size, but be cautious – an effective strategy for one company may be a bad fit for another.
The most common (and typically most cost-efficient) strategy to mitigate pension obligation risk is to offer a lump sum distribution option to terminated employees in lieu of a future monthly benefit (see the Fall 2015 SilverLink article, “Trending Up – Lump Sum Offers in Private Pension Plans”). This option is frequently offered during a temporary window of time, giving the plan sponsor control over the timing, as well as some control over which participant population is offered the lump sum option. This offer may work well for terminated participants, but it is generally not an option for actively employed participants unless the pension plan terminates. It’s also not an option for retirees currently receiving their monthly benefits.
When it comes to retiree benefits, the purchase of a group annuity can be an effective strategy to shrink the plan liability. Doing so transfers the corresponding liability, investment risk, longevity risk and administration of the benefits to an insurance carrier. Over the past couple of years, plan sponsors have shown more interest in purchasing group annuities for retirees who receive smaller monthly benefits.
Why Small Benefits?
Measured as a percent of the pension accounting obligation, the total economic cost for smaller monthly benefits is more than the economic cost for larger monthly benefits. The chart (at left) shows a typical plan with investment management fees of 5% and an investment default risk of 3%. Administrative fees (such as those charged to process monthly benefits) are at least partially charged on a flat-fee basis. There is also a flat-fee component of the Pension Benefit Guaranty Corporation (PBGC) annual premium, which is scheduled to increase annually. The smaller the monthly benefit, the higher these fixed fees are as a percent of the corresponding liability.
As illustrated in the chart, these expenses add 2% to the economic cost for average monthly benefits. If small monthly benefit amounts are isolated, administrative fees and the PBGC expense add 5% to the economic cost. The total economic cost for average monthly benefits is 110% of the pension obligation, compared to 113% for small monthly benefits, indicating that smaller benefits are more costly to maintain in the plan.
What’s the Cost to Annuitize?
If a plan sponsor can demonstrate that the small monthly benefits are largely for retirees who were lower-paid staff or blue-collar workers, the insurance carrier might be able to apply an analogous mortality table with shorter life expectancies that may decrease the annuity premium. The break-even point where the economic cost equals the annuity premium is typically in the $200 to $400 monthly benefit range, but this varies depending on actual plan expenses and assumptions applied to measure the accounting obligation, as well as the insurance carrier’s appetite and pricing assumptions.
Just the Right Size
If the total annuity premium is too small, it becomes more difficult to generate healthy, competitive interest among insurance carriers. On the other hand, if the plan sponsor wants to avoid settlement accounting (required when the cost of all settlements for the year, including lump sums and annuities, exceeds the service and interest cost components of the pension expense), this places a ceiling on the annuity premium. It is also important to be aware of how the transfer will affect the plan later. If the cost causes a decrease in the funding percentage of the plan, this may trigger an increase in the PBGC variable-rate premium, require quarterly contributions to the plan or limit future options for accelerated benefits such as lump sum distributions and additional annuity purchases.
The participant population demographics after the transfer should also be analyzed, especially if the plan is on a path to terminate within the next several years. Insurance carriers are more likely to compete for the annuity placement at plan termination if the group consists of at least 50% retiree liability. Insurance carriers prefer these immediate annuities, which they consider more predictable and, therefore, less risky.
Will This Work for My Plan?
By law, a corporate plan must be adequately funded before undergoing any risk transfer. The plan doesn’t need to have its benefits frozen or even be on a path to terminate. Purchasing group annuities for smaller monthly benefits may not be appropriate for all plans, but it could serve as an effective risk mitigation technique. SilverStone Group’s pension plan consultants can help you determine what type of risk transfer approach makes the most sense for your defined benefit plan. We encourage you to contact our experts to help you evaluate your options and implement a strategy that is best suited to your needs.
This article originally appeared in the 2017 | ISSUE TWO of the SilverLink magazine, under the title “One Size Does Not Fit All.” To receive a complimentary subscription to the SilverLink magazine, sign up here.