Cost of Maintaining Pension Liabilities Level for May

The economic cost of maintaining liability for a defined benefit (DB) pension plan in May remained level at 108.7% of the same liability, according to the Mercer U.S. Pension Buyout Index.

During May, the index also shows that the average cost of purchasing annuities from an insurer decreased from 108.9% to 108.7% of the accounting liability.

The authors of the index point out that accounting liability does not include all costs associated with maintaining a DB plan. The cost of maintaining a DB plan, they say, is approximately the same as the cost of transferring liabilities to an insurer for the sample retiree plan modeled. For retirees, the costs of maintaining the plan are about the same as the costs to transfer the obligation and risk to an insurer, according to the index.

The past several months have also illustrated the volatility in insurer annuity pricing as the buyout cost has quickly moved from less than to greater than the economic cost and is now approximately equal, according to the index. The ability to frequently monitor insurer pricing against pre-determined thresholds, and be able to execute quickly, will be important in order to take advantage of this volatility and complete a buyout under favorable pricing conditions.

The index also notes the recent study by the Society of Actuaries, which shows that people are living longer than expected and that pension actuaries may soon have to update plan mortality table assumptions, which will increase plan liabilities. Mercer expects that the Internal Revenue Service may require plans to use the new tables to assess funding from 2016 or 2017, while auditors may expect plan sponsors to reflect the new tables for accounting purposes even earlier. While the actual increase to liabilities is dependent on the specific plan, Mercer expects increases of 5% to 10%. This potentially significant increase to plan liabilities is another compelling reason for plan sponsors to purchase annuities and transfer the risk, according to the index.

A corresponding increase in the cost to purchase annuities from an insurer is not expected as initial indications are that insurers have already reflected these longer life expectancies. What this means, according to the index, is that pension liabilities are expected to increase while the cost to transfer liabilities to an insurer through a buyout is not.

Another compelling reason for transferring liabilities and risks, notes the index, is due to the recent significant increases in Pension Benefit Guaranty Corporation (PBGC) per participant premiums. These annual premiums are paid for every participant until they leave the plan and/or pass away, and were recently increased by more than 30%, from $49 per participant in 2014 to $64 per participant in 2016, and increasing with inflation thereafter. A buyout eliminates paying these annual premiums along with other administrative costs which are often a large part of the cost in maintaining the plan.

The current economic environment, together with the increase in PBGC premiums and mortality update on the horizon, makes 2014 an attractive time for sponsors to consider an annuity buyout as an effective risk management tool, according to the index. There are a number of steps involved in order to prepare for a buyout and so we recommend that DB plan sponsors act now to evaluate whether buyout is appropriate for them and develop an implementation strategy.

The index recommends that plan sponsors considering a buyout in the future should also review their plan’s investment strategy and consider increasing their allocation to liability hedging assets, either immediately, given any recent improvements in funded status, or over time as the funded status improves. This can reduce the likelihood of the funded status declining again, leading to unexpected additional cash being required to purchase annuities at a later stage.

Published monthly, the index allows plan sponsors to see at a glance the relative cost of a buyout by an insurer of retiree liabilities of a defined benefit plan and how that cost changes over time. In addition, the index shows the approximate long-term economic cost of retaining the retiree liabilities on a sponsor’s balance sheet.