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Retiree Carve Outs – The What’s, Why’s and How’s of Pension Plan Annuity Purchases – Part 1

by Charles D. Cahill & Michael S. Clark

Over the last two decades, pension plan sponsors have increasingly focused on the importance of “de-risking” their plans. Sponsors have always been concerned about the cost of administering their plans, however those concerns have increased in recent years. Sponsors are now starting to move back to an old traditional idea for addressing these concerns by purchasing annuities for some, or all, of their retirees (also known as retiree carve outs).

This article is the first in a three part series that discusses annuity purchases and the reasons sponsors are utilizing them. This first installment starts by addressing the risks and costs pension plans pose to their sponsors. It also explains what an annuity purchase involves and how they mitigate risk and costs for the plan.

The second article will address the specifics around why so many plan sponsors are purchasing annuities, how to analyze whether an annuity purchase makes sense, and the profile of sponsors that may or may not be good candidates.

The third and final installment will address the process of annuity purchases and ways to optimize your results.

What are pension risks?

To understand de-risking you first have to understand what risks pension plans pose to their sponsors and how important those risks are to the sponsor. Sponsors must contribute cash to their plans, disclose the plan’s liabilities on their company’s balance sheet, and reflect the plan’s expense on their income statement. The amount of cash, the impact on the balance sheet, and the hit to the income statement numbers depends, most importantly, on whether plan’s liabilities are well funded (otherwise known as the plan’s funded status). The importance of these risks depends on how big the plan is relative to the company’s total balance sheet.

The dictionary definition of risk is “exposure to the chance of injury or loss.” 1 In the pension plan context, ”risk” is the chance that a plan’s funded status deteriorates to a point where the levels of cash contribution requirements or balance sheet liabilities/income statement expenses become detrimental to the company. Risk is also defined as volatility; the more likely the pension plan funded status can change the riskier the plan. Sponsors use de-risking strategies to reduce, remove, or effectively manage the inherent risks and volatility of the plan’s funded status in order to reduce the potential for adverse outcomes.

There are two sides to the pension risk balance equation: assets and liabilities. Pension plan de-risking has evolved over the last twenty years to target various aspects of the equation. Many plan sponsors have lowered their pension plan risk profile by utilizing liability driven investing (LDI) or cash-out windows. LDI uses fixed income instruments to match some portion of the pension plan assets to the characteristics of the plan’s liabilities. This reduces the volatility/risk of adverse changes in funded status that occurs with changes in interest rates. Lump sum cash-out windows have been popular over the last five years as a way to transfer risk out of the plan and to the participant.

Another de-risking initiative that has become increasingly popular over the last few years, among plan sponsors, is pension plan annuity purchases (also known as retiree carve-outs or retiree annuity buyouts).

[1] www.dictionary.com

What happens in an annuity purchase?

Annuity purchases for some, or all, of current in-pay retirees effectively transfer all the responsibility and liability of making monthly pension payments from the plan sponsor to an insurance company. From the retiree’s perspective, nothing really changes. They still get their monthly check in the same amount, and form of payment, that they’ve been receiving from the company since they retired. The only difference is, instead of getting their check from their former employer, they now receive it from the selected insurance company.

When a plan sponsor transfers the retirees to the insurer, they no longer carry the liability for those specific participants and their future pension payments. Therefore, they no longer have to pay monthly fees for processing checks and no longer pay premiums to the Pension Benefit Guaranty Corporation (PBGC) for these retirees; the retirees are no longer Plan participants. Of course, sponsors can’t just give these annuities away; they also have to transfer assets (referred to as a premium) from the pension plan to the insurer. In an annuity purchase both the plan’s assets and liabilities are reduced.

Why annuity purchases make sense

Purchasing annuities reduces the plan’s risks and lowers the cost of running the plan. There is also the added benefit of having fewer participants to administer.

Reducing risk

In terms of risk, when sponsors minimize the potential for large swings in the plan’s funded status they are de-risking the plan. Removing participants from the plan, along with the liabilities and assets associated with their benefits, shrinks the size of the plan and therefore the potential for volatility in funded status. Consider the following example: A seesaw can be a fun playground toy. If you put a 60 pound kid on each end they will smoothly go up and down, but replace those 60 pound kids with 200 pound adults, and the movement becomes much more jarring. Take it a step further and put a 200 pound adult on one end and a 120 pound adult on the other end. The seesaw gets out of balance, and the up and down motion becomes erratic (and maybe it’s not as much fun anymore). In a sense, a pension plan is like a seesaw with the plan’s liabilities on one end and the plan’s assets on the other. For a plan’s funded status to be in balance both sides should be the same size. If they are not, you can expect volatility. Even if they are in balance, shrinking the size of both ends can mean a much smoother ride as the volatility will not be as extreme (think about the difference in the up and down motion of two 200 pound adults versus two 60 pound kids – let alone the stress on the seesaw). A pension plan annuity purchase effectively shrinks both sides of the funded status equation and removes the risk of large swings in funded status. By transferring risk now, sponsors also eliminate future unknown risks that could throw the pension plan out of balance. For example, if medical advances find a cure for cancer, or other old-age diseases, that prolonging of life will drive costs up as payments will be made to participants for longer periods of time. This risk becomes the insurers to bear – one they are happy to bear (the reasons for which are outside the scope of this article).

Lowering costs – Saving on PBGC premiums

Cost reduction may be the most compelling reason for plan sponsors to purchase annuities for their retirees. Pension plan annuity purchases remove costs because they reduce one of the biggest expenses that plans deal with today: PBGC premiums.

Over the last five years, PBGC premiums have skyrocketed for plan sponsors. Between the Moving Ahead for Progress in the 21st Century Act (MAP-21) and the 2013 and 2015 Bipartisan Budget Acts, both the flat rate (headcount based) and the variable rate (funded status based) premiums have more than doubled. The chart below shows how these premiums have changed since 2010 and what they are projected to be over the next few years, barring any more legislative changes

PBGC Premiums2010-201220152016201720182019
Per Participant$35$57$64$69$74$80
Variable Rate % of Underfunded0.9%2.4%3.0%3.4%3.9%*4.4%*
Variable Premium Cap per ParticipantN/A$418$500$517$533*$549*

* Based on projected wage inflation of 3%

One new aspect of PBGC premiums that became effective in 2013 is the variable rate premium cap. This cap is based on headcount, similar to the flat rate premium, and puts a ceiling on the total amount of the variable rate premium. Many plans, if not most, are or will be subject to the variable rate premium cap. Plans that are subject to the variable rate premium cap in 2017 will pay $586 per participant in PBGC premiums. That premium is paid on each active, vested terminated, and in-pay retiree participant. So, for any participant you are able to transfer out of the plan via an annuity purchase, you are effectively saving $586+ in annual premiums. If a plan subject to the cap purchases annuities for 100 retirees, the plan saves almost $60,000 in annual, non-productive, premium payments to the PBGC.

Annuity purchases make the most sense for retirees whose benefits are small. A benefit is ‘small’ or impractical for a sponsor to manage if the administrative cost of keeping those retirees is high, relative to the annuity amount. The increase in the PBGC premiums over the past few years now means that the cost of managing the benefit paid to these retirees is often extremely high. For example, if you have a retiree who receives $3,000/year in benefits and your plan is subject to the variable rate premium cap, the PBGC premium is approaching 20% of the annual benefit ($600 premium/$3,000 benefit). That is an expensive administrative cost! The administrative costs for retirees with benefits at $10,000 per year still approach 6% of the annual amount. When plan sponsors look at their retirees, it is common to have the majority of retirees fit into this small benefit category.

Even if your plan is well-funded, for small annual benefit retirees the cost of transferring them out of the plan can make a lot of economic sense.

Beyond the significant PBGC costs, when you couple them with record-keeping costs, custodian/trustee fees, and audit costs, it becomes a no-brainer to transfer small annual benefit retirees out of the plan.

Conclusion

Purchasing annuities for small benefit retirees is an effective way for plan sponsors to de-risk their pension plans. By transferring the responsibility of making pension payments to an insurer, sponsors are able to shrink the overall size of their plan and reduce administrative costs at the same time.

The next article in our series will look at why plan sponsors are purchasing annuities today and how to analyze whether an annuity purchase makes sense.

Charlie Cahill

Managing Director

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Michael Clark

Director & Consulting Actuary

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