Annuity Purchase Cost Decreased in February

March 31, 2014 ( – For February, the average cost of purchasing annuities from an insurer decreased slightly from 108.5% to 108.4% of the accounting liability, according to the Mercer U.S. Pension Buyout Index.

Index findings show that the economic cost of maintaining pension liability remained level at 108.7% of the balance sheet liability. The index tracks the relationship between the accounting liability for retirees of a hypothetical defined benefit (DB) plan and two cost measures—the estimated cost of transferring the pension liabilities to an insurance company (i.e., a buyout) and the approximate total economic cost of retaining the obligations on the balance sheet.

Some plan sponsors have been reluctant to transfer liabilities to an insurer, arguing that it is too expensive, particularly compared with the accounting liability, according to Mercer. However the accounting liability does not include all costs associated with maintaining the plan. Currently, the approximate cost of maintaining the plan is higher than the cost of transferring liabilities to an insurer for the sample plan modeled by the index.

The index also mentions how, based on a recent study by the Society of Actuaries, people are living longer than expected. As a result, actuaries may soon have to update plan mortality assumptions, which has the effect of increasing plan liabilities. While no definite date has been set for when new life expectancies may have to be used, Mercer expects that the Internal Revenue Service (IRS) may require plans to use the new tables to assess funding from 2016 onward, while auditors may expect plan sponsors to reflect the new tables for accounting purposes even earlier. The increase to plan liabilities is expected to be greater than any increase seen in annuity prices, which will be another compelling reason for plan sponsors to purchase annuities and transfer the risk, Mercer says. 

The index also notes that Pension Benefit Guaranty Corporation’s (PBGC) annual per participant premiums were recently increased from $49 per participant for 2014 to $64 per participant for 2016, with inflation-related increases scheduled thereafter. This increase is a contributing factor to the increasing costs to plan sponsors of maintaining their DB plan and is a large factor in many plan sponsors’ decisions to transfer liability.

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

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 or over time as the funded status improves, notes the index. This can reduce the likelihood of the funded status decreasing again, leading to unexpected additional cash being required to purchase annuities at a later stage.