Earlier this year, October Three (O3) released an analysis of PBGC premiums—“The PBGC Premium Burden – What Every Pension Sponsor Needs to Understand.” Here we narrow that focus to a single industry, health care.
Why health care? In an industry where cash is tight and margins are low, hospitals and similar organizations continue to face the burden of paying for legacy pension plans, even if they are frozen to new accruals today.
The finances of the health care industry are unique. Accounts receivable, on average, take nearly seven weeks to collect. Debt service typically uses up about 20% of annual cash flow (annual debt service coverage averages 5.2x). And, while many hospitals’ pension plans are closed or frozen today, a substantial number of hospital plan sponsors continue to face hefty payments for their defined benefit plans.
Primarily, those payments are for two purposes:
1) To fund the plan until it has sufficient assets for the plan sponsor to terminate it, and
2) To pay premiums to the Pension Benefit Guaranty Corporation (PBGC).
The first item is a necessity; these organizations made promises to their employees (many now retired or otherwise departed) that must be paid for. The second is largely a penalty imposed by the PBGC for the hospitals not funding their pension plans fully for vested benefit obligations.
PBGC premiums have two parts to them:
1) The fixed rate premium that is a flat dollar amount per participant, and
2) The variable rate premium (VRP) that is dependent on the amount of underfunding.
For many plans, the VRP may be five to eight times the size of the fixed rate premium, but it’s that VRP that plan sponsors may be able to control. When the plan’s actuary fails to use techniques within their reach to minimize the VRP, we classify any excess VRP payments as overpayments.
Before getting into it further, perhaps some data would be useful.
- Over the six years in the O3 study, approximately 20% of the plan sponsors considered to have made the highest overpayments were in the health care industry.
- During that period, overpayments, or said differently missed savings, in the industry amounted to about $60 million.
- In 2015 (the latest year for which we have complete data), health care sponsors missed out on potential savings of about $15 million.
- One plan, by itself, overpaid by about $2.3 million over a 6-year period from 2010-2015.
- Another sponsor with eight plans in the industry overpaid by $2.2 million in total.
Even though the solutions are not particularly complicated, it appears that sponsors in the industry are not being informed of the options that would allow them to reduce this annual burden.
Suppose we told you that reducing your variable rate premiums required no additional contributions to your plan? For nearly 95% of the health care plans that we identified, that is true. One hospital plan in our study could have reduced its VRP by nearly $900,000 had the individuals filling out certain government forms simply recorded the contributions that the hospital actually made to the plan year immediately prior to the plan year in which it was made (this is and has been permissible generally for more than 40 years). In fact, that same organization could have eliminated its entire $1.4 million in VRP by combining that recording technique with slight accelerations in the timing of contributions.
There are other techniques that are somewhat more complex and whose descriptions are beyond the scope of this piece, but all of these techniques have a common theme: By increasing contributions, a plan can reduce its PBGC variable rate premiums. These additional techniques allow sponsors to save that money without higher contributions, but rather by maximizing the credit for contributions they are making.
The buzzword du jour in the pension world is de-risking with an emphasis currently on pension buy-outs. That is, go to an insurance company and buy large group annuity contracts to settle the obligations owed to your retirees. Do they work? Yes, they do, but often cost a lot of money.
The insurance companies are taking on the plan risks and the insurance companies are in business to make money. So, in return for assuming your risks, insurance companies charge a markup. Think of it this way: when you settle an obligation to a new retiree by paying a lump sum, you are paying fair market price (consider that wholesale price), but when you settle it through an insurer, you are paying a markup (consider that retail price). So, while these buy-outs will reduce your VRP, you will likely have to spend a fair amount of money to do so. We’d ask, why spend money to reduce premiums if you can reduce premiums without spending money?
In our opinion, there are a few key takeaways for hospitals:
- If you still sponsor a defined benefit plan (including a cash balance pension plan) whether it’s ongoing or frozen, there is a good chance that you are overpaying PBGC premiums.
- There are solutions that cost additional money and there are solutions that don’t.
- You can identify whether you have been overpaying premiums, to what extent, and why.
John Lowell is an actuary and partner with October Three in the Atlanta Area. He has more than 30 years of experience consulting on corporate retirement plans ranging in size from just a few participants to hundreds of thousands. He will become president of the Conference of Consulting Actuaries later this month. He can be reached at email@example.com.
This feature is to provide general information only, does not constitute legal or tax advice, and cannot be used or substituted for legal or tax advice. Any opinions of the author do not necessarily reflect the stance of Strategic Insight or its affiliates.