Interest Rates Affect Timing for PRT Annuity Purchases

Mark Unhoch, with October Three, explains why annuity costs for pension risk transfers (PRTs) are greater when interest rates are lower.

The first quarter of 2019 shows a noticeable drop in annuity purchase interest rates for pension risk transfers (PRTs), according to October Three’s latest Annuity Purchase Update, and the second quarter has continued the trend as rates fell again in July.

The average interest rate for an annuity purchase that contains retirees only and has a liability duration of 7 years (Annuity Plan 1) is 2.46%, and the average interest rate for an annuity purchase that contains 70% retirees and 30% deferreds and has a liability duration of 15 years (Annuity Plan 2) is 2.77%.

However, Mark Unhoch, partner and practice leader responsible for the October Three Annuity Services Practice in Chicago, says, “Our experiences during 2019 have been that insurers are pricing annuity purchases aggressively. Annuity purchase prices have not risen as much as expected based on this year’s drop in interest rates.”

Unhoch explains why annuity costs are greater when interest rates are lower:

“A defined pension plan promises to pay a participant a defined amount or monthly benefit when they retire. For the example, let’s assume the participant has earned a $100/month income when they retire at age 65. The following assumption will factor into the annuity cost calculation:

  • Current age of the participant = 65 years old, and
  • Life expectancy of the participant = 20 years.

“The question the insurance company is trying to solve is ‘how much money do I need to collect today to guarantee the 65 year old participant an income stream of $100/month for their life expectancy?’

“If we use an assumption that the insurance company will not earn any interest on the money, then the calculation would be easy. The money it would need today is the monthly benefit multiplied by the participant’s life expectancy or $100  X 12 months X 20 years = $24,000.

“Now if we assume the insurance company will earn interest on the monies it collects today to provide the guarantee of $100/month for the life of the participant, the following is true:

“The higher the annuity credited rate (interest rate), the more interest it would earn and the less money it needs today in order to guarantee the monthly benefit.

“The lower the annuity credited rate (interest rate), the less interest it would earn and the more money it needs today in order to guarantee the monthly benefit

“Based on the above example and to keep it simple, let’s assume the $24,000 is going to be paid at the end of the participant’s life expectancy. The amount of money needed to be collected today using simple interest would be as follows:

“Money needed today = Amount needed in the future  /  (1 + (interest rate X participant’s life expectancy in years)).

“Interest rate = 10%, money needed today

  • = $24,000  /  (1 + (.1 X 20 ))
  • = $24,000 /   (1 + 2)
  • = $24,000 / 3  or $8,000.

“Interest rate = 5%, money needed today

  • = $24,000 /  (1 + (.05 X 20))
  • = $24,000 /  (1 + 1)
  • = $24,000 / 2 or  $12,000.”

According to the Annuity Purchase Update, annuity purchase interest rates can be volatile. Although 2018 experienced an upward trend in annuity purchase interest rates, history demonstrates these rates fluctuate over time with varying degrees of peaks and valleys.

During 2018, the spread of annuity purchase prices above the Generally Accepted Accounting Principles (GAAP) projected benefit obligation (PBO) remained fairly stable, at around 4% for Annuity Plan 1 and 12% for Annuity Plan 2. From December 2018 to July 2019, as annuity purchase interest rates and yield curve interest rates changed rapidly, the spread fluctuated slightly up and down for both plans.

“Narrowing of the spread may represent an opportunity to complete an annuity purchase at a relatively cheaper price than when the spread is larger,” Unhoch says in the Update. “The consistent short-term volatility of annuity pricing makes timing an early entrance to the insurance market a crucial part of the planning stage. By connecting with an annuity search firm early, sponsors can take advantage of favorable fluctuations in a volatile market.”