Researchers at Mercer tell PLANSPONSOR that the increase in PBGC premiums caused the relative economic cost of running a pension plan (as compared with projected benefit liabilities) to jump about 40 basis points for a theoretical plan, up to 108.6% of liabilities. The cost of retaining liabilities hovers above real liability values due to such things as administrative costs, management fees and insurance premiums.
Leah Evans, a principal at Mercer, explains that insurers are not required to pay PBGC premiums and can often run large annuity pools more efficiently than an employer can run a pension, implying that events such as premium hikes can strongly increase the relative attractiveness of a pension buyout—shorthand for the process of annuitizing liabilities.
In fact, Mercer’s Pension Buyout Index shows that as of the start of the year, the cost of enacting a buyout relative to benefit liabilities is 108.5%—a full 10 basis points below the projected cost of holding the liabilities over the long term (see “Pension Buyouts More Attractive Despite Cost Increases”). Since the index launched in early 2013, it had consistently shown at least a small gap between buyout prices and the cost of holding liabilities—a gap that would presumably need to be covered by the employer through a cash infusion during a pension buyout.
“We were already saying that buyouts were looking very attractive if you look at the buyout costs against the cost of retaining the liabilities, and this latest increase in premiums absolutely makes it even more attractive,” Evans says. “In particular, it’s probably going to be most attractive for plans with lots of participants and smaller benefits per participant.”
That’s because administration costs and PBGC premiums for most single employer plans are fixed dollar amounts, which means a plan with small benefit values and a smaller pool of assets pays the same as a plan with large benefit values (and therefore a larger asset pool) that can more easily cover administrative and insurance costs.
With additional hikes slated for both 2015 and 2016 that will push premiums up to $64 per participant within single employer pension plans—a little more than 50% increase over the $42 per-participant premiums collected in 2013—Evans says there will likely be a considerable period of time during which annuitization remains especially attractive.
A Historic Opportunity?
One outstanding question for plan sponsors and consultants in the pension buyout space is whether the markets will deliver another banner year in 2014 for corporate pension funds. Evans points out that 2013 saw the average funded status of pension plans sponsored by S&P 1500 companies climb more than 20%, standing now somewhere around 95% of fully funded (see “Pension Funding Up Sharply in 2013”).
Those numbers show pensions are still fighting to reach the 106% average pre-recession funded status, but there is no denying that employer-sponsored pension funds have recovered substantially from the low point of the financial crisis, when average funded levels hovered at 77%.
Evans says the rebound should be enough to cause pension funds to at least start thinking seriously about annuitizing pension liabilities. And even if they aren’t quite ready to transact, she thinks many plan sponsors will start taking steps to try and lock in some of the recent gains.
“We’ve seen employers get burned before when they haven’t taken action to transact and the markets deteriorated and they suddenly were looking at dismal funded statuses again,” Evans says. “If plans are getting close to or even surpass being fully funded, then I think many plans will certainly want to take some steps to protect at least some of those gains. Maybe they’ll want to keep some exposure to the markets to the extent that they’re comfortable with any associated risks, but we think they’re going to want to limit the risk exposures they have to the market.”
That means more in fixed income and less in equities, Evans says.
“We see some sponsors who may decide to take action in steps, keeping some exposure to the markets that can help bridge any remaining gaps to buyout pricing, but in the meantime move some of their assets from equities to fixed income to protect against risk,” Evans says. “It’s similar to a glide-path strategy.”
Carpe Diem … In Steps
In terms of actually preparing to transact a pension buyout with an insurance company, Evans says the first thing an employer should do is examine its pension plan data.
“In order to actually transfer the liability to an insurance company, you’ve got to have clean data,” Evans says. “The insurer has to know exactly what benefits and liabilities they are taking on. So, even if plan sponsors don’t think they’re quite ready to actually transact, I always recommend that they start reviewing their data and start filling in any gaps that exist. It’s something they’re going to have to do at some point anyway, so it makes sense to do it sooner.”
The next steps depend on the funded status of the plan. If there is still a shortfall in funded status, is the employer willing to spend cash to cover the remainder? And if so, is there enough cash on hand? Or will financing need to be secured? Evans says it’s also critical to consider the accounting and tax impact of a risk transfer exercise.
“So what we do with plan sponsors who are considering this is first work through the financials with them, looking at what the cash and accounting impacts would be, and we see if that’s something they’re comfortable with now,” Evans explains. “If they’re not, what we increasingly see plan sponsors want to do is start to identify future circumstances under which they would be more comfortable with risk transfer.”
Evans also points out that, while PBGC premium hikes shouldn’t cause an increase in the prices insurers are offering for a buyout, there are other factors that could do so, such as changes to capital requirements or the way insurers calculate interest assumptions.
“It’s always a two part question,” Evans says. “There’s the insurance pricing side and the plan circumstances side. If you’re able to monitor both of those circumstances on an ongoing basis, then you’re set to identify the timing for moving ahead with execution.”
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