Cost of Maintaining Pension Liabilities Increases

According to the Mercer U.S. Pension Buyout Index, the real cost of maintaining pension liabilities increased from 108.6% to 108.7% of the balance sheet liability during January. The index tracks the relationship between the accounting liability for retirees of a hypothetical defined benefit (DB) plan and the estimated cost of either transferring the pension liabilities to an insurance company (i.e., a buyout) or maintaining the obligations on the plan’s balance sheet.

Some plan sponsors have been reluctant to transfer liabilities to an insurer because they believe it is too expensive, particularly compared with the accounting liability, according to the index. However, it is noted that the accounting liability does not include all costs associated with the plan. Findings by Mercer show that currently the approximate cost of maintaining the plan is higher than the cost of transferring liabilities to an insurer.  

The index notes that Pension Benefit Guaranty Corporation (PBGC) annual per participant premiums were recently increased significantly, from $49 per participant in 2014 to $64 per participant in 2016, increasing with inflation thereafter. This more than 30% 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 (see “PBGC Premium Hikes Shake Up Buyout Landscape”). 

Another source of increased costs to plan sponsors of maintaining a DB plan occurs when participants live longer than expected, according to the index. A recently released draft mortality table from the Society of Actuaries predicts longer life expectancies than those typically used to determine a plan’s accounting liability. If new mortality tables or longer life expectancies are required to be used by plans in liability calculations, the result will be an increase in plan liabilities. This is another reason many plan sponsors are viewing buyouts as effective risk management tools.

Given the current economic environment, combined with the increase in PBGC premiums and the mortality update on the horizon, the index foresees 2014 as an attractive time for plan sponsors to consider an annuity buyout. Since there are a number of steps involved in order to prepare for a buyout, Mercer recommends plan sponsors act now to evaluate whether buyout is appropriate for them and develop an implementation strategy.

In addition, Mercer recommends that plan sponsors considering a buyout in the future should review their plan’s investment strategy and consider increasing their allocation to liability hedging assets, either immediately or over time. This can reduce the likelihood of the funded status declining again, leading to unexpected additional cash being required to purchase annuities at a later stage.