Is DB Plan Annuitization More Costly Than Maintaining the Plan?

Tom Harvey, director of the Advisory Team within SEI’s Institutional Group, in Oaks, Pennsylvania, says  conversations with defined benefit (DB) plan sponsors show they are fatigued because they’ve put assets in their plans and the investments have performed well since the financial crisis—but their funded status is no better than five years ago.

“Annuitization is appealing because they want to get out of managing money,” he says.

In addition to the appeal of offloading the tedious work of running the pension, employers are also commonly presented with a picture of pension annuitizaiton that makes strong financial sense. However, one problem with this process, Harvey contends in a recent Q&A, is that the costs of implementing an annuitization strategy are often quoted by insurers in terms of a premium over the pension benefit obligation (PBO) liabilities—and that premium right now is at historically low levels. 

Harvey explains to PLANSPONSOR that many real-life plans have actually performed much better than PBO projections might indicate—implying that just because the snap-shot PBO-derived premium calculation looks attractive today, this does not mean that over the projected lifetime of the pension assets and liabilities the economic picture could not very well shift. And so, for many employers, it may be more prudent in the end financially speaking to keep the pension assets and liability in house. 

Harvey suggests the PBO accounting measure indicates funded status is the same or lower than five years ago, but measuring actual liabilities shows most plan sponsors are in fact better off than five years ago. “For an individual employer, it will be about considering what the liability looks like and whether you can manage it. Many payments are due 50 years out, so plan sponsors can pay out of cash flow quite easily with the proper planning,” he says.

The ultimate measure that will settle the debate for many employers is total liability, Harvey says. He cautions plan sponsors not to worry about a fluctuating PBO projection year over year, and just to invest prudently against the true liability. “Discount rates dropped 40% this year; no one’s benefits went up. PBO drove liability higher, but no plan sponsor’s liability changed as a factual matter. PBO is not a reason to change strategy,” he adds.

Harvey also notes that in today’s low-yield environment, “it takes a lot of bond to feed liability.” It is thus not very easy for the insurers to turn a profit on pension assets, and so the cost of annuitizing must reflect this. He says it may also not be as complete or total a solution as some plan sponsors may expect. He contends some plan sponsors may be able to eliminate only one-third to half of liabilities, leaving a money management problem that could be meaningful.

Lastly, Harvey points out that pension payments are part of a whole range of commitments employers have, to be weighed carefully alongside other debt and capital expenditures. “There’s no place else that company’s feel like they have to get the commitments off the balance sheet because of funded status calculation. Pensions are pre-funded more so than other liabilities,” he notes.

While SEI contends maintaining the DB plan is cheaper than annuitization for most DB plan sponsors, Jim Kais, senior vice president and national retirement practice leader for Transamerica Retirement Solutions in Miami, says the answer is not so black and white.

He tells PLANSPONSOR there are a lot of factors plans sponsors must weigh. He agrees annuitization can be expensive. For one thing, the plan must be fully funded before annuitization will make financial sense in many cases, so a cash infusion from the employer is often needed, and it’s usually not a small amount. Kais says plan sponsors should determine whether that cash outlay and annuitization will provide more revenue and return for the company. “It’s not uncommon today for plan sponsors to borrow to fund. Interest rates are low, so it can make sense to bridge that gap if plans are going to annuitize,” Kais says.

He adds that right now demand is higher than supply—there’s a small group of companies taking on pension risk—discount rates are around 2%, and premiums are high.

There are so many factors that go into making the decision to do an annuity buyout and terminate the plan—looking at the market, where the company is in its life cycle, company goals and how risk-averse it is. “Look at a plan with a liability of $11 million. It will see an increase in liability with the new mortality tables. If it has assets of $10 million, the unfunded liability of $1 million will double just because of the change in mortality tables. This could be tough head wind for companies that may not be cash rich,” Kais says.

On a related note, Kais says DB plan sponsors need to modernize their data; processes are still very manual. They need data to analyze and run models to see if market returns will generate enough to keep the plan going, he suggests.

Finally, according to Kais, DB plan sponsors should not forget about the human resources (HR) aspect of terminating the plan and annuitizing. “It’s really important for HR to have a seat at the table with CFOs to discuss the impact for retention and retirement readiness for future workers. With no DB, will employees be able to retire?”

Even SEI concedes there are situations in which DB plan annuitization makes sense. “If the pension is so large, such as three times market capitalization, it can be unmanageable for the plan sponsor. Small plans can create administrative and disclosure burdens on the company,” Harvey says.

“We suggest looking carefully at long-term cost and whether the DB plan is really a liability the plan sponsor cannot manage; is benefit of annuitization worth it?” he adds. “But, for most plan sponsors, they need to explore the all-in cost and benefits rather than grab for a life preserver for something with which they’re frustrated.”