By Cyril Tuohy
A new white paper published by The Principal Financial Group outlines six common annuity purchase misconceptions to watch out for as pension plan risk managers and advisors move defined benefit plan liabilities off the books of plan sponsors and into group annuity contracts.
Mike Dulaney, senior consulting actuary at The Principal, said understanding the impact of annuity purchases on future defined benefit plan finances is critical, even with assumed stock market returns of 7.5 percent annually.
Many of the details remain the province of actuaries, but simple back-of-the-envelope math accessible to most financial advisors reveals surprises of mathematical phenomena brought about by interest rates and liability duration.
A group annuity may not turn out the way buyers hope.
Misconception 1: Funded ratios aren’t affected by annuity purchases for “fully funded” plans.
Reality: While defined benefit plans in the S&P 1,500 were close to 95 percent funded at the end of last year due to higher interest rates and a booming stock market, buying an annuity might decrease a plan’s funded status.
Why? Because the cost of buying the annuity is higher — as much as 10 percent higher — than the liability held on the plan sponsor's books if employees stay in the defined benefit plan.
To illustrate, Principal cites the following example: Because it costs $1.10 to settle every $1 of liability in the plan, the deficit between liabilities and assets rises even as the plan shrinks in size.
Misconception 2: Annuity purchases always reduce Pension Benefit Guaranty Corp. (PBGC) premiums.
Reality: Flat-rate premiums, which are projected to increase to $64 per person by 2016, and variable-rate premiums, which are projected to increase to 2.9 percent of unfunded plan liability, mean that PBGC premiums are set to double or triple over 2012 amounts, the paper said.
A funding shortfall due to the annuity purchase, however, can turn into big increases in the variable-rate premium, erasing any savings gained from flat-rate premiums.
“Over a period of time, the total PBGC premiums may be even higher than after the annuity purchase than it would have been if such risk transfer strategy had not been implemented,” the white paper noted.
Misconception 3: Defined benefit plan accounting expense is always lower than an annuity purchase.
Reality: With declining interest rates over the past five years, annuity purchases are likely to be classified as an account expense rather than income for most defined benefit plans due to accounting rules, the paper said.
Even when assets and liabilities are reduced, ongoing expense can be higher because assets are being reduced more than liabilities. The result is an actuarial loss which is amortized as an expense, according to the paper.
Chalk this one up to the phenomenon of accounting math.
Misconception 4: Buying annuities now for a frozen defined benefit plan is likely to reduce the overall plan termination costs.
Reality: With many frozen defined benefit plans considering an annuity purchase before plan termination as opposed to after plan termination or at-plan termination, the size of the pension liability risk dwindles as liabilities are transferred to an insurer.
The risk may dwindle, but not so the cost to terminate a defined benefit plan.
If interest rates increase, “buying annuities now could cost more than waiting for lower prices at higher rates in the future,” the report said.
Even less obvious to the untrained eye is that “purchasing annuities does not necessarily reduce cost in a declining-interest-rate environment,” the paper noted, as no one can guarantee equity returns of 7.5 percent.
With declining interest rates, longer duration liabilities increase more than the assumed income of short duration holdings, “resulting in increased ultimate termination cost,” the paper said.
Misconception 5: Purchasing annuities is likely to reduce funded-status volatility.
Reality: Leaving aside hedging strategies designed to mitigate volatility, buying annuities for all retirees in The Principal’s example generated more volatility for the plan sponsor — a most counterintuitive finding, indeed.
Interest rates and plan liability durations affect volatility of the plans. But reducing volatility, which is often cited as a reason for buying annuities, isn’t always the case, according to the white paper.
Misconception 6: If I buy an annuity, there’s no need to do anything else to manage pension risk.
Reality: Of course, plan sponsors could buy the annuity and then let it run on autopilot by doing nothing else to the defined benefit plan. But what if the plan sponsor changed the asset allocation? What if the sponsor contributed cash to the plan? Or offered lump sums to terminated plan participants?
Plan sponsors who consider other management strategies to complement annuity purchases may well come out ahead depending on the economic scenario.
So, annuity purchases aren’t always what you thought? Right!
No one said it would be easy.
Cyril Tuohy is a writer based in Pennsylvania. He has covered the financial services industry for more than 15 years. Cyril may be reached at email@example.com.
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