1 RETIREE LIFE INSURANCE: Solutions to Help Employers Maintain A Valuable Benefit Program The Prudential Insurance Company of America (Prudential) 751 Broad Street, Newark, NJ
3 Table of contents Introduction... 2 Challenges Posed by Retiree Life Insurance Benefit Programs... 3 Solutions for the Challenges Posed by Retiree Life Insurance Benefit Programs... 4 Evaluating the Solutions...10 Conclusion
4 INTRODUCTION Most employers offer their employees a range of retirement benefits as part of a comprehensive benefits program to attract and retain talent. These retirement benefits may include defined benefit plans, defined contribution plans, retiree health insurance, and retiree life insurance. Retiree life insurance provides employees a life insurance benefit after retiring. It has been a key feature of the employer-provided benefits landscape, particularly among large corporations. Today, 64% of Fortune 1000 companies maintain post-retirement life insurance benefits for retirees 1 While it may appear retirees have little need for life insurance, this benefit addresses critical financial needs in retirement. Retiree life insurance can help a surviving spouse fund funeral expenses, living expenses, or costs associated with the care of children or grandchildren. Retiree life insurance can be especially valuable to retirees because the cost of life insurance is dramatically higher for retirees than for younger individuals. Retirees with serious health issues may be unable to purchase life insurance at any price. Unfortunately, if current trends persist, fewer of tomorrow s retirees will have access to retiree life insurance benefits. Only 23% of companies offer retiree life insurance benefits to new hires. 2 Many companies are curtailing this benefit because of concerns about cost and complexity. The objective of this white paper is to describe solutions that enable employers to offer retiree life insurance benefits while addressing employers financial and other concerns. How Retiree Life Insurance Works Retiree life insurance is a group life insurance benefit that extends into retirement. Term insurance is the most common offering, and employers usually fund the cost of the premiums. The death benefit may be a fixed amount, such as $10,000, or a multiple of salary. Employers, or third-party benefits administrators that employers hire to handle benefits administration, often bear much of the administrative burden associated with retiree group life insurance benefits: Paying premiums Enrolling participants Maintaining beneficiary records Handling inquiries Submitting claims W-2 reporting* The administrative responsibilities handled by the insurer are often limited to taking in premiums and processing death benefit claims. Depending upon the agreement between the employer and the insurer, however, the insurer may take on more of the administration for retiree life insurance benefits. *For employer-paid retiree life benefit amounts over $50, Towers Watson, Accounting for Pensions and Other Postretirement Benefits 2012, 2012, page Towers Watson, Accounting for Pensions and Other Postretirement Benefits 2012, 2012, page 4.
5 Challenges Posed by Retiree Life Insurance Benefit Programs Today, employers find it increasingly difficult to maintain the current level of funding for retiree life insurance benefits because of three growing challenges posed by this benefit program: Increasing costs. As the workforce ages and more employees retire, increased incidence of retiree life insurance claims can increase the overall costs of an employer s group life insurance benefit program. Costs can also increase if new retirees are added to an employer s benefit program as a result of mergers or acquisitions. Increasing liabilities. Employers must record a liability, in accordance with the Financial Accounting Standard 106 (FAS 106), related to retiree life insurance benefits on their balance sheets. The size of this liability increases as an employee s length of service increases, and continues to increase after the employee retires. The net effect on an employer s financial position is an increase in the employer s liabilities-to-equity ratio. Increasing complexity of administration. Administering retiree life insurance benefits requires paying premiums, maintaining beneficiary records, responding to inquiries, submitting claims, as well as reporting imputed W-2 income for life insurance coverage. The administrative burden is growing as the number of retirees increases. Moreover, the administrative burden can increase when companies acquire companies that have retirees participating in a retiree life insurance program. Administration can be especially challenging for employers or their third-party administrators because of the difficulty of keeping track of dispersed retiree populations. These challenges are leading some employers to curtail retiree life insurance benefits. A 2011 Prudential survey found that 17% of employers currently offering retiree life insurance benefits will continue offering the benefit only at a reduced level or will eliminate it altogether. 3 This document describes a comprehensive set of solutions available to employers to address the challenges posed by retiree life insurance benefits, while maintaining some level of retiree life insurance benefits for employees. These solutions can also help employers avoid negative employee sentiment stemming from an abrupt termination of retiree life insurance benefits. How FAS 106 Works The Financial Accounting Standards Board passed Financial Accounting Standard (FAS) 106 in This standard requires that employers with an obligation to pay a retiree life insurance benefit in the future must accrue a liability on their balance sheet during the employee s active years and into retirement. Employers book the net liability, that is, the total liability minus amounts that have been set aside to pre-fund the liability with restricted assets. These liabilities are usually disclosed in the footnotes of an annual report or 10-K. Employers liability for a specific employee at any point in time is the present value of the death benefits they expect will be paid to the employee s beneficiaries in the future. During the active years, the liability grows as the employee s years of service and the present value of the death benefit increase. The liability associated with the employee continues to grow throughout retirement until the benefit is paid, at which time the liability associated with that employee is released from the balance sheet. Accounting Standards Codification (ASC) Topic 715, Compensation Retirement Benefits. 3 Prudential Financial, Sixth Annual Study of Employee Benefits: Today & Beyond Topline Survey Results,
6 Solutions for the Challenges Posed by Retiree Life Insurance Benefit Programs There are four solutions available to employers to help address the challenges posed by retiree life insurance benefit programs: 1. Plan design changes to reduce the costs and liabilities associated with retiree life insurance benefits. 2. The use of a retired lives reserve (RLR) to pre-fund retiree life insurance premiums on a tax-advantaged basis. Exhibit 1, below, compares these solutions in terms of who funds the benefit, and when the benefit is funded. This paper describes these solutions in more detail, and discusses how each solution addresses the challenges that employers are trying to address. 3. A retiree life insurance buy-out to permanently transfer the liabilities and most of the administrative responsibilities associated with retiree life insurance benefits to an insurer in exchange for a one-time premium payment. 4. The use of voluntary retiree life insurance benefits to provide employees with retiree life insurance benefits at their own expense. Voluntary benefit options include voluntary retiree reducing term life and group universal life. Exhibit 1: Overview of Retiree Life Insurance Solutions Funded By Funding Period Solution 1 Plan design changes Employer During retirement Solution 2 Retired lives reserve Employer Before and during retirement Solution 3 Retiree life insurance buy-out Employer One-time funding for a specific group of retirees Solution 4 Voluntary retiree life insurance benefits Voluntary Retiree Reducing Term Life Employee During retirement Group Universal Life Employee Before and potentially during retirement 4
7 Solution One: Plan Design Changes Employers have a number of options for modifying the design of their retiree life insurance benefit programs to reduce the costs and future liabilities associated with these programs: Introduce a benefit reduction schedule. For example, an employer may introduce a reduction schedule to a multiple-of-salary plan so that it provides a reducing level of life insurance coverage to retirees as they age (e.g., reduces to 50% of the original benefit at age 70). Add a benefit maximum or change the multiple-of-salary plan. Employers who provide benefits based on an employee s multiple-of-salary may reduce the multiple, thereby reducing the benefit for all employees proportionally. Employers may also consider converting from a multipleof-salary plan to a flat plan (e.g., a $10,000 benefit for each employee). Modify eligibility criteria. Employers can reduce the number of retirees covered by the plan by increasing eligibility requirements. For example, new criteria may require employees to have worked a certain number of years before retirement in order to be eligible for the benefit. Plan design changes address two of the challenges facing employers. Specifically, plan design changes: Lower the cost of insurance premiums, because the benefit level may be reduced, or the benefit may be offered to fewer employees. Employers can work with benefits consultants or insurers to analyze the impact of specific plan design changes on their employee populations. Reduce the current level and future growth of the FAS 106 liability, thereby improving an employer s liabilities-toequity ratio. Plan design changes generally do not reduce administrative requirements, because employers or their third-party administrators must continue servicing existing and future retirees. Furthermore, plan design changes may lead to some degree of employee dissatisfaction because benefit levels are reduced. Separate retirees and active employees for experience tracking and pricing purposes. Retiree life insurance claims can drive up overall blended experience rates and costs for group life insurance benefit programs. Separating retirees and active employees for pricing purposes may lower group life insurance rates for active employees, and provide employers with a more granular view of the costs of their active employee and retiree group life insurance benefit programs. 5
8 Solution Two: The Retired Lives Reserve A retired lives reserve (RLR) is a funding mechanism that allows an employer to set aside funds during an employee s working years to pay for the employee s retiree life insurance premiums. A 2010 Prudential survey found that 45% of employers offering retiree life insurance benefits pre-fund the premiums. 4 Contributions made to an RLR are usually tax deductible, 5 and may be invested in an interest bearing account on a tax deferred basis. The assets placed in an RLR are restricted and cannot be easily accessed by the employer for other purposes without paying taxes and penalties. However, an RLR does allow employers to offset the FAS 106 liability associated with retiree life insurance benefits. An example of how an RLR would impact an employer s balance sheet is shown in Exhibit 2. In this example, the employer reserves $20 million to fully address a $20 million FAS 106 liability associated with retiree life insurance benefits. The reserve offsets the liability on the balance sheet, and improves the employer s liabilities-to-equity ratio from 1.50 to RLRs address all of the challenges facing employers to some degree. Specifically, RLRs: Reduce costs by providing a current tax deduction for contributions to the RLR, as well as tax deferral on the interest earned on assets within the RLR. Offset an employer s FAS 106 liability by reserving against it, thereby improving an employer s liabilities-to-equity ratio. Streamline plan administration because retiree life insurance premiums are deducted from the RLR by the insurance company administering the RLR. However, the employer or its third-party administrator maintains administrative responsibilities for enrolling participants, maintaining beneficiary records, handling inquiries, submitting claims, and W-2 reporting when necessary. The RLR is favorable for employees, because the fact that an employer has pre-funded the benefit increases the chances that the employer will maintain the benefit. However, the establishment of an RLR is generally not communicated to employees. Exhibit 2: Balance Sheet Impact of a Retired Lives Reserve* Hypothetical employer with retiree life insurance liabilities ($Millions) Assets Current assets $500 Long-term assets $500 Total $1,000 Liabilities Retiree life liability $20 Other liabilities $580 Shareholders equity $400 Total $1,000 $20 million unfunded liability associated with retiree life insurance benefits Liabilities-to-equity ratio of 1.50 Hypothetical employer after executing a retired lives reserve ($Millions) Assets Current assets $480 Long-term assets $500 Total $980 Liabilities Retiree life liability $20 Less: Reserve ($20) Retiree life liability (net) $0 Other liabilities $580 Shareholders equity $400 Total $980 $20 million liability associated with retiree life insurance benefits $20 million set aside to reserve for liability Liabilities-to-equity ratio improves to 1.45 *In each scenario, the employer incurs annual premiums and administrative costs. 6 4 Prudential Financial, Fifth Annual Study of Employee Benefits: Today & Beyond, Tax deductible up to the Deficit Reduction Act (DEFRA) limit, which is equal to the premiums associated with $50,000 in coverage per employee.
9 Solution Three: The Retiree Life Insurance Buy-out A retiree life insurance buy-out enables an employer to transfer its retiree life insurance liabilities for a designated group of retirees to an insurer in exchange for a one-time, tax-deductible payment. The employer does not have to pay any future retiree life insurance premiums for the designated group, and, as a result, the employer is not exposed to the risk that future premiums may increase due to unfavorable mortality experience or changes in the price of insurance. The employer is relieved of most administrative responsibilities for servicing the designated group, and the employer s FAS 106 liability associated with the designated group is removed from the balance sheet. Finally, the buy-out reduces investment risk for employers, because the insurer becomes solely responsible for investing the premium and absorbing any unfavorable investment returns. 6 An example of the impact of a retiree life insurance buy-out is shown in Exhibit 3, below. In this example, the employer pays a $22 million premium to address $20 million in retiree life insurance liabilities associated with a group of retirees. (The premium is somewhat more than the liability because the premium includes the capitalization of the insurer s administrative fees and many include differences in mortality and interest assumptions.) The buy-out removes the liability from the balance sheet, thereby improving the employer s liabilities-to-equity ratio from 1.50 to Exhibit 3: Balance Sheet Impact of a Retiree Life Insurance Buy-out Hypothetical employer with retiree life insurance liabilities ($Millions)* Assets Current assets $500 Long-term assets $500 Total $1,000 Liabilities Retiree life liability $20 Other liabilities $580 Shareholders equity $400 Total $1,000 $20 million unfunded liability associated with retiree life insurance benefits for a group of retirees Liabilities-to-equity ratio of 1.50 Hypothetical employer after executing a retiree life insurance buy-out ($Millions)** Assets Current assets $478 Long-term assets $500 Total $978 Liabilities Retiree life liability $0 Other liabilities $580 Shareholders equity $398 Total $978 $22 million premium paid to insurer Retiree life insurance liability for a group of retirees is removed from the balance sheet Liabilities-to-equity ratio improves to 1.46 *The employer incurs annual premiums and administrative costs. **Annual premiums are eliminated and administrative costs are greatly reduced. 6 An RLR may be a source of funds for a buy-out, but these funds may not be tax deductible because the employer would have already received a tax deduction on contributions to the RLR up to the DEFRA limit (i.e., the premiums associated with $50,000 of coverage per employee). 7
10 Solution Three (continued) Retiree life insurance buy-outs address each of the challenges facing employers. Specifically, retiree life insurance buy-outs: Potentially reduce costs because the upfront premium payment allows for an accelerated tax deduction. In addition, if an employer s group life insurance premiums were based upon the pooled experience of active employees and retirees, the employer may obtain lower group life insurance rates for its active employees once the retirees are removed from the pool. Finally, the employer no longer pays retiree life insurance premiums for retirees covered by the buy-out, and is not exposed to the risk of future increases in the cost of insurance for these retirees. Although not communicated to retirees, a buy-out transaction benefits retirees, because the buy-out irrevocably guarantees that their retiree life insurance benefit will be maintained. Remove the FAS 106 liability, thereby improving an employer s liabilities-to-equity ratio. Shift most of the administrative responsibilities for servicing the designated group to the insurer, thereby freeing up the employer s administrative resources Responsibility for W-2 reporting for imputed income for life insurance coverage beyond $50,000 per employee and ERISA Form 5500 reporting remains with the employer. Responsibilities for maintaining beneficiary records, handling inquiries, and processing claims are assumed by the insurer.
11 Solution Four: Voluntary Retiree Life Insurance Benefits Employers seeking an alternative to employer-paid retiree life insurance benefits can offer these benefits on a voluntary basis to employees. Voluntary benefits allow the employer to address the challenges posed by retiree life insurance benefits, while providing employees a convenient way to access these benefits through the workplace. A survey revealed that 79% of the employers that are considering offering retiree life insurance benefits within the next five years will likely have retirees pay for all or some of the benefit. 8 There are two types of voluntary benefits that address employees needs for retiree life insurance: Retiree reducing term life insurance provides employees with term insurance at a premium which remains the same, while the face amount of the life insurance declines over time. Many retiree reducing term life insurance policies feature a specified amount of guaranteed issue coverage that does not require evidence of good health. Group universal life insurance offers a cash accumulation savings vehicle that enables employees to build up a cash balance within an insurance policy to fund a life insurance benefit in retirement. Employees may either contribute to the fund during their working years to pre-fund the benefit in retirement, or they may choose to pay the cost of insurance on a quarterly basis during retirement. Employees earn a tax-deferred fixed rate of interest on their cash balances, and can access their money easily in the form of a loan or a withdrawal. At death, in addition to the face amount of the insurance, the balance in the cash accumulation fund is passed on to beneficiaries on a tax-free basis. Voluntary retiree life insurance benefits address each of the challenges facing employers. Specifically, voluntary benefits: Eliminate an employer s costs associated with retiree life insurance benefits. Do not incur a FAS 106 liability. Significantly streamline plan administration for the employer (or remove the need for the employer to pay a third-party administrator to handle these functions). The insurer providing the voluntary benefits typically assumes most responsibilities for plan administration, including enrolling participants, maintaining beneficiary records, handling inquiries, and submitting and processing claims, as part of the service package offered by the insurer. Voluntary retiree life insurance benefits can be positioned as a value-added benefit to employees. Although employees pay for the benefit, voluntary benefits enable employees to obtain a needed benefit with the convenience of workplace enrollment. 8 Prudential Financial, Sixth Annual Study of Employee Benefits: Today & Beyond Topline Survey Results,
12 Evaluating the Solutions A comparison of how each solution addresses the challenges facing employers, and affects employees and retirees, is shown in Exhibit 4, below. This comparison demonstrates that employers must carefully weigh a set of competing considerations, such as the need to lower benefit costs and the desire to maintain employee and retiree satisfaction. Financial considerations also come into play, because some solutions, such as the RLR or retiree life insurance buy-out, require companies to deploy capital to realize the benefits associated with these solutions; voluntary benefits, on the other hand, allow an employer to avoid costs and liabilities, while also reducing administrative duties. One approach for employers is to develop a retiree life insurance benefits strategy that is tailored for different segments of the participant population, such as new hires, mid-career employees, and retirees. For example, an employer could maintain employer-paid benefits for midcareer employees and retirees, while replacing employer-paid retiree life insurance benefits for new hires with voluntary benefits. Moreover, these solutions are not mutually exclusive. For example, an employer could make plan design changes that reduce the level of employer-paid retiree life insurance benefits for mid-career employees, while offering voluntary benefits to these employees to supplement the employerpaid benefits. Exhibit 4: Impact of Retiree Life Insurance Solutions Plan Design Changes Retired Lives Reserve Retiree Life Buy-out Voluntary Retiree Reducing Term Life Group Universal Life Impact on Employers Costs Liabilities Administration Reduces future premiums Upfront cost Current tax deduction for contributions Tax-deferred interest Significant upfront cost Accelerated tax deductions for payment Experience and rates for active plan may improve No cost to employer Lowers liability Offsets liability Removes liability Creates no incremental liability Employer or its thirdparty administrator handles most functions Employer or its thirdparty administrator handles most functions Insurer handles most functions Insurer handles most functions Impact on Employees and Retirees Reduces benefit Employer pre-funds benefit (but not communicated to employees) Provides irrevocable guarantee for benefit (but not communicated to employees) Funded by employees Group Universal Life provides tax-deferred investment and includes a guaranteed interest option 10
13 Conclusion Employers offering retirement benefits today face a number of challenges, including rising healthcare costs, underfunded defined benefit pension plans, and the pressure to reduce costs across all benefits. Retiree life insurance benefits pose an additional set of challenges to employers. There is a comprehensive set of solutions that enables employers to adapt retiree life insurance benefits to their business needs, while preserving a valuable employee benefit. 11
14 For more information, please contact the contributors: KEVIN HARRINGTON Vice President, Product Management, Prudential (973) ROBERT PATIENCE Vice President, Group Insurance, Prudential (973) JIM POGUE Vice President, Life/AD&D Product, Prudential
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