WHAT CAN WE LEARN FROM SIX COMMON ANNUITY PURCHASE MISCONCEPTIONS?

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1 THOUGHTCAPITAL OCTOBER 2014 PENSION RISK MANAGEMENT: WHAT CAN WE LEARN FROM SIX COMMON ANNUITY PURCHASE MISCONCEPTIONS? For decades, an annuity purchase has offered a safe and effective way for DB plan sponsors to completely eliminate investment, interest rate and mortality risk related to settled obligations. In fact, in some common situations, the purchase of an annuity could be a sound approach: Retirees in frozen plans These participants would typically have an annuity purchased at plan termination. The timing of an annuity purchase is one of the most important considerations. Sponsors who have fully embraced Liability Driven Investing (LDI) Part of the cost of purchasing an annuity is paying out plan assets (and the opportunity for them to grow faster than plan liabilities by taking risk). This cost is eliminated or reduced if a plan sponsor is already embracing asset strategies designed to track liability changes. Sponsors with large pension plans relative to company size In these situations, the risks associated with the plan (the unknowns) may be too large for the company to absorb, and worthy for elimination at a known price. However, like any risk management strategy, annuity purchases require careful consideration. The financial impact of parting with a potentially significant portion of plan assets in exchange for elimination of benefit payments obligations and risk should be fully understood in order to make informed decisions. EXECUTIVE SUMMARY Risk management decisions for defined benefit (DB) plan sponsors are complex and challenging to make. Not only are multiple risk management options available (investment allocation, plan design, lump sums, annuities, and more) but the timing of their implementation can also be critical. A single premium group annuity contract (annuity purchase) can meet many objectives a DB plan sponsor may have as part of a well-planned longterm risk management strategy. The key is careful planning and analysis. This white paper examines common misconceptions regarding the impact of an annuity purchase to help plan sponsors better understand this risk management option and when to implement it. COMMON MISCONCEPTIONS ABOUT ANNUITY PURCHASES Given the complexity, it s not surprising that there are several common misconceptions regarding the impact of an annuity purchase. In an effort to bring clarity, the following analysis uses a hypothetical DB plan to illustrate these misconceptions. THE CASE STUDY PLAN: 1 A DB plan that is 95% funded (based on accounting liabilities) at 1/1/2014 and purchases annuities for all retirees (23% of plan participants, and 40% of plan liabilities). The plan sponsor makes regular cash contributions and has a static asset allocation of 50% equities and 50% core bonds Information for the hypothetical case study plan a. At the beginning of the forecast (1/1/2014) this frozen plan has approximately $72 million in accounting liabilities measured at 4.9% and is 95% funded. Approximately 40% of the liabilities are for the current retirees who represent about 23% of all participants in the plan. b. In all scenarios cash contributions are assumed at $0.5 million per year for the first seven years of the forecast. 2. In all but one scenario, DB plan assets are assumed to be invested in a static asset allocation of equal (50%) equity and core fixed income exposures. Asset allocation is re-balanced as needed, including after annuity purchase, if applicable. The one exception is the illustration in Misconception #6, we assumed 50% Long Term Bond allocation for the With AP scenario. In all scenarios, annual equity return is assumed to be 7.5% and fixed income classes returns are assumed to be consistent with assumed interest rate movements and appropriate durations.

2 MISCONCEPTION #1 Funded ratios aren t impacted by annuity purchase for fully funded plans. For many DB plans, 2013 was a great year. Stock markets went up and higher interest rates reduced plan liabilities. As a result, most DB plans saw dramatic increases in their funded status. According to Mercer research, DB plans of S&P 1500 companies were close to 95% funded on an aggregate basis at the end of This dramatic improvement in funded status is often cited as a reason to act now and purchase annuities for all or some of the retirees in your plan. However, the purchase of an annuity may actually decrease a plan s funded status and this could have financial and administrative implications. Increased contribution requirements, restrictions on lump sum payments, government reporting, increased Pension Benefit Guaranty Corporation (PBGC) premiums, participant notification, and violation of debt covenants are all potential consequences of sudden funding ratio decreases or deficit increases. Why does the purchase of an annuity typically cause a decrease in funded status? Let s define the Transfer Index as the ratio of an annuity premium over the accounting liability being held on the sponsor s books for the individuals included in the purchase. The Transfer Index can vary significantly, but for an average retiree population it currently stands at around 110%. Said another way, the cost of buying an annuity is 10% more than the liability held on the sponsor s books if the individuals remain in the DB plan. Let s take a look at our case study. 1 Purchasing annuities for our entire retiree group (40% of liabilities) would reduce the plan s overall funding ratio by 10%, dropping it from 95% to 85%, as illustrated on the Annuity Purchase (AP) Impact on Funded Status 95.0% $65 graph below. This is directly tied to the Transfer Index; $68.0 $ % $45 it costs $1.10 to settle every $1.00 of liability in our example. (See more on the development of this result in Funded Status Math below.) In addition to the $25 $5 $36.5 $43.0 funding ratio reduction, the deficit between liabilities and assets expressed in dollars increases, even as the plan shrinks to 60% of its original size. It is also important to note the funded status that -$15 -$35 Pre AP Assets ($31.5) ($28.6) AP Change Liabilities Post AP Funded Status matters is on the date the annuity is purchased. Using historical or even slightly dated information to make this decision can be misleading. Millions FUNDED STATUS MATH: If you are considering transferring P% of plan liabilities through an annuity purchase, the funded status decreases by the following amount: (Transfer Index Funded Percentage)/((1/P) 1) In our example, the Transfer Index is 110%, the Funded Percentage is 95% and the percentage of the plan liabilities being settled (P) is 40%. Based on that, the funding ratio impact is: (110% 95%)/((1/40%) 1) = 15%/1.5 = 10% reduction in the funding ratio. Note that this equation goes to zero as the Funded Percentage gets closer to the Transfer Index. 3. Mercer Point of View: Time to Act on Pension Risk Now, March 2014, states that aggregate funded status of S&P 1500 at the end of 2013 was nearly 95%. 2

3 THOUGHTCAPITAL OCTOBER 2014 MISCONCEPTION #2 Annuity purchases always reduce PBGC premiums. PBGC premiums have two components: a flat rate premium payable per participant in the plan, and a variable rate premium payable as a percentage of a plan s unfunded liability. Under current law, the flat rate premium is projected to increase to $64 per person by The variable rate premium (VRP) is slated to increase to at least 2.9% of unfunded liability (capped at $500 per person). The increase results in premiums that are double to triple the 2012 amounts. A common misconception is that annuities will always reduce PBGC premiums or avoid the impact of recent and possible future significant increases in PBGC premium rates. Moving individuals out of the plan by annuity purchase would reduce the flat rate premium and the $500 per person cap on the VRP. However, as shown in this case study, the increased funding shortfall as a result of the annuity purchase can actually result in significant increases in the VRP, offsetting or even completely erasing any flat premium savings. Over a period of time, the total PBGC premiums may be even higher after the annuity purchase than it would have been if such risk transfer strategy had not been implemented. The graph at right illustrates PBGC premiums 4 for our case study plan assuming annuities are purchased for all retirees ( With AP, indicated by dashed lines) and annuities are not purchased ( No AP, indicated by solid lines) 5. Under both scenarios, total PBGC premiums are higher if the annuity is purchased. For our illustration, we assumed that annuities are purchased at the end of 2014 at a rate equivalent to those available at the end of After 2014, future interest rates over the next four years either increase 1% (Scenario 1, shown in orange) or decrease 1% (Scenario 2, shown in green), then remain at these levels thereafter. Equity returns are assumed to be 7.5% each year of the forecast. This is not to suggest that annuity purchases never reduce PBGC premiums. For a plan that is well funded and without variable premiums, flat rate savings are realized. If future market conditions are such that the head-count based VRP ceiling applies, PBGC premiums savings are also likely to materialize. However, for other situations, the flat rate savings are often not sufficient to offset the increase in the plan s unfunded liabilities and subsequent increase in variable rate premium. Annual PBGC Premiums $450,000 $400,000 $350,000 $300,000 $250,000 $200,000 $150,000 $100,000 $50,000 $ No AP Scenario 1 With AP Scenario 1 No AP Scenario 2 With AP Scenario 2 Total PBGC Premiums Over 10 years of forecast Present value at 5.5% Scenarios Total (millions) No AP Scenario Savings With AP Scenario No AP Scenario With AP Scenario THE PROSPECT OF PBGC PREMIUM REDUCTIONS IS A LARGE MOTIVATOR TO LOOK AT AN ANNUITY PURCHASE. If this is the goal of the annuity purchase, it is important to understand the impact and whether other actions (such as additional funding or additional risk-management strategies) should be implemented to help ensure savings are realized. 4. PBGC premiums are according to the provisions of the Bipartisan Budget Act of 2013, reflecting the future wage growth assumed at 2.25% per year, and are paid out of plan s assets during the forecast. 5. With AP scenario means annuity was purchased for current retirees at the end of No AP scenario means plan continues without any transfer of retirees liabilities to an insurance company. Annuity purchase is assumed to occur at the end of 2014 (with accounting settlement expense reflected for 2014 fiscal year) based on the rates at the time of purchase. 3

4 MISCONCEPTION #3 Ongoing DB plan accounting expense is always lower after an annuity purchase. Plan accounting expense is an important metric for many DB sponsors because it impacts financial statements of the organization. Due to DB accounting rules, it s likely that annuity purchases could have an impact on the sponsor s income statement in the year of purchase. As a result of declining interest rates over the past five years, this is likely to be an accounting expense rather than income for most plans. That said, if a plan has deferred gains, it may actually be pension income. To the right is a graph forecasting ongoing DB plan expense for our case study plan under the same economic scenarios from Misconception #2. Annuities in these scenarios are purchased at the end of 2014 at a rate equivalent to those available at the end of After 2014, future interest rates over the next four years either increase 1% (Scenario 1, shown in orange) or decrease 1% (Scenario 2, shown in green), then remain at these levels thereafter. Equity returns are assumed to be 7.5% each year of the forecast. In the annuity purchase scenarios, the plan incurs a $2.5 million settlement charge in 2014, which is not reflected on the graph or in the table. Millions Annual Pension Accounting Expense $1.4 $1.2 $1.0 $0.8 $0.6 $0.4 $0.2 $ No AP Scenario 1 With AP Scenario 1 No AP Scenario 2 With AP Scenario 2 Total DB plan expense shown excluding settlement charge of $2.5 million in the first year, as the present value of on-going expense over 10 years at 5.5% On-going Expense (not including settlement charges Total (millions) No AP Scenario With AP Scenario No AP Scenario With AP Scenario Savings WHY IS ONGOING EXPENSE HIGHER WHEN BOTH ASSETS AND LIABILITIES HAD BEEN REDUCED? Once again, the answer is the Transfer Index, and the assets being reduced by more than the liabilities. This creates an actuarial loss which is amortized in expense. Moreover, assets are often assumed to return at a higher rate than liabilities under U.S. pension accounting rules, further magnifying the impact of the Transfer Index. In adverse market conditions, the ongoing expense is likely to decrease after settlement, but total DB plan expense for the period, including the settlement charge, will probably still be higher. To avoid surprises, it is important to understand the impact of the purchase on the financial statements and plan accordingly. 4

5 THOUGHTCAPITAL OCTOBER 2014 MISCONCEPTION #4 Purchasing annuities now for a frozen plan is likely to reduce the overall termination cost. For a frozen plan, purchasing annuities for retirees at plan termination is common practice. However, many frozen plans are now considering annuity purchase as a risk-transfer strategy before termination takes place. Pre-termination annuity purchases certainly reduce the overall size of the risk to be managed going forward, but they do not necessarily reduce the overall cost to terminate. In our case study, we define the cost-to-terminate as the present value of cash contributions over ten years plus the present value of the residual contribution at the end of the period to close any gap that exists between plan assets and the cost of termination. The initial termination gap for our example plan is $12.6 million. If interest rates are assumed to Initial Gap and Cost-to-Terminate Over 10 Years increase as shown in Scenario 1, it is intuitive that purchasing annuities now could cost more than $18 waiting for lower prices at higher rates in the future. $16 Less obviously, we see that purchasing annuities does not necessarily reduce cost in a declining interest rate environment as illustrated in Scenario 2. This result is driven by the lost assumed equity return of 7.5% annually. Different assumed returns or a different investment policy would produce varying results which may or may not reduce the overall cost of termination. Since no future asset return can be guaranteed, sponsors must weigh the value of the risk being eliminated by purchasing pre-termination annuities against the anticipated overall cost of terminating the plan. Millions $14 $12 $10 $8 $6 $4 $2 $0 $12.6 Initial Gap $12.6 No AP 56% Higher $4.3 $6.7 Scenario 1 Rates Up With AP $14.0 9% Higher $15.3 Scenario 2 Rates Down WHY IS THE TOTAL COST-TO-TERMINATE HIGHER FOR WITH AP SCENARIO EVEN IF RATES DECLINE AFTER THE ANNUITY PURCHASE (SCENARIO 2)? This result is driven by assumed lost equity returns over the projection period, and the fact that purchasing annuities for all retirees of the plan increases the overall duration of plan liabilities. In a declining rate environment, the longer duration liabilities would increase more than the short duration fixed income holdings assumed, resulting in increased ultimate termination cost. If an annuity is purchased, the investment strategy should be analyzed due to the increased interest rate risk of the plan (liabilities are going to change much more as rates change). 5

6 MISCONCEPTION #5 Purchasing annuities is likely to reduce funded status volatility. Reducing volatility is often cited as a reason for purchasing annuities. However, purchasing annuities for all retirees in our example plan actually resulted in greater volatility of the plan s funding ratio and unfunded liability. [Note that LDI hedging strategies could be used to help reduce volatility before or after the purchase of annuities, but those results are not modeled here.] The graph at right depicts the accounting funded status at the end of the 10-year period under four different interest rate scenarios. 6 The top results correspond with a 1% increase in interest rates in year one. The top of the orange bar reflects rates rising 1% over a period of four years. The top of the gray bar assumes rates stay constant throughout the projection period. And the bottom result assumes rates drop 1% over four years. The spread of funding ratios assuming no annuity purchase is 23% vs. 33% when all retirees are settled through an annuity in the first year. This is intuitive considering the longer duration of the remaining plan. Perhaps more surprising is the finding that volatility of the plan s unfunded liability on a gross dollar basis is greater under the annuity purchase scenario as well, even though the size of the plan is 40% less. This is driven by assumed lost returns on plan assets over the projection period in conjunction with longer plan liability duration. 110% 105% 100% 96% 90% 85% 80% 75% 70% Accounting Funded Status in 10 Years 108% 106% 96% 85% No AP Rates up in Year 1 before settlement Scenario 1: Rates up after settlement Rates same as at the end of 2013 Scenario 2: Rates down after settlement With AP 105% 96% 83% 72% Assets Liability = Surplus at end of 10 years (millions) No AP With AP Rate Up Before Settlement Scenario1 Rates Up 3.7 (1.9) Rates Same (2.3) (7.9) Scenario 2 Rates Down (10.5) (14.6) Range HOW DIFFERENT WOULD THE PLAN BE AFTER ANNUITY PURCHASE FOR CURRENT RETIREES? Your plan s demographic profile would generally be that of a much younger plan, including significantly lower benefit payouts and higher duration or sensitivity to interest rates movements. Once again, this points to increased importance of LDI and other investment strategies after an annuity is purchased that would help manage the increased interest rate risk For funded status volatility illustration we added two additional economic scenarios for the future interest rate movements. The neutral or Rates the same as at the end of 2013 is in-between our Scenarios 1 and 2, where rates are assumed to stay at the levels of 12/31/2013 not only during 2014 but for all future years of the forecast. Another scenario Rates up in Year 1 before settlement assumes that interest rates increased by 1% in 2014, with settlement occurring at this higher level, and for all future years thereafter rates remain at this higher level. Note that after 5 years interest rates in this scenario and Scenario 1 will be the same. The chart at right illustrates rates for accounting liabilities under all scenarios used in the funded status volatility chart. Interest Rate Scenarios 6.5% 6.0% 5.5% 5.9% 5.0% 4.5% 4.9% 4.0% 3.5% 3.9% 3.0% Beginning of the year Rates up in Year 1 Scenario 1 Rates same Scenario 2

7 THOUGHTCAPITAL OCTOBER 2014 MISCONCEPTION #6 If I purchase an annuity, there is no need to do anything else to manage pension risk. Our case study and previous examples illustrated the potential impact of an annuity purchase for a hypothetical plan. Our plan sponsor purchased an annuity for retirees but took no other action with respect to the remaining plan. What if the plan sponsor altered their asset allocation for the remaining plan (either increasing or decreasing risk)? What if they made a cash contribution to fund the Transfer Index? What if they offered lump sums to terminated participants? The results could be different (and potentially more favorable in the same economic scenarios), if other risk management strategies were considered in combination with an annuity purchase. For example, combining annuity purchase and LDI investment strategies allocating 50% to long term bonds, results in decrease of cost-toterminate in 10 years by 12% in Scenario 1 and 34% in Scenario 2. 2 Initial Gap and Cost-to-Terminate Over 10 Years $18 $16 $14 $12 $10 $8 $6 $4 $2 $0 $12.6 Initial Gap $ % Lower $4.3 $3.8 Scenario 1 Rates Up No AP With AP $ % Lower $9.2 Scenario 2 Rates Down CONCLUSION The use of annuities to help manage DB plan risks will continue to be a very important, safe, and effective risk management technique among many options that should be considered as part of a plan sponsor s overall risk management strategy. While the results presented in this case study demonstrate that some of the commonly cited reasons for purchasing annuities don t necessarily hold in several simple economic scenarios (for a plan that makes no other changes), there are other considerations in this very complex decision. As a result, it s important to remember that the actual impact of purchasing annuities on any particular plan will vary depending on the purchase group, liability characteristics, funding and investment policies, asset performance, and subsequent risk management decisions. Only through careful analysis can the impact of an annuity purchase on your plan be properly understood and planned for. 7

8 WE LL GIVE YOU AN EDGE Case study is for illustrative purposes only, does not reflect actual plan data. Asset allocation and diversification do not ensure a profit or protect against a loss. Equity investment options involve greater risk, including heightened volatility, than fixed-income investment options. Fixed-income investments are subject to interest rate risk; as interest rates rise their value will decline. Guarantees are based on the claims paying abilities of the issuing insurance company. Insurance products and plan administrative services are provided by Principal Life Insurance Company, a member of the Principal Financial Group (The Principal ), Des Moines, IA Principal Financial Services, Inc. PQ11748 t ri 10/2014

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