Compelling Case for Pension Buy-out
Perspectives, August 2017
Sharp increases in PBGC premiums have made reducing headcount a priority for some U.S. plan sponsors. Decreasing the number of vested terminated participants can be best accomplised through a lump sum window, but for sponsors interested in a significant reduction in headcount a retiree buy-out may make the most sense. Of course, these strategies can be used together for maximum impact.
Relentless Increase in PBGC Costs
Since 2012, PBGC premiums have increased significantly, driving up the cost of maintaining a pension plan. Sponsors of qualified pension plans are required to pay annual premiums to the PBGC in exchange for benefit protections, should the company become unable to meet its pension obligations. There are two components to the annual PBGC premium: 1) a flat per-person charge and 2) a variable charge calculated as a percentage of the plan’s underfunding which is subject to a per person cap. As shown in Figure 1, between 2012 and 2019 the flat-rate premium is set to increase over 225% while the variable rate premium is set to increase over 460%.
Figure 1. Schedule of PBGC Premium Rates
*Subject to indexing and may be higher than the amount shown.
Further fueling these increases, plan sponsors will be faced with a 3–5% increase in PBGC liability when the IRS mortality requirements take effect in 2018. The increase can be significant—for a plan that is currently 95% funded, that funding ratio may decrease to 90% which will double the variable premium.1
Figure 2. Impact of rising PBGC costs per-person2
Source: Prudential calculations. See footnote for all assumptions.
Short of a full plan termination, a plan sponsor who wants to minimize PBGC premiums can look to two options: lump sum offers to vested terminated participants and annuitization of retiree benefits.
The Lump Sum Option
It has become common for a plan sponsor who is looking to decrease participant headcount to offer a lump sum payout to a portion of, or all of, its vested terminated population for a period of time (i.e., 60–90 days) in what is known as a “lump sum window.” A plan sponsor can settle the vested terminated liabilities at an amount close to the GAAP liability, making this an economical option.
While popular, there are some drawbacks to this approach:
- Typically, only 10–15% of the liability is attributable to the vested terminated population,3 thus the headcount and liability reduction opportunities are limited.
- Although the industry statistics place the average lump sum acceptance rate around 50%, there is significant variation which leaves the sponsor with uncertainty.
- Data for this segment of the population is famously incomplete, requiring a significant data clean-up effort that costs a sponsor both time and money.
For plan sponsors looking to significantly reduce headcount and plan liabilities with certainty, a small benefit retiree buy-out is a very useful de-risking tool.
There is a compelling case for the annuitization of retirees with small benefits. Simply put, the PBGC premiums and other costs of maintaining these participants within the plan are higher than the cost of settling them with an insurer. As illustrated in Figure 3, the carrying costs of participants with the smallest benefits are as high as 26% of GAAP liability. By comparison, a buy-out for this group may cost 106% of GAAP liability, making this an attractive option for the sponsor.
Figure 3. Relative value for a plan paying flat-rate and variable rate premiums4
A key benefit of annuitizing retirees is the ability to transfer a significant number of participants and plan liability, as the retired population typically represents 50% of plan liabilities. Further, because there is no participant optionality involved, a sponsor can choose with certainty the liability to be transferred to an insurer. Finally, given the in-pay status of this group, the data is generally very clean, making for an efficient process.
One additional advantage to a small benefit buy-out is that the pricing may be more attractive for the retirees with the smallest benefits. This is due to the recognition that participants with higher benefits are anticipated to outlive those receiving smaller benefits. Since the GAAP liability does not differentiate by benefit size, the price of a small benefit transaction measured as a percentage of GAAP liability will typically yield the most efficient economics.
The Bottom Line
Both lump sum offers and retiree buy-outs allow for reduction in participant headcount and efficient transfer of plan sponsor risk, however they are not created equal.
While a plan sponsor can offer several rounds of vested terminated lump sum offers, ultimately there is a limited return. The average plan, whose vested terminated group comprises 10–15% of the liability, faces a ceiling in headcount and liability reduction.
In the case of a retiree buy-out, although slightly more expensive relative to GAAP liability, there is a greater opportunity for headcount and liability reduction, combined with less data clean up and certainty of results.
Perhaps the best strategy is for the plan sponsor to combine strategies. Many have already maximized the achievable reduction in vested terminated headcount and would now be well served in pursuing the retiree buy-out option.