The 5 Myths: Myth No. 4, Cost Prohibitive

The 5 Myths Holding Back Plan Sponsors

Aside from just looking at potential risk, taking into account asset management fees, changing mortality tables, potential credit downgrades, and administrative expenses – transferring your risk to an insurer can actually be a cheaper option.

Myth Four The Hidden Costs of Defined Benefit Plans

  1. Myth Transferring DB risk to an insurer is cost prohibitive.
  2. Fact Transferring DB risk can actually mitigate expenses.
Morgan Stanley found that investors view pension deficits as riskier than corporate debt.

The economic cost of transferring risk is lower than what many sponsors and analysts perceive, be-cause the cost of trans-ferring risk includes many expenses that sponsors will incur even if they don’t transfer risk. A disaggregation of the costs of a retiree buy-out is illustrated in Exhibit 4.

In this example, the total cost of the retiree buy-out is 104 percent of the DB plan’s Generally Accepted Accounting Principles (GAAP) liability for its retirees.

Exhibit 4: The Disaggregated Costs of a Retiree Buy-out

For illustration only. Percentages represent present value of estimated future costs.
Buy-out Valuation Economic Value of Plan Sponsor Liabilities
104% 106%

Costs Borne by Plan Sponsors

  • Administrative and PBGC expenses: 3%
  • Investment management fees: 2%
  • Credit defaults and downgrades: 1%
  • Mortality: 6%

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The buy-out premium includes a capitalization of the following costs that would be borne by the plan sponsor over time regardless of whether or not they transferred risk via a buy-out:

Administrative Expenses and PBGC Premiums

Plan sponsors incur annual expenses related to participant servicing and plan administration. These costs are estimated to be $40 per participant each year. PBGC premiums are $64 in 2016, increasing to $69 in 2017, and $74 in 2018, with indexing thereafter.1

Investment Management Fees

Plan sponsors incur investment management expenses related to managing the assets within a DB plan. The analysis presented in Exhibit 4 assumes investment management expenses of 30 basis points per annum.

Credit Defaults and Downgrades

As an alternative to transferring risk, plan sponsors can execute an LDI strategy that closely matches the plan’s assets to its liabilities. Executing such a strategy would require a significant allocation to fixed-income securities, in particular long-duration AA corporate bonds. However, sponsors employing this strategy will incur on-going costs within the bond portfolio related to credit defaults and downgrades. The analysis presented in Exhibit 4 assumes that the cost of defaults and downgrades is 24 basis points per annum.2

Since the buy-out premium is a one-time payment to the insurer, the premium must account for all similar future costs that the insurer will now bear over time. Of course, executing a buy-out also means that sponsors are paying for these costs in advance via a single payment, rather than gradually over time.

Many plan sponsors could issue debt to fund a pension deficit, and this may be particularly attractive in a low-interest rate environment. By doing so, they replace volatile pension debt with contractual, fixed debt obligations. Morgan Stanley found that investors view pension deficits as riskier than corporate debt because when interest rates fall and pension liabilities grow, the pension implicitly claims a greater portion of a company’s total assets—to the detriment of its other creditors and shareholders.3 For further insights into the potential benefits of a borrow-to-fund solution, please read our latest research, "Borrowing to Fund Pensions Could Enhance Shareholder Value."

REFERENCES

  • 1 “PBGC Premium Increases in the Bipartisan Budget Act of 2015: Strategic Implications for Pension Plan Sponsors,” Aon Hewitt, December 2015.
  • 2Prudential analysis of credit default and downgrade costs for a typical AA corporate bond portfolio.
  • 3“Pensions in Practice: When Is It Optimal to De-Risk a Pension Plan?” Morgan Stanley, May 2013.