London Market Monitor – 31 August 2022
Our August review of the markets and Solvency II discount rates.
Monitor the annuity buyout market monthly with the Milliman Pension Buyout Index.
For chief financial officers (CFOs) and executives who are responsible for financial reporting, it is important that their projections closely reflect reality as results are realized over time. These professionals, however, do not always have control of some of the levers that cause financial results to deviate from projections, which can create a sense of uneasiness. As a result, minimizing or managing volatility is one of the primary goals in an organization’s financial planning.
For pension plan sponsors, this goal can be elusive because pension liabilities are directly affected by constantly changing interest rates, which sponsors have no control over. This relationship negatively impacts volatility reduction.
Because the liabilities reported on a financial statement are determined as of the “measurement” date, the prevailing interest rate on that one date can have significant implications. Adding to the year-to-year uncertainty is that pension liabilities also vary with annual mortality updates from the Society of Actuaries (SOA) due to changes in expected future improvement in mortality.
Both the mortality and interest rate risks can be transferred to an insurance company for a price. In return, the insurance company will take on the obligations of the pension plan, generally through a group annuity purchase. This transfer of the risks and responsibilities associated with the pension plan is one of several ways to “de-risk” a pension plan. And while the work involved in purchasing an annuity can be a significant strain on resources for a plan sponsor, this article shows, with a real-life example, how having a dedicated and experienced team as a business partner in this endeavor can benefit the plan sponsor both financially and administratively.
Before diving into the specifics of our client’s experience, we first want to outline an overview of the process to obtain competitive bids on a group annuity.
The annuity purchase process is made up of the bidding phase and the post-sale phase. Within the bidding phase, there are two steps: the preliminary bid and the final bid.
In the preliminary bid phase, an annuity purchase team provides the pension plan bid package to insurance carriers currently in the group annuity contract market. Each insurer assesses the bid package and determines whether or not to bid. After the preliminary bids are submitted, the annuity placement team reviews and summarizes the proposals. This team then produces a due diligence package designed to help plan sponsors fulfill their fiduciary obligation to select the “safest annuity provider available” according to Department of Labor (DOL) guidance issued in Interpretive Bulletin 95-1.
In the final bid process, the annuity purchase team then updates the census data to reflect any changes that have occurred since the preliminary bid and then final bids are requested from the insurers. On the final bid date, insurers submit their final quotes and the plan sponsor selects the carrier within a very narrow timeframe. After the plan sponsor executes the acceptance documents, the premium is transferred to the insurer shortly thereafter and the pension obligations are now the responsibility of the insurer.
During the post-sale phase, both the plan sponsor and the insurance company communicate with participants. The plan sponsor sends a “goodbye letter” notifying retired participants that their pension benefits will be paid by the selected insurer going forward (if this is the group included in the annuity purchase). If future retirees are included in the annuity purchase, they will be made aware of the insurance company now responsible for paying their retirement benefit, and how to contact it.
The insurer then transitions the participants to its administration system and follows up by sending them a “welcome letter.” The post-sale phase also includes a review by the plan sponsor and annuity placement consultant to finalize the annuity purchase contract to account for any data corrections that impact the cost of the annuity. This more detailed review of the census data may result in adjustments, either up or down, to the original purchase price.
The table in Figure 1 outlines these three steps in the annuity purchase process.
The plan sponsor may find the annuity purchase process involves several different areas of expertise outside their core capabilities. The table in Figure 2 provides an overview of the roles and responsibilities in the annuity placement process.
|Plan Sponsor||All decisions regarding annuity placement process.|
|Legal Counsel||Review contracts with insurance carriers and bid specifications.|
|Administration Provider||Provide data for bids and transition file to selected insurance carrier.|
|Independent Expert||Provide unbiased, comprehensive analysis and evaluation of insurance carriers in markets, due diligence, coordination of transition to selected carrier, and assistance in contracting process.|
|Review of Insurers||Provide necessary information to meet DOL Interpretive Bulletin (IB) 95-1 requirements so plan’s fiduciary can properly select appropriate insurance carrier.|
|Communication Team||Develop engaging communications to accompany required notices to help participants understand changes. Write, design, print, and mail materials.|
|Fiduciary||Review of insurance vendors and selection of appropriate insurer based on DOL IB 95-1 requirements.|
|Trustee||Provide information on retirees for transition file to selected insurance carrier.|
Our case study below shares one plan sponsor’s experience obtaining a group annuity for its plan.
Plan Sponsor A maintains two pension plans, one covering its hourly employees and one covering its salaried employees. The salaried plan has been hard-frozen (i.e., no additional accruals to participants) for a number of years. The hourly plan includes employees represented by several different unions. The benefits for some of these union groups have been hard-frozen while a small number of union employees continue to accrue benefits in the pension plan. Both plans are significantly underfunded on a Pension Benefit Guaranty Corporation (PBGC) premium basis and are projected to pay variable rate premiums at the per participant cap for seven to eight more years. The plan sponsor has previously offered two lump sum windows with the take-up rate declining in the second window. Due to expected further declines in the numbers electing to take the lump sum as well as the window’s associated costs and other considerations, it was decided to not offer a third window.
Instead, the plan sponsor considered an annuity purchase for in-pay participants with “small” monthly benefit payments relative to the PBGC premiums paid on behalf of these participants. The factors considered were:
In light of these considerations, we prepared the following analysis:
Decision, annuity purchase process, and outcomes:
As noted above, the competitive bidding phase involves multiple bids and strict deadlines. It is at this time that the bidders “sharpen their pencils” in an attempt to win the business.
By way of example, we will show how the competitive bidding process can drive insurers into converging bids so that the “sweet spot” of winning the business and making a profit is achieved. Because that sweet spot is very limited, it is not surprising when the final bids all end up being relatively close to one another.
Figure 3 shows the real-life results of a two-stage bidding process by a group of four insurance companies all trying to win the same business. In this instance, the group annuity bid involved only retirees and, because this type of annuity contains the most information that annuity providers seek (who, when, and how much to be paid), it should result in the most competitive bids. All results are shown as a ratio of the bid to the accounting liability or projected benefit obligation (PBO).
|Bid Phase||High Bid||Low Bid||Range|
Plan sponsors will no doubt be happy to see their costs decrease during this process and it is interesting to compare how closely the bids get to the prevailing “true” value, as measured by the PBO based on current interest rates. Because the insurers all had the same information, we see final bids coalesce around a small range; 0.86% here. Given the myriad of assumptions and vast amounts of data involved in these cost exercises, it is remarkable how close all of the insurers are at the end of the day.
The margin (or excess over PBO) insurers charge for annuities is fluid, as are the interest rates they are based upon. Milliman tracks this metric through the Milliman Pension Buyout Index (MPBI). The MPBI provides a monthly snapshot of the expected premium over PBO a plan sponsor looking to annuitize liabilities for retirees may need to pay. This is determined based on the input from several annuity providers. Figure 4 shows historical results provided in the latest MPBI.
This monthly review allows users to track trends in the annuity placement market over time and through various economic conditions.
Relative costs for annuities are shown, in the graph in Figure 4, as an average of all reporting annuity providers as well as what a plan sponsor may expect in a competitive bidding situation, indicated by the dark red “Competitive” line on the graph. The latest competitive bid in the graph shows some annuity companies have bid under the current PBO of the plan’s assumed liabilities. Because this indicates that plan sponsors may be able to offload liabilities at less than the carrying cost, it could be the case that the annuity purchase would result in an actuarial gain under Financial Accounting Standards Board (FASB) accounting instead of the more common actuarial loss. Of course, this situation is subject to many other factors and can change quickly.
The differences between the average and competitive bids also give insight into some of the value obtained through the competitive bidding process. The difference between the competitive and average index has ranged from around 1% to 5% over the past few years and currently is about 3%. This means we would estimate that a plan sponsor would see savings in the cost of an annuity purchase of about 3% when put through a formal, competitive bidding process. In terms of dollars, for plan liabilities totaling $100 million, competitive bidding could save a plan sponsor upwards of $3 million.
Note that the MPBI is based on a PBO calculated using a discount rate based on the Above Median FTSE yield curve. The ratio will be different for plans that use other methods to develop their discount rates. Please see our MPBI publications for more assumptions and caveats.
As shown above, competitive bidding can result in significant savings to the plan sponsor. These savings are partially offset by the costs involved to provide annuity placement services. Overall, costs associated with annuity placements come from two sources: those imposed by the insurance company and fees charged by the annuity placement group. Looking at the former, many factors go into pricing the annuity from the insurer’s perspective. Current interest rates, margin requirements, and the size of the annuity are obvious components of the pricing exercise. Perhaps not so apparent are other factors, including, but not limited to:
The other source of fees comes from the plan sponsor’s agent in the annuity purchase process. This is the role of the annuity purchase team. They facilitate the engagement with the insurers, gather data, solicit multiple rounds of bids, provide the required due diligence report, guide and counsel the plan sponsor, and, ultimately, assist with the handoff to the winning insurance company. There may also be ancillary costs from the plan’s actuary or administration team.
Many plan sponsors aren’t comfortable making the selection of insurer as sole fiduciary, and in some cases will seek assistance by having another entity take on a co-fiduciary role and assist in this choice. For these plan sponsors, some annuity placement groups will provide co-fiduciary services to help sponsors decide which insurer might provide the best option when comparing safety, cost, and participant services.
Paying benefits to retirees is an incredible responsibility taken on by plan sponsors. Selecting an outside organization to assume this role may be even more so. There are many important steps that need to be taken to successfully offload pension liabilities and having a trusted partner can make this a much less stressful endeavor.
Plan sponsors that hire an experienced and dedicated annuity placement team to facilitate their competitive bidding process typically find the benefits received to be well worth the cost.