For a number of years now the proportion of employers in the US and Canada offering defined benefit pension plans to employees has been on the decline. Research shows that today fewer than 30% of Fortune 100 employers in the US offer defined benefit pension plans. Up until the late 90’s defined benefit plans were quite typical, with 90% of Fortune 100 companies offering such plans to new employees.
As employers continue to find ways to reduce the risks associated with defined contribution pension plans, well-established companies such as GM, Ford, Verizon and Heinz have decided to move some of their pension obligations off their books, electing instead to have an insurance company take on the responsibility. This process, known as de-risking, requires the employer to make a lump-sum payment for a group annuity from an insurance company, resulting in a transfer of the unpredictable pension obligation from the employer’s books.
The switch should have no effect on the retired pensioner as long as the insurance company is able to continue making payments on the annuity. However, for the employer that purchases the annuity, the adjustment offers an opportunity to mitigate volatile risk. This prospect has become even more appealing, especially because in recent years employers have been forced to spend billions on their pension funds to comply with accounting rules that are based on stock market volatility and low interest rates.
Given the strong performance of the stock market in recent years and the prospects that rising interest rates could be around the corner, it is becoming less costly for employers to purchase these annuities in order to de-risk. Hence, the appetite for these insurance contracts has been on the rise. According to the Washington Post, a survey of 182 companies conducted by Prudential revealed that 53% of those companies had already relocated their defined benefit pension duties to a third-party insurer or were likely to do so in the next two years.
Several factors are cited as to why companies are de-risking, including the desire to cut longevity risk as advances in medicine and healthcare have resulted in longer life expectancy. As pensioners live longer, companies are faced with higher-than-expected payout ratios, funding more than they had originally planned. Additionally, most executives would rather focus on running the core business than on maintaining costly pension plans.
Nonetheless, with traditional defined benefit pension plans all but extinct and those that remain being frozen – meaning that benefit accruals have been discontinued or curtailed in some way, or that they will no longer accept new employees – many worry that employees may end up in a worse position than before due to the choices presented. In many cases, when the employer de-risks using an annuity, employees are given the option of a lump-sum payment since that is less expensive for the employer. The worry is that employees who have been mostly hands-off with respect to their retirement savings are now responsible for investing what could be an extremely large sum that should last the rest of their lives. In these instances, the employee has taken on the longevity risk. As more employees encounter these situations, they need to exercise extreme care with their investment decisions. When in doubt, individuals who are less comfortable investing on their own should seek the help of a qualified investment professional.