The budget approved by Congress on Wednesday raises premiums companies must pay to the Pension Benefits Guaranty Corp., a point that might cause many employers to settle their retirement plan liabilities through lump sum payments or by buying annuities.
The effect of the premium hikes, according to Aon Hewitt, could increase the carrying costs of unfunded pension liabilities by more than 3 percent. That would cause companies to consider derisking their pension plans.
The two approaches to doing that are either offering plan participants a lump sum payout or purchasing an annuity from an insurance company. In each case, the pension liabilities are removed from the company books.
Lump sums eliminate administrative costs and mortality factors like life spans, Aon Hewitt said in a paper, and “may present a significant opportunity to settle certain pension liabilities at a discount to their economic value” in 2014 and 2015.
The buying of annuities might also reap savings for a company, although they would likely be less than in the case of lump sums.
Flat-rate PBGC premiums were already set to rise from $42 to $49 per plan participant next year. In 2015, the rate will rise to $57 and in 2016 it will be $67. In addition, rates in those two years are subject to an inflation adjustment that could cause them to go up even more.
Variable rate premiums, which are paid based on how underfunded a plan is, will also rise, from $9 per every $1,000 of underfunding this year to $14 in 2014. The rates the following two years, which will also be tied to inflation, will be $24 and $29.
“What they’re doing is pretty ridiculous in raising the premiums,” said Zorast Wadia, principal and consulting actuary at Milliman Inc. in New York. He added that the assumptions used by the PBGC are too conservative, making the need for higher premiums greater than is necessary.
In addition, the budget bill, which now only awaits the president’s signature, changes the link between investment strategy and premiums. Now, the level of variable premiums a company is chained to how long a plan remains underfunded.
Now, the level of variable premiums a company will pay is chained to how long a plan remains underfunded.
“This disincentivizes high-risk/high-reward investment strategies for well funded plans,” Aon Hewitt said. That’s because taking high risks leaves more possibility a plan would become underfunded.
The estimated $8 billion in new premiums over the next decade would go toward reducing deficits by the Pension Benefit Guaranty Corp., a government agency that covers pension payments to retirees when bankrupt companies can't.
The PBGC has complained for years that operating in the red threatens the agency's ability to act as a safety net in the future, as more employers default on their pension plans.
Pensions used to be the most common type of retirement benefit, guaranteeing workers a specific monthly payment for life regardless of the ups and downs of the stock market. Fewer than 9 percent of private-sector employers still offer them, while 88 percent of employers opt instead to sponsor 401(k) retirement plans.
The number of pension plans the PBGC insures for individual employers has plunged from an all-time high of 112,208 in 1985 to about 23,000 this year. The number has continued to drop by about 1,000 per year since 2010, according to PBGC figures.
Olivia Mitchell, a pension expert at the University of Pennsylvania's Wharton business school, said the trend of companies ending or freezing their pension plans has been playing out regardless of rising premiums. She said the latest increase may be painful for some businesses but argues that it's needed because the system is not solvent in the long run.
"I think the reality is that we have undercharged premiums for defined benefit insurance since the beginning," Mitchell said. "We have to start now to help the system bail out its shortfalls before it's too late."
The PBGC protects the pension benefits of nearly 44 million current and future beneficiaries. It now pays out benefits to 1.5 million people in plans that have failed.
The agency has about $85 billion in assets from the pension plans it has taken over, premiums and investment income to cover its annual operating losses. But it estimates its potential exposure to future pension losses from financially weak companies at about $292 billion. Some business groups say that estimate is too high.
In a report last year, the Government Accountability Office, Congress' auditing and investigative arm, recommended that the PBGC restructure its premium rates to make it more risk-based and better reflect the risk of future claims. Financially healthier firms would pay less and financially riskier sponsors would pay more.
The Obama administration has proposed similar changes in the way pension premiums are charged. When PBGC Director Josh Gotbaum testified before Congress last year, he called it unfair that financially sound companies are being asked to make up the difference for those that are not.
The Associated Press contributed to this report.