Attention pension plan sponsors: Hold on tight, you’re in for a bumpy year-end.

October 21, 2014 Scott Kropf, FSA, EA, MAAA, FCA

Being a retirement plan actuary is tough. Now, I know what you’re thinking: what about all the fame, the glory, being in the #1 profession since…? Well, all that is true of course, but I can tell you that delivering year-end financial results to plan sponsors for most of the past 15 years has been a real drag. And this year-end looks to be no different. Here’s why:

  • Fixed income interest rates are way down. By about 0.75% year-to-date, which will increase most retirement plan liabilities by more than 10%.
  • Equity returns are flat for the year. This translates to an anemic return of maybe 1% to 2% for a typically invested plan – and as I write this, rates aren’t looking any better!
  • We are living longer! It takes an actuary to turn that into bad news. But for plan sponsors this means that pension and healthcare benefits will be paid out longer, increasing liabilities by 10% or more at year-end.

Yes, if you participate in a pension plan then you can expect to live a little longer. How much longer? Well, according to a new mortality study the Society of Actuaries expects to release very soon, at 65 you’re expected to live about 2 years longer than we thought. Good for you (but maybe not so good for your plan).

So, if you’re keeping score, most plans will be looking at a 20%+ increase in benefits liability at year-end with almost no increase in the asset value backing those benefits. Besides the higher balance sheet liability at year-end, this will have a significantly greater effect on 2015 benefit expense due to the leverage in the calculation.

What’s a plan sponsor to do?

As far as interest rates and equity returns are concerned, what’s done is done. If economic conditions don’t change, this is what we’re in for.

On living longer? Well, that’s an assumption, otherwise known as an extremely well thought out, well documented, statistically backed…guess. For example, this new mortality study concluded that life expectancy ultimately will increase at a rate of 1% per year. Great news for sure, but trying to predict mortality trends many years into the future becomes much more of an art than a science.

So as we rejoice about living longer and lament about the increased benefits cost it brings, the obvious question that comes to mind is: What about all those other assumptions we use to calculate how much benefit a plan sponsor will have to pay 10, 20, 30 or more years into the future? Is it time to dust off those assumptions to ensure they align well with plan experience and expected future trends?

The clear answer to that question is yes! Just as we are all living longer, employee retirement, turnover, and other trends have changed too. Retirement in your early 60’s is becoming very rare, and if you believe a lot of the surveys out there, retirement planning for many of us comes down to working as long as we are able. The good news is that if you haven’t reviewed your plan assumptions in a while, then updating them to reflect current expectations may reduce your cost, somewhat offsetting the additional 2 years of payments.

How is that? Well, to stick with the retirement example, the impact of retiring one year later may reduce a plan’s liability by up to 4% to 5% for current employees, depending on the plan. That’s pretty significant for one assumption. Of course, there are other good reasons to review assumptions, even if they are not nearly as enticing as financial savings. Professional standards and accounting statements require that each assumption be a current best estimate, and new Actuarial Standards of Practice are requiring your actuary document how each significant assumption was selected. Do you know what your actuary will say? If not, it might be a good time to ask.

Naturally, the actual cost of providing the benefits depends on what really happens. You want your assumptions to provide a reasonable estimate of the costs along the way.

To learn more about this topic, click on one of the links below or, better yet, talk to your actuary! But be nice, it’s going to be a tough year-end.

Year End Assumption Review

Retiree Medical Cost Assumptions

 

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