Part 1: Accounting for the True (Ongoing) Nature of DB Plan Expenses; The Present Value of Future Expenses ("Annuals vs Perennials")
Eliminating ongoing plan expenses represent a significant cost savings opportunity to a plan sponsor whether the plan expenses are being paid directly by the plan sponsor (outside the plan) or deducted from the plan assets (inside the plan). We can compare the nature of plan expenses to flowers in a way that there are annual flowers that need to be planted each year versus perennials flowers that bloom each year without needing to replanted. Much like flowers that are annuals plan expenses are ongoing yearly expenses. Annuities, on the other hand, are perennial in that they are a one time expense implicit with the cost of the annuity.
“Annual” plan expenses typically include outsourced services such as actuarial, recordkeeping and administration, legal, accounting and audit, asset management, trustee and custodial as well as internal management costs such as HR administration. PBGC premiums are a significant annual expense as well. Depending on the size of the plan these costs can amount to 50 bps to 200 bps (annually) of the plan assets. When considered as a percentage of annual plan contributions total plan expenses can represent 25% of more of annual plan contributions. These are significant, ongoing costs.
A simple way to estimate the present value of future annual plan expenses is to total the annual plan expenses listed above and multiply this amount by the plan’s average duration (in years). For example, annual plan expenses = $100,000 x 10 year average plan duration = $1,000,000. (a typical durations for a plan with mostly retirees). A more accurate number could be calculated if you project the annual costs (including projected future increases) and apply a discount rate value to the future expenses, however, if costs rise at a rate similar to the discount rate being applied the net result is the same.
When annuitizing and accumulated/accrued benefit obligation (ABO) the insurer is taking on and guaranteeing the payment of the accrued benefit promised and the cost to administer the benefit. The administration costs are implicit (included) in the (one time) annuity purchase cost (similar to perennial flowers which are only planted once).
Therefore, when evaluating the annuitizing of benefits approach versus continuing to actively manage and administer the benefits, it is important that the plan sponsor account for the PV of future expenses to objectively compare the two approaches:
||Insured Benefits Payments
(Annuity Purchase Cost)
|PV Future Expense Cost
|Total Cost (All In)
In the above example we have assumed that an insurance company can provide and administer the same benefit payments for the 10% higher cost than the current plan ABO. If these were the case, the plan could effectively transfer all benefit obligations and the associated annual plan costs and related responsibilities to an insurance company at no added cost to the plan sponsor. If the annuity purchase cost was, instead, only 5% higher, the plan sponsor would actually save $ 500,000. ($ 10,500,000 vs current cost of $ 11,000,000) Insurance company expenses also include mortality expenses and have lower administrative costs when compared to most plan sponsors. This is due to their size and scale of investment and administration operations and the fact that they are investing almost exclusively in fixed instruments (bonds) that have lower asset management costs.
Another equally significant benefit provide by annuitizing the plan obligations is the plan sponsor has irrevocably transferred all of the risk and volatility associated with actively investing plan assets (including the inherent business and fiduciary risks related thereto) and all mortality risk to a major, financially sound insurance company who now becomes the first guarantor of the benefits.
Dietrich & Associates, Inc. Is a leading employee benefits brokerage and consulting company specializing in providing retirement plan sponsors with terminal funding annuity solutions for the Defined Benefits Pensions Plans, 401(k) Annuity Plans and Other Post Employment Benefit Plans. Dietrich & Associates, Inc. offers clients annuity funded solutions that are innovative and focused toward mitigating financial volatility and risk and minimizing administrative regulatory responsibilities. www.dietrichassociates.com