Imagine someone offers you a choice. You can have a lifetime annual annuity of $100,000 *starting now* or a $200,000 lifetime annuity *starting in 10 years. *Which option would you choose? Why? What factors would you consider in making your decision?

Perhaps you would decide based on your “gut reaction”. Or since the annuity is payable for life, you may consider the history of your family’s longevity. If you had a financial background, you would probably look at a present value calculation.

In any case, ideally, you would assign some value to both scenarios and choose the most valuable option. But how do you value a stream of payments that continues for an indefinite period of time (i.e., your lifetime)?

We will provide thoughts regarding this question in today’s post. Doing so also will explain the concept of actuarial equivalence in Defined Benefit Plans.

When valuing a stream of lifetime payments, you need to consider three principles.

- First, a dollar today is worth more than a dollar a year from now
- Second, the likelihood of payment decreases every year
- Third, more payments are expected when payments start earlier

Let’s tackle the first principle – a dollar today is worth more than a dollar a year from now. This concept is called the “time value of money”. Think about it, if you receive a dollar today, you would be able to invest it and expect a return on your money. That would mean that a dollar received and invested today is expected to be worth more than a dollar received in a year. Hence the preference for a dollar today.

The second principle – the likelihood of payment decreases every year – is a result of payments being made only while the annuitant is alive.

To illustrate this, imagine someone receiving annual payments starting at age 55. If paid immediately, the first payment would be guaranteed. The second payment would be extremely likely. However, by the 45th payment (at age 100) the payment would be very unlikely. The annuitant would probably be deceased. Payments in between these extremes would have corresponding probabilities that would decrease the farther out you go.

This principle is intuitive. If you receive lifetime payments starting now, you would receive more payments than if you started payments in 10 years. Of course, the value of the payments would be adjusted for the “time value of money” and the likelihood of payment, as mentioned above. Even so, starting payments 10 years earlier would result in additional expected value. That’s because payments in year 10 and beyond have the same value whether you start payment now or in 10 years. The difference then would be the value of the first 10 payments.

Actuarial Present Value (“APV”) ties together the three principles described above. For those with a financial background, an APV is like a Present Value, but an APV reflects that payment is contingent on the annuitant’s life.

So how do APVs relate to Defined Benefit Plans? Typically, Defined Benefit Plans provide employees options regarding the payment of their retirement benefit. For example, small business plans will often allow an annuity for life, a reduced annuity paid while either the employee or spouse is alive, or a one-time lump sum in lieu of an annuity.

The conversion from one form of payment to another is often done by calculating the payment amounts such that the APVs of the payment options are equal. For example, a lifetime annuity of $100,000 per year may be equivalent to an $80,000 employee and spouse joint annuity or a one-time lump sum payment of $1.3 million. The equivalence of APVs in the payment options is called actuarial equivalence in Defined Benefit Plans.

Actuarial assumptions are used to calculate the APVs for actuarial equivalence in Defined Benefit Plans. In its simplest form, the assumption basis is comprised of an interest rate and a mortality table.

Actuarial assumptions for this purpose are specified in the Defined Benefit Plan Document. In some cases, actuarial assumptions are prescribed. For example, one-time lump sum payments cannot be less than the amount calculated using prescribed “market” assumptions.

As you can imagine, actuarial assumptions can have a large impact on APVs and the corresponding payment amounts in the Defined Benefit Plan. For example, older mortality tables tend to have higher mortality rates than current mortality tables. This is because longevity has improved significantly over the last several decades. Thus, using an older mortality table could result in an APV that is significantly lower than one calculated using a current table. In general, retirement payment options would be lower as a result.

In many cases, employers adopted corporate Defined Benefit Plans several decades ago. As a result, Plan sponsors, in general, used mortality tables available at the time of Plan adoption. However, since that time, life expectancy has improved significantly. Additionally, interest rates have decreased. Many Defined Benefit Plans, as a result, tend to use higher mortality and interest rates for their actuarial equivalence than “current” rates.

What is the impact of higher life expectancy as it relates to actuarial equivalence in a Defined Benefit Plan? As mentioned, Defined Benefit Plans using older mortality tables tend to have lower spousal survivor and early retirement benefits than Plans using current mortality tables. On the other hand, these Plans also tend to have higher late retirement benefits than Plans using a “current” basis.

Interestingly, the impact of falling interest rates is more nuanced than the effect of lower mortality rates. For example, using lower interest rates actually produces lower spousal survivor benefits than higher interest rates. Thus, when it comes to spousal survivor benefits, the impact of reflecting longer life expectancy is offset to some degree by the effect of reflecting lower interest rates.

How much the two factors “offset” depends not only on the change in the mortality table and interest rate used for the Plan’s actuarial equivalence but also on the age of the participant, the age of the participant’s spouse, and even the percentage of the survivor benefit.

Yes, updating the Plan’s mortality table and interest rate to a “current” basis impacts Plan participants differently. For example, relative to the original basis, such an update may increase spousal survivor benefits for some participants and reduce benefits for other participants because of the differences in age and/or the form of payment selected.

The impact on early retirement benefits of using interest rates that are higher than “current” rates, on the other hand, actually compounds, rather than mitigates, the impact of using an older mortality table. With no offsetting effect, higher interest and mortality rates in combination can result in a significantly lower early retirement benefit than if a more “current” basis was used. As you may expect, the impact on late retirement benefits also is multiplied but in a way that is favorable to the participant (i.e., a higher benefit than if a more “current” basis was used).

Note that for both spousal survivor and early/late retirement benefits, some Plans do not use an explicit actuarial basis at all (i.e., mortality table and interest rate) but rather a table of predefined factors. These predefined factors may or may not be consistent with a more “current” actuarial equivalence basis.

Up until this point, we have focused entirely on traditional Defined Benefit Plans. Let’s next discuss actuarial equivalence in a Cash Balance Plan.

A Cash Balance Plan is a type of Defined Benefit Plan. However, rather than providing a guaranteed benefit for life, Cash Balance benefits are expressed as account balances.

As an example, a traditional Plan could provide a monthly pension starting at age 65 of $10,000 until the participant deceases. On the other hand, a Cash Balance benefit simply could be a one-time payout of $1 million.

Of course, Cash Balance Plans are Defined Benefit Plans. Thus, they also must offer a guaranteed lifetime payment. In fact, converting the account balance to the guaranteed payment stream is where actuarial equivalence issues may occur in a Cash Balance Plan.

That being said, actuarial equivalence issues tend to occur less frequently in Cash Balance Plans than in their traditional counterparts. That’s because a high percentage of Cash Balance participants elect payment of their account balance, instead of a monthly annuity, making an actuarial conversion unnecessary. On the other hand, many traditional Plans don’t even offer lump sum distributions unless the amount is nominal.

When updating a Plan’s actuarial equivalence basis, employers must grandfather the amounts accrued under the original basis. This can create both administrative and cost issues.

For instance, updating the Plan’s actuarial equivalence basis may increase administrative complexity. That’s because to grandfather the benefit, the employer must calculate the benefit accrued on both the date of the actuarial equivalence update and the date when the benefit is payable.

Alternatively, the employer could have their actuary test several possible reasonable actuarial equivalence options and use one that ensures that all participants are better off under the updated assumptions. Under this approach, two sets of calculations would not be required to demonstrate the grandfathering rules are satisfied because a cutback is not possible. Although this approach is easier to administer, it may be significantly more expensive because participant benefits will be higher than required.

Under either approach, updating the Plan’s actuarial equivalence basis impacts the administration and overall cost of the Plan.

Recently, actuarial equivalence in Defined Benefit Plans has been a “hot topic”. This is because lawsuits have challenged the actuarial assumptions used by certain Defined Benefit Plans. The lawsuits allege that the Defined Benefit Plans are using outdated assumptions. According to the arguments, this results in optional payment amounts that are lower than those calculated under a reasonable set of assumptions (i.e., more current mortality tables and/or interest rates).

These lawsuits have underscored the importance of actuarial equivalence in Defined Benefit Plans. They also serve as a reminder that employers and Defined Benefit Plan practitioners need to consider the reasonableness of actuarial assumptions in both the implementation and ongoing administration of Defined Benefit Plans.

Other Posts:

Telephone:

Email:

info@saberpension.com

Copyright © 2024 Saber Pension & Actuarial Services, LLC

(480) 795-8256

Fax:

(480) 393-8490