Tuesday, March 6, 2012

Defined Benefit Supply and Demand

This should be good. This fool is writing about supply of DB plans and demand for DB plans? No, not really. But, we are going to look at a really simple way that supply and demand affect DB plans.

There are lots of DB plans out there that are frozen, be it soft or hard. Presumably, very few of them will ever be unfrozen. More likely is that plan sponsors are seeking to terminate those plans that are frozen. And, since the process for doing other than a standard termination often requires a plan sponsor to go into bankruptcy (yes, there are other ways, but that is beyond the scope of this article).

Let's look at the standard termination process in the simplest of terms. A plan has to be fully funded (including employer commitments) for the purchase of annuities, sufficient to provide all the benefits accrued and vested in the plan. Determining the level of assets to do that should be fairly simple, right?

Of course, it's simple. Presumably, you know what your funded status is on a PPA basis and you just pick up the phone and call your actuary. Actuaries have good rules of thumb for estimating everything, so your actuary will just give you a loading factor and you'll know where you stand, right?

Not so fast. Life insurance companies that are in the annuity business presumably want plan termination business. It's where they can get a large volume of business quickly. Let's consider a couple of scenarios.

Plan investments perform well, interest rates stay stable. If this is the case, then funded statuses will improve. A reasonable number of plans will be able to terminate. Insurance companies will presumably hit their goals for annuity volume.

Plan investments perform well, interest rates go up. Now, virtually everyone will think they can terminate their plans. The market will be flooded with demand for annuities. Insurers either will not be able to accommodate that much volume or will be able to create that impression.

In the second case, there is more demand, but no change in supply. I learned about this in Economics 101 (actually, it was called 14.001, and if you understand that, you'll know where I took it). Prices go up. So, your actuary's rule of thumb is going to be off by a bit ... and in the wrong direction.

We could create lots more scenarios to look at supply and demand, but this is pretty basic stuff. It's intuitive.

If you have a frozen plan and you're looking to terminate it, wouldn't you like to be able to track this loading factor or ratio of plan termination liability to PPA liability? Now you can. Contact us. Contact me.

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