February 2023 Annuity Purchase Update
• Average annuity purchase rates dipped this past month- with the average duration 7 annuity purchase rate at 4.31% and average duration 15 annuity purchase rate at 4.28%.
• The Pension Risk Transfer Market kicked off 2023 with a strong start as plan sponsors continue to take steps toward plan termination at record pace.
• Strong stock market returns offset the impact of lower interest rates.
•Contrary to the historical lull we typically see in the first quarter, there has been high volume of placement inquiries thus far in the year. Plan sponsors should consider connecting with an annuity search firm soon.
Narrative
As mentioned in the Pension Finance update, pension funding status improved as strong stock market returns offset the impact of lower interest rates. Annuity purchase interest rates followed an upward trend in 2022. Both the average duration 7 rate and average duration 15 rate decreased in the last month, but the market remains very active. Average annuity rates decreased this past month with the average duration 7 annuity rate at 4.31% and the average duration 15 annuity rate at 4.28%. As expected, the market rush of 2022 spilled into 2023. Plan sponsors are going out to market at record pace in an effort to terminate their pension plans. Insurance carriers are seeing record number annuity placement inquiries year to date. It is crucial for plan sponsors to enter the market place sooner rather than later to exploit favorable pricing.
As seen in the graph below, rates in 2022 were higher than historical averages. In 2022, the average duration 7 annuity rate was 3.71% and the average duration 15 annuity purchase rate was 3.76%. As of February 2023, rates are well over these average rates. Annuity purchase interest rates and treasury yield rates fluctuate over time. The 10 year treasury rates correlate with the duration 7 annuity purchase interest rates. Similarly, the 30 year treasury rates correlate with the duration 15 annuity purchase interest rates. Given the rapid increase in rates and surge in market activity, a timely entry into the market place is critical for plan sponsors to receive favorable pricing. Implementing a Pension Risk Transfer strategy can help a plan sponsor fulfill organizational goals, including reducing volatility in financial disclosures due to volatile interest rates.
Top 3 ways PRT is lowering plan costs
The graph below displays the spread between annuity purchase price above GAAP projected benefit obligation (PBO). We refer to GAAP PBO and accounting book value interchangeably. In February 2023, the spread for Annuity Plan 1 and Annuity Plan 2 widened. In 2022, we observed the annuity purchase cost of retiree placements was consistently between 94% – 105% of the pension accounting value with the average at 100.55%. An increase in annuity purchase rates inversely lowers annuity purchase prices relative to accounting book value. Please note, that the below PBO calculations exclude future overhead costs paid by plan sponsors to retain participants in the plan. Administrative expenses and PBGC premiums are examples of these overhead costs. Future overhead costs would narrow the spread, though the extent is plan specific.
Annuity purchase cost fluctuate from month to month. Given the decrease in rates this past month, we recorded an increase in annuity purchase cost. Since last month, The purchase price for Annuity Plan 1 increased 2.64% and Annuity Plan 2 jumped 5.38%. An early entrance to the insurance market is a vital component of the planning stage because of the consistent short-term volatility of annuity pricing. By connecting with an annuity search firm early on, plan sponsors can capitalize on favorable fluctuations in a volatile market.
Additional Risk Mitigation Strategies to Consider
It is difficult to predict the market, however the decrease in annuity purchase interest rates this past month could suggest a potential downward trend in rates and a corresponding increase in price. Annuity purchases for plan sponsors do not need to occur on an all-or-nothing basis. To hedge against a potential loss as a result of dropping rates, plan sponsors could consider settling the retiree liability earlier on. Also, many plan sponsors can benefit by purchasing annuities even for a subset of plan participants. This is especially true for retirees with small benefit amounts. In 2022, we saw an increase in the number of lift-out transactions. Plan sponsors pay PBGC premiums for participants that do not vary based on the size of the participant’s benefit. For retirees with small benefit amounts, the PBGC premium overhead burden is substantial and can be eliminated through an annuity purchase. Retiree carveouts have controlled a vast majority of market activity in 2022 so we are expecting to see more plan terminations in 2023.
October Three advises plan sponsors through every step of the Pension Risk Transfer (PRT) process. Through long-established relationships with insurers in the PRT marketplace, October Three collects annuity purchase rates for Duration 7 years and Duration 15 years on a monthly basis. We have constructed two hypothetical annuity plans, which have been valued using the latest mortality tables and mortality improvement scales. Annuity Plan 1 contains retirees only and has a liability duration of 7 years. Annuity Plan 2 includes 70% retirees and 30% deferred and has a liability duration of 15 years. Using the collected annuity purchase rates and 2 hypothetical annuity plans, we have produced the following graphs representative of actual PRT market activity and the corresponding impact on pension plans.