Longer Life Expectancies Raise the Bar on Pensions

Americans are living longer. That's good news for people--but it's creating challenges in the world of traditional defined-benefit pensions.

American men are living an average of two years longer than they were in 2000 (the last time the tables were revised), and women are getting an additional 2.4 years of life, according to new mortality projections from the Society of Actuaries (SOA). The SOA is the official keeper of the mortality tables used to calculate the value of future pension obligations, and longer lives mean greater cost for plan sponsors.

Those new tables, released last month, will give employers additional reasons to "de-risk" their pension plans by offering lump-sum buyouts to retirees and former workers, or transfer their obligations to private insurance companies by buying huge group annuities to pay out benefits. That, in turn, will force workers and retirees to make some tough decisions about their benefits.

The SOA projections are updated periodically, and they are used by plan sponsors and regulators to measure the cost of pension plan benefits. The new projections utilized data from about 2 million participants in pension plans over a five-year period, plus the SOA's own projections of anticipated future mortality improvement.

The projection is based only on one slice of the American population--workers receiving pensions, but it does reflect a broader trend. Average life expectancy in the United States rose by almost eight years from 1978 to 2011, to 78.7 years, according to the Organization for Economic Cooperation and Development (OECD).

According to the SOA, the gains reflect several factors: decades of improved access to health care, notably Medicare and Medicaid for the elderly, disabled, and poor; the discovery and availability of antibiotics and immunizations; clean water supply and waste removal; and the rapid rate of growth in the general standard of living.

"Access to health care and technology have played a large role," says Dale Hall, the SOA's managing director of research.

Clarifying the Longevity Data
Numbers like these often are cited to justify a range of retirement-related policy ideas--cutting entitlement spending, encouraging people to work longer, or delaying Social Security benefits. So before we continue, a few words of clarification about what the SOA projections mean--and what they don't mean.

First, the gains in longevity aren't evenly distributed among the population. Along with the gender gap, the SOA data show that higher-income white-collar workers outlive blue-collar workers (see table). Other research also points to a sizable longevity gap by educational attainment and race.

And in a global context, it's worth noting that the U.S. is no gold medalist in the longevity Olympics. The OECD reported last year that the average life expectancy among its member nations is now higher, at 80.1 years, than the U.S. average. (The OECD comprises most of the world's major economic powers, including the United States.)

Longevity gains from age 65 are even more telling, because they wash out deaths due to infant mortality as well as most violent and accidental deaths. Here, Americans are near the bottom of the ranking of 34 OECD member countries. The only countries with smaller gains in longevity from age 65 over the past 50 years were Iceland, Hungary, Denmark, Greece, Turkey, Mexico, and the Slovak Republic.

Implications for Pensions
The new SOA projections underscore the need for retirees to focus on longevity risk as they set goals for retirement saving and withdrawal rates. And, when considering the numbers, it's important to remember that the mortality data simply reflects averages; many of us--especially women--can expect to beat those numbers. 

But the new SOA projections also will have direct implications for defined-benefit pensions. Maintaining pension plans will become more expensive for plan sponsors, because the longer life spans will require them to increase projected future costs on their balance sheets. The value of payouts will rise anywhere from 4% to 8%, depending on the age of the annuitant (see table).

"It raises the bar," says Rick Jones, a senior partner at Aon Hewitt, the employee benefit consulting firm. "We think the audit community will require plan sponsors to consider the new mortality tables at the end of 2014." The new SOA projections also will be adopted over the next few years by federal regulatory agencies that oversee pensions and will require plan sponsors to increase funding levels to meet expected rising obligations.

That, in turn, likely will accelerate a major trend among plan sponsors to adopt de-risking strategies. Sometimes, that simply means reducing equity exposure in plan portfolios. But it also can mean offering lump-sum buyouts to retirees and former workers, or transferring their obligations to private insurance companies by buying huge group annuities to pay out benefits.

Deciding whether to accept a lump-sum offer is a highly personal decision. A key factor is how healthy you think you are in relation to the rest of the population. If you think you'll beat the averages, a lifetime of pension income will always beat the lump sum. The bigger picture of your retirement assets also matters; some people decide to take lump-sum deals when they have other guaranteed income streams, such as a spouse's pension or high Social Security benefits.

Others think they can do better by taking the lump sum and investing the proceeds. That's possible, but it needs to be weighed against the risks of withdrawing too much, market setbacks, or living far beyond the actuarial averages. And "doing better" on a risk-adjusted basis means you would have to consistently beat the rate used to calculate the lump sum by investing in nearly risk-free investments--certificates of deposit and Treasuries--since the pension income stream you would receive is guaranteed, with the exception of failed plans.

Another factor: New mortality projections may boost the value of lump-sum offers. The Internal Revenue Service will adopt tables within the next few years--2016 at the earliest--that govern the minimums required for lump-sum distributions. Those tables will be based on the SOA tables. That prospect likely will motivate some plan sponsors to offer lump-sum deals now, while they are less expensive.

Workers offered lump sums now might want to wait for a better deal down the road. But there's a caveat: The value of future offers also will be affected by interest rates, which are at historic lows. Higher interest rates would be reflected in higher discount rates, which are used to calculate lump-sum values, and lower payouts. Wilshire Consulting has estimated that a 50-basis-point jump in rates would offset the payout increases generated by the new mortality tables.

Although lump-sum buyouts are take-it-or-leave it deals, there could be additional buyout windows down the road in many cases, as sponsors work to reduce their pension obligations.

Mark Miller is a retirement columnist and author of The Hard Times Guide to Retirement Security: Practical Strategies for Money, Work, and Living. The views expressed in this article do not necessarily reflect the views of Morningstar.com.