Group Annuities [Reprint 2016 ed.] 9781512814514

Table of contents :
Foreword
Preface
Contents
List of Tables
Chapter 1. Introduction
Chapter 2. The Development of Group Annuities
Chapter 3. Legal Aspects of Group Annuity Contracts
Chapter 4. General Provisions of Group Annuity Contracts
Chapter 5. The Specific Provisions of Group Annuity Contracts
Chapter 6. The Specific Provisions of Group Annuity Contracts (Continued)
Chapter 7. Other Group Annuity Contracts
Chapter 8. Underwriting Group Annuity Contracts
Chapter 9. Administration of Group Annuity Retirement Plans
Chapter 10. Analysis of Cost Factors
Chapter 11. Premiums, Dividends, and Reserves
Chapter 12. Evaluation of Group Annuities
APPENDIX A. Fifty-six U. S. Life Insurance Companies Having Group Annuity Contracts in Force December 31, 1953
APPENDIX B. Schedule of First Group Annuity Contracts Written by the Seven Leading U. S. Companies
APPENDIX C. Group Annuity Financial Experience of Seven Leading Life Companies
APPENDIX D. Historical Schedule of Deferred Group Annuity Rates
APPENDIX E. Schedule of Current Group Annuity Rate Bases
APPENDIX F. The Definition and Standard Provision Sections of the New York Insurance Law
APPENDIX G. Sections 401 and 404, Internal Revenue Code of 1954
Bibliography
Index

Citation preview

THE S. S. HUEBNER FOUNDATION FOR INSURANCE EDUCATION Lectures L I F E I N S U R A N C E T R E N D S AND P R O B L E M S T H E B E N E F I C I A R Y IN L I F E I N S U R A N C E L I F E INSURANCE TRENDS AT MID-CF.NTURY I N V E S T M E N T OF L I F E I N S U R A N C E F U N D S A C C I D E N T AND SICKNESS INSURANCE

Studies A N A N A L Y S I S OF G O V E R N M E N T L I F E INSURANCE A N A N A L Y S I S OF G R O U P L I F E I N S U R A N C E T H E E C O N O M I C T H E O R Y OF R I S K A N D I N S U R A N C E G R O U P ANNUITIES

GROUP ANNUITIES by

Kenneth Black, Jr., Ph.D. Associate Professor of Insurance Universit\ of Georgia Atlanta Division

University of Pennsylvania Press Philadelphia

1955

Copyright

1955

U N I V E R S I T Y OF PENNSYLVANIA PRESS Manufactured

in the United States of America

Published in Great Britain, India, and Pakistan by Geoffrey Cumberlege: Oxford University Press London, Bombay, and Karachi

To The Memory DR.

DAVID

of

MCCAHAN

THE

S. S. H U E B N E R

FOR

INSURANCE

FOUNDATION EDUCATION

T h e S. S. H u c b n e r F o u n d a t i o n for I n s u r a n c e E d u c a t i o n was crcalcd in 1940, u n d e r t h e sponsorship of t h e A m e r i c a n L i f e C o n v e n t i o n , t h e I n s t i t u t e of Life I n s u r a n c e , a n d t h e Association of L i f e I n s u r a n c e Presidents (now t h e L i f e I n s u r a n c e Association of America). Its p r i m a r y p u r p o s e is to aid in s t r e n g t h e n ing i n s u r a n c e e d u c a t i o n on the collegiate level. It f u n c t i o n s a l o n g t h r e e p r i n cipal lines: 1. P r o v i d i n g fellowships a n d scholarships to aid teachers in accredited colleges a n d universities of t h e U n i t e d Stales a n d C a n a d a , or persons w h o a r e c o n t e m p l a t i n g a t e a c h i n g career in such colleges a n d universities, to secure p r e p a r a t i o n at t h e g r a d u a t e level for i n s u r a n c e t e a c h i n g a n d research. 2. B u i l d i n g u p a n d m a i n t a i n i n g a research service center in i n s u r a n c e books a n d o t h e r source m a t e r i a l which will be a v a i l a b l e t h r o u g h circ u l a t i n g privileges to teachers in accredited colleges a n d universities desirous of c o n d u c t i n g research in i n s u r a n c e subjects. 3. P u b l i s h i n g research theses a n d o t h e r studies which c o n s t i t u t e a distinct c o n t r i b u t i o n directly or indirectly to i n s u r a n c e knowledge. F i n a n c i a l s u p p o r t for t h e F o u n d a t i o n is p r o v i d e d by m o r e t h a n o n e h u n d r e d life i n s u r a n c e c o m p a n i e s which c o n t r i b u t e on t h e basis of t h e i r o r d i n a r y life i n s u r a n c e in force. The p r o g r a m of activities is u n d e r the general direction of a Board of T r u s t e e s r e p r e s e n t i n g t h e life i n s u r a n c e i n s t i t u t i o n . Actual o p e r a t i o n of t h e F o u n d a t i o n a n d of its affairs has been delegated to t h e University of Pennsylvania u n d e r an a d m i n i s t r a t i v e p l a n s u b m i t t e d by t h e University a n d a p p r o v e d by t h e F o u n d a t i o n T r u s t e e s . In accordance t h e r e w i t h t h e University h a s established a n A d m i n i s t r a t i v e B o a r d consisting of seven officers a n d f a c u l t y m e m b e r s of t h e University of P e n n s y l v a n i a a n d t h r e e faculty m e m b e r s of o t h e r universities. It has also a p p o i n t e d a n E x e c u t i v e Director.

BOARD OF TRUSTEES Leroy A. Lincoln, C h a i r m a n of t h e B o a r d , M e t r o p o l i t a n Life I n s u r a n c e Co. (Chairman ) H a r r i s o n L. A m b e r , President, Berkshire L i f e I n s u r a n c e Co. H a r o l d J . C u m m i n g s , President, M i n n e s o t a M u t u a l Life I n s u r a n c e Co. E d m u n d M. McConney, President, Bankers L i f e Co. R a y D. M u r p h y , President, E q u i t a b l e Life Assurance Society of t h e U. S. W i l l i a m M. R o t h a e r m e l , A l t a d e n a , C a l i f o r n i a A d o l p h A. R y d g r e n , C h a i r m a n of t h e B o a r d , C o n t i n e n t a l A m e r i c a n L i f e I n s u r a n c e Co. E l d o n Stevenson, Jr., President, N a t i o n a l Life 8c Accident I n s u r a n c e Co. F r a n k F. W e i d e n b o r n e r , Vice P r e s i d e n t , G u a r d i a n L i f e I n s u r a n c e Co. of America ADMINISTRATIVE BOARD S. S. H u c b n e r , Honorary Chairman Harry J. Loman, Chairman D a n M. McGill, Executive Director C. C a n b y B a l d e r s t o n Edison L. Bowers Roy F. Nichols Ralph H. Blanchard C h a r l e s C. C e n t e r E d w i n B. W i l l i a m s C. A. K u l p vii

Foreword One of the primary objectives of T h e S. S. Huebner Foundation for Insurance Education is to publish the findings of graduate research and other studies which contribute in a significant measure to the store of insurance knowledge. In conformity with that objective, the Foundation has undertaken the publication of two series of volumes, designated as "Huebner Foundation Lectures" and "Huebner Foundation Studies," the first series comprising a compilation of addresses on selected insurance topics and the second a presentation of the results of intensive research in specific areas. T h i s particular volume is the fourth in the "Studies" series and the third stemming directly from the Foundation's program of graduate fellowships and scholarships. It represents the doctoral dissertation of Kenneth Black, Jr., written while he was preparing for an insurance educational career under a Foundation fellowship grant. T h e book does not pretend to embrace the entire field of private pensions. As is made clear by its title, it is concerned with only one type of funding medium, albeit an extremely significant one. It was envisioned as a companion volume to Gregg's work on group life insurance. In view of this, the author had to restrain his natural impulse to examine other important funding media. A native of Virginia and a veteran of World W a r II, Dr. Black received both the A.B. and M.S. degrees from the University of North Carolina, the former in 1948 and the latter in 1950. At the conclusion of his work at the University of North Carolina, he was awarded a Huebner Foundation fellowship and studied at the University of Pennsylvania for the next three years, receiving the Ph.D. degree in 1953. In the fall of 1953, he was appointed to an associate professorship in the Atlanta Division of the University of Georgia School of Business Administration and named Chairman of the Insurance Department. ix

X

FOREWORD

The

n a t u r e o f t h e purposes for w h i c h

the Foundation

was

c r e a t e d p r e c l u d e it f r o m t a k i n g a n e d i t o r i a l p o s i t i o n o n c o n t r o versial

insurance

t h e o r i e s or practices.

I t does n o t ,

therefore,

d e t r a c t in any wise f r o m the q u a l i t y of this v o l u m e to state t h a t the

findings

of fact a n d c o n c l u s i o n s d e r i v e d t h e r e f r o m are those

o f t h e a u t h o r a n d n o t of the F o u n d a t i o n . DAN M . M C G I L L

Executive Philadelphia January 1955

Director

Preface T h e growth of the private pension m o v e m e n t over the past quarter-century is o n e of the most significant developments affecting the e c o n o m i c and social welfare of the U n i t e d States. D u r i n g this period the n u m b e r of pension plans has increased from a few h u n d r e d to a p p r o x i m a t e l y twenty-two thousand. Various arrangem e n t s are available for the f u n d i n g of these pension plans, b u t o n e of the most basic is the g r o u p annuity contract. F r o m the s t a n d p o i n t of coverage, it represents the basic a p p r o a c h of life i n s u r a n c e companies to the underwriting of pension benefits. B e c a u s e of their d o m i n a n t role in the field of insured pensions, g r o u p a n n u i t i e s would seem to deserve careful e x a m i n a t i o n and analysis. It is the purpose of this volume to provide a comprehensive analysis of the structure and operations of the g r o u p a n n u i t y contract. An a t t e m p t has been m a d e to strike a b a l a n c e b e t w e e n general principles and detailed o p e r a t i n g practices in the h o p e that the v o l u m e might prove equally useful to those persons actively engaged in pension underwriting a n d those who desire only a general understanding of this basic pension i n s t r u m e n t . It is a pleasure to acknowledge the cooperation a n d help provided by a host of insurance c o m p a n y executives a n d o t h e r personnel in the p r e p a r a t i o n of this volume. Special recognition should be accorded Mr. R a y M. Peterson, Vice President a n d Associate Actuary, E q u i t a b l e L i f e Assurance Society of the U n i t e d States, a n d Mr. F. P. Perkins, Actuary, A e t n a L i f e I n s u r a n c e C o m p a n y , both of whom read the manuscript in its entirety a n d m a d e valuable suggestions a n d criticisms. M r . J o h n K . Dyer, J r . , Vice President, T o w e r s , P e r r i n , Forster a n d Crosby, Inc., also reviewed the c o m p l e t e d m a n u s c r i p t and was particularly helpful in providing an objectivity that is difficult to achieve in a study such as this. T h e b o o k bears the strong i m p r i n t of D r . G. W r i g h t H o f f m a n a n d D r . D a n M . M c G i l l , b o t h of the I n s u r a n c e faculty of the xi

xii

PREFACE

W h a r t o n School of F i n a n c e and Commerce, who gave unstintedly of their time and counsel. As Executive Director of T h e S. S. H u e b n e r F o u n d a t i o n for Insurance Education during the period of the author's residence at the University of Pennsylvania, the late Dr. David M c C a h a n exerted a strong influence on the study. T h e other members of the Insurance staff at the University of Pennsylvania offered many constructive suggestions, and Miss Mary Drever, administrative assistant to the Executive Director of the H u e b n e r F o u n d a t i o n , handled the details of publication in her usual capable m a n n e r . N o n e of those who read the manuscript, it hardly need be said, bears any responsibility for the deficiencies that may remain in the completed work. T h e a u t h o r also wishes to express his sincere appreciation to T h e S. S. H u e b n e r F o u n d a t i o n for Insurance E d u c a t i o n for the financial assistance granted to h i m during his period of study at the University of Pennsylvania, and for assuming p u b l i c a t i o n of this volume. Finally, in recognition of his inestimable c o n t r i b u t i o n to insurance literature and education, and his inspirational guidance of the Fellows and Scholars of T h e S. S. H u e b n e r F o u n d a t i o n for Insurance E d u c a t i o n , this volume is gratefully dedicated to the memory of Dr. David M c C a h a n . KENNETH

Atlanta January

1955

BLACK,

JR.

Contents CHAPTER FOREWORD

ix

PREFACE

xi

L I S T OF T A B L E S 1.

INTRODUCTION

Growth Scope Approach 2.

T H E D E V E L O P M E N T OF G R O U P ANNUITIES

First Contracts Basic Deferred G r o u p Annuity Pattern Growth of G r o u p Annuities Premium Income G r o u p Annuity Companies Forces Affecting Growth Economic Depression Social Security Legislation World W a r II Unions Variations in t h e Basic Deferred G r o u p Annuity Pattern Deposit Administration Immediate Participation Guarantee G r o u p Permanent 3.

PACE

L E G A L A S P E C T S OF G R O U P A N N U I T Y C O N T R A C T S

G r o u p Annuity Statutes Federal Income T a x Law Importance of Legally Qualifying a Plan Requirements of a Qualified Plan General Legal Considerations Social Security Act Corporation Law T r u s t Law Rule Against Perpetuities Power to T e r m i n a t e or Change Federal and State Securities Acts Rights of Creditors Obligation to Bargain on Retirement Plans Other Laws xiii

wii L

4 5 6 7

9 12 14 14 15 17 17 18 21 24 26 26 27 28 30

30 32 32 33 35 35 35 36 37 38 39 40 41 41

xiv

CONTENTS

CHAPTER

4.

l'Ar.F.

G E N E R A L PROVISIONS OF G R O U P A N N U I T Y C O N T R A C T S

Introductory Clauses Insuring Agreement Effective Date and Payment of Premiums General Provisions Certificate Beneficiary Assignment Information to be Furnished Evidence of Survival Contract Amendments Entire Contract Reserves and Distribution of Surplus Group Annuity Application 5.

T H E SPECIFIC PROVISIONS OF G R O U P A N N U I T Y C O N T R A C T S

Eligibility Provisions Requirements for Membership in Plan Requirements for Rcceipt of Retirement Annuity Retirement Benefit Provisions Benefit Formula Past Service Integration Requirements Annuity Forms 6.

T H E SPECIFIC PROVISIONS OF G R O U P A N N U I T Y C O N T R A C T S

43

43 44 45 46 46 47 48 49 49 50 50 50 51 53

53 53 58 65 65 69 71 72 76

(Continued) Supplemental Benefit Provisions Death Benefits Withdrawal Benefits Disability Retirement Premiums and Rates Premiums Rate Guarantees Other Provisions Amendment or Termination of a Group Annuity Plan Method of Payment of Retirement Annuities 7.

76 76 78 81 82 82 88 88 88 90

OTHER GROUP ANNUITY CONTRACTS

92

Deposit Administration Distinguishing Feature Deposit Fund Plan Characteristics Discontinuance Supplemental Deposit Administration Negotiated Plans Immediate Participation Guarantee Immediate Participation Procedure Flexibility Group Permanent

92 93 93 96 102 104 104 105 105 109 110

xv

C O N T E N T S CHAPTER

PACE

Retirement Income R e t i r e m e n t Age F o r m s of A n n u i t i e s D e a t h Benefits W i t h d r a w a l Benefits Discontinuance Special G r o u p A n n u i t y Plans Profit S h a r i n g Group Immediate Annuity Contract 8.

UNDERWRITING GROUP ANNUITY

110 112 113 114 11 fi 117 1IH 118 119

CONTRACTS

120

Deferred G r o u p Annuity Contracts Eligibility Benefits Premiums Miscellaneous Coinsurance Deposit A d m i n i s t r a t i o n C o n t r a c t s M i n i m u m Case R e q u i r e m e n t s O t h e r Contracts Immediate Participation Guarantee Group Permanent 9.

ADMINISTRATION OF G R O U P A N N U I T Y

122 122 127 131 134 135 136 137 138 139 139 RF.TIREMF.NT P L A N S

Insurer Administration Installation Servicing Employer Administration Installation Servicing 10.

141 141 143 146 146 147

ANALYSIS OF C O S T FACTORS

Mortality Mortality Improvement Current Mortality Tables C o m p a r i s o n of 1937 S t a n d a r d A n n u i t y T a b l e with A n n u i t y M o r t a l i t y T a b l e for 1951 w i t h P r o j e c t i o n Effect of M o r t a l i t y I m p r o v e m e n t o n Pension Costs Interest T h e Experience Rate Effect of Interest o n Pension Costs Effect of F e d e r a l I n c o m e T a x Expenses Acquisition Expense Administration Expense Taxes Expense Record O t h e r Factors Turnover Employee Contributions Contingencies

141

149

150 150 154 Group 158 162 163 164 166 167 167 168 170 171 171 174 174 175 176

xvi

C O N T E N T S

CHAPTER 11.

I PACE

P R E M I U M S , D I V I D E N D S , AND R E S E R V E S

Rate Bases Methods of Funding Unit Purchase Method Money Purchase Method Entry Age Normal Method Attained Age Method Aggregate Cost Method T h e Effect of Funding Methods on Premiums Other Methods Limitations on Funding Due to Tax Requirements Dividends Experience Accounts Analysis of Surplus Dividend Reserves Reserves Contract Reserves Contingency Reserves 12.

EVALUATION OF G R O U P ANNUITIES

Comparative Analysis of Group Annuity Contracts Employee Employer Insurance Company Important Trends Increase in Benefit Levels Growth of Deposit Administration Trend Toward "Annuity Companies" Other Issues

178

178 180 181 181 182 182 183 184 184 18.5 188 189 190 19") 198 198 199 201

201 201 202 207 211 211 213 21Γ) 217

APPENDIX A

Fifty-six U. S. Life Insurance Companies Having Group Annuity Contracts in Force December 31, 1953

221

APPENDIX Β

Schedule of First Group Annuity Contracts Written by the Seven Leading U. S. Companies

224

APPENDIX C

Group Annuity Financial Experience of Seven Leading Life Companies

225

APPENDIX D

Historical Schedule of Deferred Group Annuity Rates

236

APPENDIX Ε

Schedule of Current Group Annuity Rate Bases

237

APPENDIX F

T h e Definition and Standard Provision Sections of the New York Insurance Law

238

APPENDIX G

Sections 401 and 404, Internal Revenue Code of 1954 BIBI.IOT.RAPHY INDEX

211 249 257

LIST OF TABLES TABLE

PACE

1. G r o u p A n n u i t y P r e m i u m s Paid to U n i t e d States Life C o m p a n i e s for Period 1921-1953

Insurance 15

2. I l l u s t r a t i v e Scale for Staggered R e t i r e m e n t s 3. P r o p o r t i o n of R e t i r e m e n t I n c o m e Available at Early f o r Male a n d F e m a l e U n d e r Unit Benefit Plan

60 Retirement 62

4. Illustrative Unit Benefit I'lan Using Salary Classes

66

5. Percentage of M a l e Employee's N o r m a l R e t i r e m e n t I n c o m e Payable U n d e r J o i n t a n d Survivorship O p t i o n

74

6. C a l c u l a t i o n of E m p l o y e r Credit on T e r m i n a t i o n of Employee A f t e r T w o Years' Service

87

7. I l l u s t r a t i o n of Deposit F u n d with Applicable G u a r a n t e e s

96

8. Illustrative T e r m i n a t i o n Values U n d e r G r o u p P e r m a n e n t I n s u r a n c e of $1000 a n d I n c o m e of $10 Per M o n t h at Age 65

117

9. T y p i c a l Schedules of M a x i m u m Ratios of Employee C o n t r i b u t i o n s to Benefits C r e d i t e d for T h r e e N o r m a l R e t i r e m e n t Ages

132

10. L o n g - T e r m Decreases in U n i t e d States W h i t e P o p u l a t i o n Mortality Rates—Average R a t e of Decrease Per Year (Geometrical Basis)

152

11. R a t i o of Reserves o n 1937 S t a n d a r d A n n u i t y T a b l e a n d 2 | 4 % Interest to Reserves on GA-1951 T a b l e with Projection a n d 2>/2% Interest

160

12. R a t i o of Reserves o n 1937 S t a n d a r d A n n u i t y T a b l e a n d 2i/£% Interest to Reserves on GA-1951 T a b l e with Projection a n d 21/2% Interest

163

13. E a r n i n g s C r e d i t e d t o G r o u p A n n u i t y Business—Average for Seven L e a d i n g C o m p a n i e s for Period 1942-1953

165

14. A p p r o x i m a t e Effect of Variations in Interest Assumption on T o t a l Single P r e m i u m Costs

166

15. Illustration of t h e Effect of Federal Income T a x on Interest E a r n ings of O n e L a r g e C o m p a n y for Period 1942-1953

168

16. T y p i c a l Commission Scales for G r o u p A n n u i t y Contracts

169

17. State T a x e s C o m p a r e d with T o t a l G r o u p A n n u i t y E x p e n s e s Average for Seven L e a d i n g C o m p a n i e s for Period 1942-1953

171

18. G r o u p A n n u i t y Expenses as a Percentage of Net Premiums—Average for Seven L e a d i n g C o m p a n i e s for Period 1942-1953

172

19. G r o u p A n n u i t y Expenses for O n e C o m p a n y Expressed as a Percentage of A n n u a l P r e m i u m for O n e Year

173

20. G r o u p A n n u i t y R a t e Bases for Seven L e a d i n g C o m p a n i e s as of August 20, 1954

179

21. G r o u p A n n u i t y Reserves C o m p a r e d with T o t a l Reserves for Seven L e a d i n g C o m p a n i e s as of December 31, 1953

199

22. Comparison of A n n u i t y Reserves with T o t a l Reserves for Fifteen L e a d i n g G r o u p A n n u i t y C o m p a n i e s for Period 1940-1953

216

xvii

Chapter 1 Intro ductiün

It is p r o b a b l e that in every period of h u m a n history the economic status of the aged has been a problem. Certainly, d u r i n g the lifetime of this country, it has been a continuing one. T h e drive for security since the depression of the 1930's—due in part to the effects of the depression itself and in part to the increasing prop o r t i o n of o u r population coming into the higher age b r a c k e t s has led to greatly increased interest and activity in this whole area. T o d a y , the individual, private industry and government are all playing a vital role in seeking a solution to the problem presented by o u r older citizens. Each individual still has a primary responsibility for his own welfare. Personal thrift has played a n d always should play a m a j o r role in providing for the declining years of life. But in recent years, employees have received additional help from private industry and f r o m government. T h e efforts of the latter have been directed toward providing a basic m i n i m u m benefit through the various forms of Social Security legislation. W i t h assurance of a m i n i m u m benefit, the employee can then seek to increase his oldage income through his own individual efforts, supplemented by any benefits his employer may provide. T h e role of private industry in this area has been an i m p o r t a n t one. Its most significant contribution probably lies in the developm e n t of private pension plans. In the development and growth of these plans, employer objectives have not been uniform. Many of the early plans began either as a move to meet the needs of retiring employees or as a reward for long and f a i t h f u l service. B u t while these initial plans were motivated mainly by philanthropy, employers g r a n t i n g such benefits soon f o u n d that they were reaping favorable business results. Production was increased 1

2

Introduction

t h r o u g h better satisfied employees, lower turnover, a n d systematic retirement. G r a d u a l l y , increased production came to be an imp o r t a n t motive in f r a m i n g new plans. Today, except in those plans arising f r o m collective bargaining, the prime consideration of employers in installing a pension plan is doubtless to facilitate production. Every well-established firm is eventually faced with the problem of s u p e r a n n u a t e d workers and must choose between three alternative procedures: to discharge them; to leave them on the payroll; or to grant t h e m a retirement income. For business as well as h u m a n i t a r i a n reasons, the first choice is not practicable and the second p r o c e d u r e is expensive, with retirement costs hidden in the payroll. Experience has indicated that a well-planned retirem e n t p r o g r a m is the most efficient way to meet the problem. O n e of the most i m p o r t a n t advantages adduced for a planned retirement p r o g r a m is that it keeps the organization young and able to meet active competition. T h e retirement of top managem e n t at a fixed retirement age is generally accepted as an important factor in the continued successful operation of a business. T h e knowledge that top m a n a g e m e n t will be so retired and promotional lanes kept open will prevent talented a n d ambitious employees f r o m seeking opportunities elsewhere. T h u s , older workers, particularly in supervisory capacities, w h o m i g h t retard the work of others, are systematically replaced by m o r e vigorous, more efficient workers. A n o t h e r advantage argued for a well-planned r e t i r e m e n t prog r a m is that it reduces turnover, particularly at the m a n a g e m e n t a n d higher-pay levels. T h i s function of a pension plan has led to emphasis of the p o i n t of view that a pension plan is justified not only as a means of meeting the s u p e r a n n u a t i o n p r o b l e m , but as a differential wage paid to encourage long and f a i t h f u l service. Regardless of the validity of this position, a well-planned retirem e n t p r o g r a m does t e n d to reduce turnover a n d such reduction may be i m p o r t a n t d u r i n g periods of high employment. Practically all other advantages claimed for pension plans are based on the premise that the plan will improve the operation of a business. Naturally, in m a k i n g a decision for or against a pension plan, an employer m u s t measure the value of the increased efficiency and

Introduction

3

production arising from its installation against the cost of such a program. In recent years, because of a favorable tax situation, the cost of a pension program to an employer has been relatively lower and to this extent the tax savings feature has been an important factor in the rapid development of private retirement plans. In many cases, employers who might otherwise have hesitated have installed plans because a large part of their contributions were in reality paid out of taxes. Although the basic reason for the installation of a pension plan by an employer is that it will meet the problem of the superannuated worker, reduce turnover, and generally improve the operation of his business, social philosophy and, more recently, union pressure have been appreciable forces in the development and growth of private pension plans. An employer installing a plan expects to improve the operation of his business; but he may also be fulfilling a genuine desire to improve the security and welfare of his employees. Similarly, the presence of a union does not necessarily mean that the employer would not have established the plan without union pressure. Since the Inland Steel decision by the Supreme Court of the United States, however, it has been necessary to distinguish between those plans arising out of collective bargaining and those where a union is not involved. T h i s decision, rendered in 1949, provided not only that pensions were a proper subject for collective bargaining, but that an employer could not install a pension plan unilaterally, without the union's approval. T h i s would appear to apply even where the plan is noncontributory. As a result of this decision, pension plans installed in unionized industries have become more and more a product of union pressure and philosophy. T h e basic motivation, objectives, and design of such plans are very different from those installed unilaterally by employers. Evidence of the importance of this distinction may be found in the fact that, for the most part, unions have preferred noninsured plans, where they normally can have a greater hand in the administration and control of the plan. It should be noted, however, that in many cases the installation of a plan for workers paid on an hourly basis leads directly to the establishment of one for salaried nonunion employees.

Introduction

4 GROWTH

T h e rapid growth of private retirement plans, then, serves as evidence not only of the employee's interest in but also of industry's acceptance of the desirability of a planned retirement program. As the number of private retirement plans has increased, two broad categories have developed: insured and noninsured. T h e noninsured plan is in reality self-administered, usually employing a bank or trust company to handle the investment of the pension fund. T h o u g h the employer assumes all of the risks under such a plan, it has become very popular in recent years, particularly among large employers. T h e other category, the insured pension plan, includes those plans underwritten by life insurance companies. In this latter area, most of the administration of the plan is turned over to the insurance company, and advantage is taken of the insurance company's ability to guarantee promised benefits. It is with the development and current status of this type of plan that this study is concerned. Although begun more than thirty years ago, the insured type of pension plan has developed at an accelerated rate only in the past ten years. In 1931, the group annuity premiums deposited with United States life insurance companies amounted to only $32,196,000; by 1941, premium income had risen to $197,035,000; and by 1953, group annuity premium income had risen to a total of $935,322,000. T h e basic insured plan—the deferred group annuity—was developed in the 1920's and still remains the predominant form, whether measured by number of persons covered or by volume of reserves. Over the years, certain variations of this basic pattern have been developed to meet the changing needs of the employer and the exigencies of competition. In addition to examining the development and current status of the insured pension plan, it is the purpose of this study to analyze and to evaluate significant trends. In order to appraise such trends, it will be necessary to review the principles and practices of the various companies underwriting group annuity plans and to determine the reasons behind the various d e v e l o p ments that have taken place.

Introduction

5 SCOPE

Pension plans underwritten by life insurance companies and involving groups of insured persons may be divided into two classes: those employing individual policies and those using a g r o u p contract. Both of these plans are written through an employer. Under the former, each individual employee has a separate policy and, except for the method of collecting premiums, the setup is not essentially different from the sale of an individual annuity policy to each employee. In the g r o u p contract plan, however, one master contract is issued to the employer and only certificates of participation are issued to individual employees. It is this latter method of underwriting a retirement program, the group basis, that is considered in this study of insured plans. T h e group basis includes group permanent retirement plans which provide substantial insurance benefits, as well as plans normally classified as group annuities. It excludes individual policy pension trusts, although much of the material regarding taxes, mortality, and other selected features of a group plan would be applicable to this type of plan also. T h i s study is directed in the main toward unilateral g r o u p plans, i.e., those set up by employers and not requiring approval by the union. T h e impact and implications of collective bargaining are considered, therefore, only as a collateral aspect. T h i s does not imply that collectively bargained plans are not important, but rather recognizes the complexity of integrating a detailed discussion of such plans in this study. As of December 31, 1953, there were forty United States life insurance companies actively writing group annuities. Seven of the companies, however, accounted for 95 per cent of the premium income. T h e survey of current practices is based upon the operations of these seven leading companies. In addition, the practices of a number of smaller companies were reviewed to ascertain important differences in operation. T h e time period covered in this study is from 1921, when the first group annuity contract was issued by a life insurance company, through 1953.

6

Introduction APPROACH

A word should be said regarding the m a n n e r in which this study is to be presented. C h a p t e r 2 deals with the development of the g r o u p a n n u i t y business. T h e early development of the basic deferred g r o u p a n n u i t y p a t t e r n by the U n i t e d States life insurance companies is presented a n d the growth which the business has experienced since its inception is summarized. T h e i m p o r t a n t forces affecting this growth are discussed briefly and the several variations of the basic g r o u p a n n u i t y pattern are indicated. T h i s background presentation and C h a p t e r 3, which reviews the broad legal considerations that govern the designing of a g r o u p a n n u i t y contract, serve as a f o u n d a t i o n for a fairly detailed study of the g r o u p a n n u i t y contract. T h e "general provisions," the substance of which appears in similar form in all g r o u p a n n u i t y contracts, are examined in C h a p t e r 4. Chapters 5 a n d 6 review the "specific provisions" of the g r o u p a n n u i t y contract, those designed to meet the p a r t i c u l a r needs of the individual employer. Chapters 5 a n d 6 also present a detailed analysis of the basic deferred g r o u p a n n u i t y plan. C h a p t e r 7 indicates i m p o r t a n t characteristics of other g r o u p annuity plans which differ f r o m the basic one. T h e principal u n d e r w r i t i n g rules employed by life insurance companies are reviewed in C h a p t e r 8. C h a p t e r 9 distinguishes the administrative functions of the insurance company a n d those of the employer in the o p e r a t i o n of a g r o u p annuity r e t i r e m e n t program. C h a p t e r 10 is an analysis of the factors underlying the cost of an insured retirement program, with p a r t i c u l a r reference to the i m p r o v e m e n t in mortality a n d its effect on pension costs. C h a p t e r 11 reviews the basic f u n d i n g methods employed in m e e t i n g pension costs, a n d also examines the dividend a n d reserve policies of the life insurance companies with regard to the g r o u p a n n u i t y business. In C h a p t e r 12 a comparative analysis of the four basic g r o u p a n n u i t y contracts is m a d e f r o m three viewpoints: that of the employee, that of the employer, a n d that of the life i n s u r a n c e company. Finally, the trends which a p p e a r significant to the writer as a result of this study are indicated.

Chapter 2

The Development of Group Annuities In most of the early pension plans, retirement benefits were paid as a "supplementary payroll." Payments were taken out of current operating revenue a n d were charged to o p e r a t i n g cost. T h e a m o u n t s involved, when c o m p a r e d with the total o p e r a t i n g expenditures, were small a n d a p p e a r to have received very little attention from m a j o r executives. By 1915, pension payments had, in many cases, reached sizable proportions; industrial activity a n d payrolls were also increasing rapidly, however, so that the pension roll was still too small in relation to other expense items to give serious concern. In some cases, indeed, because of the disproportionate increase in the payrolls, 1 pensions became a decreasing percentage of total expenditures. W i t h the beginning of the recession in late 1920, however, many industries cut their payrolls drastically. T h i s reduction, combined with the fact that pension payments were still increasing, b r o u g h t into clear view the rapidly rising importance of the " s u p p l e m e n t a r y payroll." Many company executives became concerned, especially in view of low profits and the necessity of cutting expenses wherever possible. 2 A b o u t this time an event occurred that dramatized in a vivid m a n n e r the need for careful consideration of b o t h pensions a n d the methods of providing for them. In 1909 a well-known packing firm, Morris and Company, had established a pension f u n d on a contributory basis. Employees c o n t r i b u t e d 3 per cent of salary or wages; the employer c o n t r i b u t e d $25,000 a year, setting its liability at a m a x i m u m of $500,000. In 1923, when Morris a n d Company merged with A r m o u r a n d Company, actuaries esti1 Ingalls K i m b a l l , " I n d u s t r i a l P e n s i o n s . " The Annals of The Academy of Political and Social Science, C L X I (May, 1932), p . 34. 2 Ibid., p. 34.

7

American

8

Development of Group Annuities

mated that an aggregate of over $7,000,000 would be necessary to pay the promised annuities to 600 employees who had already retired. Not only was the maximum commitment of $500,000 completely inadequate to meet the firm's obligations to its pensioners but provided nothing for the active employees who would retire later. Armour and Company refused to assume the pension obligations of Morris and Company, and the employees of the latter company were left "high and dry." A voluntary contribution of half a million dollars by a member of the Morris family only postponed, by fourteen months, the day when all retirement payments ceased; and the status of the old workers, many of whom were wholly dependent upon the pension, remained just as hopeless despite this generous gesture. 3 Some of the retired workers took the case to court and demanded that a sufficient trust fund to meet their needs be set aside from the assets of Morris and Company. But the pension rules of Morris and Company provided that "no pensioners . . . shall be entitled to have any part of the capital or income of the company set aside to provide for same. All moneys shall be paid out of the Pension Fund." In deciding against the claims of the retired employees, the court in effect ruled that in view of the expressed provisions of the pension fund, the plan created no contractual liability on the part of Morris and Company. 4 T h e Morris case was reported in newspapers throughout the country and a great deal of interest was aroused among workers, executives, and the public. T h e fact that the disaster had developed in spite of the generous attempts—even beyond the extent of any legal responsibility—of the Morris family to meet the problem caused many employers to wonder if a similar development could not take place with regard to their own pension programs. There was a tremendously increased interest in pensions after this case, and many employers began questioning the soundness of their own pension procedures. Certainly, if the increased interest in pensions in the 1920's was the door of entrance for the insurance company, the Morris case was its handle. During the decade from 1910 to 1920, the growth of g r o u p life 3 A b r a h a m Epstein, The Problem of Old Age Pensions in p p . 43-44. Cowles v. Morris and Company, Circuit Court, Cook C o u n t y , M a r c h 21, 1925; Epstein, op. cit., p . 44.

Industry, Illinois,

9

First Contracts 5

insurance brought about an increasingly intimate contact between business men and officers of life insurance companies. Competition among insurers in this area was keen, and individual companies began offering a variety of additional services to group life policyholders in order to hold their clients. It was natural, therefore, that some group life policyholders should turn to the insurance companies for help in handling their pension problems.® T h e private pension consultant also played a part in drawing the life insurance companies into the pension field. Many of the plans put into operation prior to 1921 were established and serviced by independent pension consulting firms. Some of these consultants were in touch with insurance companies in handling other insurance coverages and urged the companies to use their capacity to provide guarantees based on given mortality and interest assumptions to this field. Many of these pension consultants became experts in the practical problems associated with pension planning and contributed greatly to the ultimate development of present-day group annuity plans. FIRST CONTRACTS

T h e first group annuity contract in this country was issued by the Metropolitan Life Insurance Company on December 25, 1921, to William E. Rudge, Inc. Prior to this date, companies had been asked to prepare proposals, but nothing definite had developed from the negotiations. 7 Under this group pension contract, as it was called, a pension bond was purchased each year by the employer for each eligible employee, the bond being a single pre5 Davis W . G r e g g , An Analysis of Group Life Insurance, p . 21. β F o r e x a m p l e , t h e E q u i t a b l e L i f e A s s u r a n c e Society of t h e U. S. c o n d u c t e d a n i n v e s t i g a t i o n c o s t i n g o v e r $40,000 f o r o n e of its g r o u p life clients, t h e S t a n d a r d O i l C o m p a n y of N e w J e r s e y . A l t h o u g h s o m e of t h e i n f o r m a t i o n d e v e l o p e d in t h e i n v e s t i g a t i o n is still b e i n g u s e d by t h e E q u i t a b l e , t h e c o m p a n y h a d n o idea of e n t e r i n g t h e p e n s i o n field at t h a t t i m e . 7 R . A. H o h a u s , " G r o u p A n n u i t i e s , " Record of the American Institute of Actuaries, X V I I I (1929), p . 53. A l t h o u g h t h e policy w r i t t e n i n 1921 is c o n s i d e r e d t o b e t h e first g r o u p a n n u i t y c o n t r a c t , a n d was t h e first c o n t r a c t w h i c h r e s e m b l e d t h e g r o u p a n n u i t y as it is k n o w n t o d a y , t w o o t h e r p l a n s h a d b e e n u n d e r w r i t t e n p r i o r t o this d a t e . In 1909, a life i n s u r a n c e c o m p a n y p l a c e d its o w n p e n s i o n p l a n o n w h a t was called a n i n s u r a n c e basis, a n d d u r i n g t h e p e r i o d 1916-1920 a n i n d u s t r i a l c o n c e r n ' s r e t i r e m e n t p r o g r a m was u n d e r w r i t t e n by a n i n s u r a n c e c o m p a n y . See M u r r a y W . L a t i m e r , Industrial Pension Systems in the United States a n d Canada, Vol. I., p . 5 1 .

10

Development of Group Annuities

mium deferred annuity of $10 a year payable at age 65. T h i s bond became the absolute property of the employee. T h e plan provided for the purchase of a bond each year, so that an employee with forty years of service would have forty bonds purchased for him and could expect to receive an annuity of $400 a year. 8 In one respect this contract was far ahead of its time since it provided for full vesting. 9 T h e annuities purchased each year became the absolute property of the employee and were not contingent on the individual's remaining in the service of the employer. However, this vesting provision which provided for no refund to the employer in the event an employee terminated employment proved to be one of the objections which caused this particular type of contract to have a limited acceptance. Many employers were not willing to contribute funds for employees who did not remain in their service. At this point of development, pensions had not become accepted as good business, but rather were considered a philanthropic gesture by the employer. A more important reason for this limited acceptance was the fact that the method of providing benefits was completely different from the most generally accepted type of benefit formula used under self-administered plans. Most of these early plans based the benefit on the number of years of service and the salary during the last year of service or some modification, such as, the average salary for the last five or ten years. It took some time to interest employers in a formula based on average pay with full advance funding. 1 0 During 1922, the group and actuarial divisions of the Metropolitan Life continued their experimentation, study, and consultations, even though no new contracts were issued. 11 In May, 1923, they announced publicly that " t h e company in cooperation with several of the large industries in this country, is beginning to write pension certificates." 1 - In J u n e of that same year a 8 Hohaus, op. cit., p. ">3. It is perhaps of some historical interest to note that the contract became paid-up on December 25, 1924, because the employer discontinued contributions. 9 See p. 79. 10 Henry E. Blagden, " G r o u p Annuities," Best's Insurance Xeii's, Life F.d.. November 1942, p. 13. 11 L. I. Dublin, Λ Family of Thirty Million, p. 184. 12 "Metropolitan Life Pension l'lan," Weekly Underwriter, May 26, 1923, p. 949.

First Contracts

11

twelve-page pamphlet was issued by the company's group department describing in some detail the plan offered. T h e announcement and pamphlet were well received. Commenting on the announcement, the editor of the Weekly Underwriter stated: 13 I h e . . . pamphlet . . . should be in the hands of every insurance salesman in the United States, as it represents a factor of insurance long sought and generally desired. . . . It is an " O l d Age G r o u p Ins u r a n c e " plan that the employee doesn't have to "die to w i n " and will prove very popular with employers and employees as well.

Following this announcement, the next contract was issued by the Metropolitan in 1924 to an employer who already had a "retirement plan" on a pay-as-you-go basis. T h i s employer desired to guarantee a certain portion of the retirement income of his older employees. Although such a plan was not suitable for general use, it was very satisfactory for this employer. Historically, it is of interest because of the inclusion of a provision for a credit to the employer if the employee left the service before retirement age while in good health, and an option to allow the annuity payments to commence at ages other than that originally designated as the retirement age. 14 Early in 1924, the Equitable Life Assurance Society, a pioneer in the development of group life insurance, announced its intention of offering a group pension service, thus becoming the second company to enter the field.15 However, the Equitable did not write its first contract until July 4, 1927. Later in 1924, the Metropolitan Life issued its third contract. It was the first one written on a contributory basis, and while it differed in many details from the contracts issued later, it became the basis for most of the contributory plans written up to 1930. Besides the contributory feature, it is of interest because it provided for cash-surrender values to both employee and employer, optional retirement dates, and options to the employee to elect a paid-up annuity instead of the surrender values on termination of employment. 18 13 "Old Age Pensions for Employees," Weekly Underwriter, J u n e 2, 1923, p. 992. n Hohaus, op. cit., pp. 53-54. 1 5 "Group Pension Plan of Equitable Society," Weekly Underwriter, March 8. 1924, p. 595. ie Hohaus, op. cit., p. 54. It may be noted that although this contract was the third to be completed, technically its effective date preceded that of the

12

Development of Group Annuities BASIC D E F E R R E D G R O U P ANNUITY

PATTERN

W h i l e the Metropolitan's first three contracts by no means constituted a satisfactory showing in view of the effort that was made in this direction, their operation showed that they contained the essentials of a workable plan. T h e next step was to find a plan which would incorporate these essentials and be salable generally. Considerable time and study were devoted to the search for such a plan and in 1927 one was finally developed. 1 7 Certain of the essential refinements in the plan were due to a railroad operating official who was searching for the solution to an entirely different problem. 1 8 Indeed, many of the developments in the field of group annuities were suggested by men not in the insurance business. 19 T h e fundamental principle behind the plan developed in 1927 was the purchase of a unit of deferred annuity each time a premium or consideration was received. T h e amount of this deferred annuity was related to the salary received by the employee after the last purchase had been made. T h e premium for such annuity was paid either entirely by the employer or in part by the employer and in part by the employee. In either event, mortality both before and after retirement was taken into consideration and usually no provision was made for any return, on death, of that portion of purchase money contributed by the employer. In other words, employer premiums were discounted for mortality. It can be seen that this procedure was not markedly different from the pension bond approach originally used by the Metropolitan. 2 0 However, some significant changes had been made. In the first place, the amount of annuity purchased each year was usually related to salary. Secondly, the annuity was not irrevocably vested in the employee but was subject to cancellation upon termination of employment prior to retirement. If the annuity "second" contract. T h e effective date of this contributory plan was January 1, 1924, but work on it was not completed until December, 1924. 17 Dublin, op. cit., p. 185. 18 Hohaus, op. cit., p. 56. 19 J . E. Kavanaugh, "Group Cover Great Boon to Employer," Weekly Underwriter, December 15. 1928, p. 1291. 20 Blagden, op. cit., p. 16.

Basic Deferred Group Annuity Pattern

13

was cancelled, a return was made to the employee of his contribution with interest and the employer was granted a credit for the balance. T h i s provision was added to meet the objection of the employer to the earlier form, namely, that he was putting up money for employees who left his service. Basically, the deferred group annuity plan has not changed since this beginning. 2 1 Certain options have been added from time to time which have made the program more flexible. From the over-all viewpoint this type of plan permitted the employer to transfer most of the administration of his pension plan to the insurance company and provided the employee with a guarantee that those benefits which accrued to him during his working years would be paid at retirement. T w o other points in this early period of development are of historical interest. In 1925, the term group annuities was substituted for group pensions "primarily to lend to insured retirement plans the atmosphere of financial soundness with which annuities are surrounded." 2 2 Many pension plans had had unfortunate results, and it was felt that the unfavorable connotations associated with the word "pensions" might be obviated somewhat by this change. In addition, it was hoped that the change would avoid the idea of charity which was frequently associated with the word "pensions." T h e r e is no way of knowing to what extent sales were stimulated, but this change in designation was soon followed by greatly increased activity in the field.23 T h e second point relates to the development of the use of employee contributions in financing retirement plans. Prior to the entrance of the insurance companies into the field, many employers had hesitated to permit contributions by employees because of the fear of an implied contract and a disinclination to handle employees' money. 2 4 W i t h the insurance companies administering the retirement plans, however, many employers changed their attitude in this regard. In addition, the successful use of employee contributions in group life insurance plans un2 1 D. C. Bronson, "Pensions—1949," Transactions I (1949), p. 224. 22 Hohaus, op. cit., p. 55. 23 Ibid., p. 55. Kimball, op. cit., p. 38.

of the Society

of

Actuaries,

14

Development of Group Annuities

doubtedly paved the way for this development. 25 In any event, since that time, a large percentage of insured pension plans have incorporated the contributory principle. GROWTH

OF

GROUP

ANNUITIES

Since their introduction in 1921, group annuities have experienced a tremendous growth, whether measured by premium income, reserves, or otherwise. T h e growth of group annuities for the period 1921 to 1953 will be presented here by reviewing the premium income of the United States life insurance companies currently active in the group annuity field. Also, the probable reasons for the relative sparsity of companies actively writing group annuities will be examined briefly. Following this, the most important forces which have influenced this growth will be reviewed. Premium

Income

T h e growth pattern of group annuities is indicated by T a b l e 1. T h e amount of premiums deposited has increased every year since 1930, except 1933, 1939, 1942 and 1949. Prior to 1930, so few plans were in force that any exceptional payment for past service could easily distort the premium income picture for that year. T h e depression of the early 1930's and the recession of 1937 may have produced reductions in premium volume. Adjustments in past service premiums probably account for much of the fluctuation, since the insurance companies permit much flexibility in this regard. 28 T h e apparent reduction in premiums in 1942 is misleading. Actually, the year 1942 was a normal period of growth, and the decrease is due to the inordinate increase in premium income in the preceding year. T h e unusual increase in 1941 resulted from employers who anticipated the passage of the Revenue Act of 1942 by making substantial past service payments under their plans. Regardless of the reason, it was only a temporary setback and premium income increased rapidly throughout the remainder of the war period. T h e decrease in premiums in 1949 was due 25 J. E. Kavanaugh, "Advancing Social Welfare T h r o u g h G r o u p Insurance," Proceedings of the Association of Life Insurance Presidents, December 12, 1928, p. 132. 2β See p. 84.

Growth of Group Annuities

15 27

mainly to the transfer of the advance funds of a very large plan to an uninsured basis. It should be noted that the growth has been greatest in the last thirteen years. In 1941, premium income had grown to $197,TABLE 1 GROUP

ANNUITY

PREMIUMS

PAID TO U N I T E D STATES L I F E FOR

Premium Income

Year 1921 1922 1923 1924 1925 1926 1927 1928 1929 1930 1931 1932 1933 1934 1935

• Less than Source: (a) surveyed; (b) supplemented

PERIOD

INSURANCE

COMPANIES

1921-1953

Year

Premium Income

• • •

1936 $ 80,347,000 81,227,000 1937 1938 100,555,000 97,829,000 $ 241,000 1939 127,491,000 1940 11,427,000 1941 197,035,000 8,914,000 175,266,000 3,423,000 1942 201,070,000 16,902,000 1943 277,682,000 25351,000 1944 24,995,000 1945 291.370,000 1946 352,619,000 32,196,000 48,863,000 1947 442.746,000 1948 535,405,000 35,089,000 1949 526,143,000 42,210,000 1950 62,652,000 696,096,000 754,085,000 1951 851,814,000 1952 935,322,000 1953 $1,000; 1921-S396, 1922-$368, 192S-$342. Figures for 1921-35 obtained directly from seven companies figures for 1934-53 obtained from the Compend, Flitcraft, Inc., by i n f o r m a t i o n from other sources.

035,000 and by 1953, to $935,322,000. T h e increase, $738,287,000, in this thirteen-year period is over three and one-half times the total amount deposited in 1941. Thus, the growth figures shown here indicate that the real growth period for group annuities dates from the beginning of World War II. 28 Group Annuity

Companies

From 1940 to 1953, the number of companies offering group annuity coverage in the United States increased from twelve to 27 Advance f u n d s represent estimated p r e m i u m s paid to the insurance company but not applied to purchase an a n n u i t y . See p. 101. 28 T h e r e are no accurate figures regarding t h e present coverage of private pension plans. The Federal Reserve Bank of New York estimates, however, that there were approximately 10 to II million employees covered under 15,500 plans as of December 1953. See "Private Pension Plans," Monthly Review, Federal Reserve Bank of New York, 1953.

16

Development of Group Annuities

forty. T h e accelerated growth of the business in recent years is illustrated by the fact that of the forty companies writing group annuities in 1953, twenty-six have entered the field since 1944. 3 0 Despite this increase, the number of companies writing group annuities is still low compared with the number writing other forms of group business. Probably one of the most important reasons for this is the fact that a large volume of business is required to support group annuity operations. Although the necessary staff is not large in relation to the premium volume, obtaining and training competent men to handle this business has been and still is a point of concern for most companies. T h i s problem is aggravated by the fact that there has been a tendency for the better men, once they are trained, to enter the pension consultant field. 29

T h e need for a large amount of business leads to another and perhaps more serious problem. T h e reserves on group annuity business build up rapidly and a company actively writing group annuities may find that a large proportion of its assets pertains thereto. T h e s e reserves must be held for extended periods of time which produces a serious investment problem in finding investment outlets. In view further of the secular trend of mortality improvement, the consequent gradual reduction in any margins provided for group annuities, and the extremely competitive situation which exists today, many companies have been hesitant to develop this type of business. It may be noted also that many of the companies have been able to offer a pension service through the medium of the individual policy pension trust. 3 1 T h e market potential here is considerably greater than that for group annuities, 3 2 since, although 29 T h e Compend, Flitcraft, Inc., New York. A survey of United States life insurance companies by the Institute of Life Insurance indicated that as of December 31, 1953, there were fifty-nine companies with one or more gproup annuity contracts in force. Although the Flitcraft figures include only forty companies, the premium income of these forty companies represents more than 99 per cent of the total premium income of all fifty-nine companies. T h e companies included in the Flitcraft data, therefore, represent the "going concern" group annuity companies. 30 Ibid. 31 For a good discussion of the basic principles of this approach see John B. St. John, "Financing a Pension Plan," Pensions and Profit Sharing, pp. 105113. 32 This, of course, is true only in terms of number of plans. One group annuity plan may cover more employees than a great number of individual policy pension trusts.

Forces Affecting Growth

17

plans have been written where thousands of employees were involved, this approach is particularly adapted to the very small employer. T h e individual policy pension trust has also been more popular with agents as a higher rate of commission is paid for such business than for g r o u p annuity business. For these and probably other reasons, most companies have chosen to remain out of the group annuity field, although a number of additional companies announced their entrance into the field d u r i n g 1953. FORCES A F F E C T I N G

GROWTH

Many diverse forces have affected the growth of g r o u p annuities. Probably the most i m p o r t a n t include: (1) the depression of the 1930's, (2) Social Security legislation, (3) W o r l d W a r II, and (4) unions. T h e following discussion makes no attempt to determine the exact effect of these individual forces. R a t h e r it indicates the direction of influence and the probability of their continued importance in the f u t u r e development of the g r o u p annuity business. Economic

Depression

W i t h the onset of the economic depression in the early 1930's, it might have been expected that sales in the g r o u p a n n u i t y field would drop. Instead, sales continued to grow, and interest in retirement plans reached an unprecedented level. 33 T h e reasons for the growth are uncertain, but a n u m b e r of suggestions have been made. In the face of lower consumer demand, most employers were forced to reduce payrolls and cut expenses wherever possible. Such employers had to choose between dismissing men who had given many years of f a i t h f u l service b u t had outlived their period of efficiency, a n d releasing younger, more efficient employees. Few other jobs were available to the older workers and very few had saved anything like enough to support themselves for the remainder of their lives. Employers facing this problem soon realized that a properly planned retirement program would automatically have taken care of the situation. Some employers, whose older employees had provided for their old age 33 " G r o u p Pension Is Enjoying a Boom," National July 8, 1932. p. 3.

Underwriter,

Life Ed.,

18

Development οί Group Annuities

through systematic saving and now f o u n d their savings wiped out, developed a new concept of social responsibility; others regarded g r o u p annuities merely as a good means of forestalling what they considered to be socialistic old age pension legislation. 34 Another factor which influenced employers was the growing burden of accrued liability if the installation of a plan was post poned. Where benefits are based on service and salary, the longer a firm waits to install a pension plan, the greater becomes the backlog of past service credits earned by employees. W h e n this situation was explained to them, many employers, cognizant now of the need for a plan, perceived the wisdom of starting the plan at once in order to take advantage of employee contributions. 35 T h e net result was a considerably reduced sales resistance and a great deal of activity in the field. 36 T h e probable effect of f u t u r e depressions cannot be stated with any certainty. T h e depression of the 1930's does not serve as a guide, since the business was in its formative years then, whereas now it is a thriving branch of the insurance industry whose product is both well known and widely employed. In addition, the later variations of the basic deferred g r o u p annuity pattern, such as deposit administration and immediate participation guarantee, have not been tested to any extent u n d e r conditions of economic stress. Certainly, the problem of reducing payrolls and expenses will re-emphasize the need for a p l a n n e d retirement program. Also, bankruptcies and mergers will undoubtedly cause the termination of some plans. But any attempt to estimate the ultimate results of f u t u r e depressions would be sheer speculation. Social Security

Legislation

An event of some importance in the development of group annuities was the passage of the Social Security Act in 1935,37 by which a Federal system of retirement annuities was established for 34 ibid., p. 3. 35 Since past service costs are normally paid for by the employer, it was to his advantage to install a plan a n d stop t h e accrual of past service credits See p. 69. 38 " G r o u p Pension Is Going Ahead Fast," National Underwriter, Life Ed., December 23, 1932, p. 3; "Employers T a k i n g Many G r o u p Plans," National Underwriter, Life Ed., May 11, 1934, p. 1. 37 Public Law 271, 74th Congress, Second Session, 1935.

Forces Affecting Growth

19

all employees covered by the A c t . T h e p r o g r a m was to be financed by payroll taxes which were to be shared e q u a l l y by the e m p l o y e r a n d the e m p l o y e e . 3 8 For those e m p l o y m e n t s n o t ex38

cluded by the Act, coverage was compulsory, regardless of the presence o r absence of a private pension p l a n . 4 0 As a result of the passage of this Act, a t r e m e n d o u s a m o u n t of publicity was given the p r o b l e m of p r o v i d i n g for old age. U n doubtedly, this stimulated interest in private r e t i r e m e n t plans as well as in personal savings programs. P e r h a p s the most significant effect of the legislation was that it e n c o u r a g e d provision for the vesting of benefits purchased by e m p l o y e e c o n t r i b u t i o n s in case of withdrawal from service, instead of the l i q u i d a t i o n a n d probable dissipation for other purposes of whatever credit may have been accrued toward the provision for r e t i r e m e n t i n c o m e . 4 1 T h e Federal program e n a b l e d employees to take pension e q u i t i e s with them when they moved f r o m one j o b to a n o t h e r . W i t h the Social Security benefit as a base, it became m o r e r e a s o n a b l e to provide for vesting even when the a m o u n t s involved were relatively small. Also, the Act a c c e n t u a t e d the shift from self-administered plans to those underwritten by insurance c o m p a n i e s . New plans a d o p t e d in the four-year period following the passage of the Act were almost all underwritten by insurance c o m p a n i e s ; d u r i n g the same period the rate of d i s c o n t i n u a n c e for self-administered plans was more than seven times as great as for g r o u p a n n u i t y plans. 4 A n o t h e r result o f the Social Security Act was the revision of many private plans to take a c c o u n t of the Federal p r o g r a m . 4 3 Μ Ibid., T i t l e II, Set. 201-10. ••i" Ibid., T i t l e VIII, Sec. 801-7. 4° An amendment was introduced by Senator Bennett Clark under which private plans would have been exempted from the operation of the Federal Plan subject to certain regulations. After considerable discussion, the amendment was rejected, and in the final act no consideration was given private plans. See Μ. B. Folsom, "Company Annuity Plans and the Federal Old Age Benefit Plan,'· Harvard Business Review, XIV (Julv 1936), pp. 421-22. 41 Rainard B. Robbins, " T h e Effect of Social Security Legislation on Private Pension Plans," Journal of the American Association of University Teachers of Insurance, V (March, 1938), p. 55. 42 National Industrial Conference Board, Inc., Company Pension Plans and the Social Security Act, p. 24. 43 Ibid., p. 24; Murray W. Latimer and Karl T u f e l , Trends in Industrial Pensions, pp. 10-14. T h e operation of a company pension plan as a supplement to a governmental program was not entirely new. A number of industrial companies had had experience in foreign countries. For example,

20

Development of Group Annuities

At first, it was believed that the old age benefits provided under the Act would relieve the employer of the necessity of granting additional benefits under a private plan, but it was soon realized that the Federal plan would provide an insufficient level of benefits in all but a limited number of cases.44 T h e Social Security Act did, however, furnish a base on which a company plan could be superimposed, so that the retirement income from both sources could be brought to a far more satisfactory level. Also, with the Government pension as a base, the cost of providing the necessary additional benefits was much less than if the employer bore the entire expense of an adequate pension plan. 45 T h o u g h many plans were revised, for these and other reasons, a study by the National Industrial Conference Board of 220 active pension plans showed that by 1939, 35 per cent of the plans had not been revised.4® This delay in making adjustment may be explained by the constant agitation for certain fundamental changes in the Act which began almost as soon as it became effective. Inasmuch as Government pension payments were not scheduled to begin until 1942,47 companies could afford to wait for further Congressional action rather than revise their plans and then have to do it again at a later date. In 1939, the Social Security Act was amended 4 8 to provide for the immediate payment of benefits, and by the beginning of the United States' participation in World War II, in late 1941, practically all plans had been revised to take account of the benefits provided under the Act. 49 In 1950, the Social Security Act was amended to extend coverage to new groups and to raise substantially the level of benefits to all groups. 50 However, relatively few private plans were revised the Eastman Kodak Company had plans in England, Brazil, Uruguay and France where a governmental program existed. See Folsom, op. cit., pp. 418-19. 44 F. Beatrice Brower, Trends in Company Pension Plans, p. 5. / 4 214 21/4 2 2 2

Rate Schedule Applicable A A A A A A Β C C

schedule in effect at the time they were paid in will apply regardless of when the application is made. Thus, the first funds used will be those paid on 1-1-45 and rate schedule A will apply. When the first $10,000 together with its interest earnings has been used up, those payments made on 1-1-46 will be used, and so on ad infinitum. Plan

Characteristics

T h e deposit administration plan permits a greater degree of flexibility in plan provisions than is normally available with a deferred group annuity contract. Eligibility. Because no funds are allocated to individual employees prior to retirement or vesting, the problem of eliminating employee turnover through an eligibility period is not the same as that encountered under a deferred group annuity contract. T h e records established for a deposit administration plan are much simpler, so that under a noncontributory plan it is possible to

Deposit Administration

97

i n c l u d e all employees u n d e r the plan, even though it is known t h a t a n u m b e r of them will not remain with the employer until r e t i r e m e n t . C o n t r i b u t i o n s u n d e r the deposit administration contract can be discounted for expected turnover either through a t u r n o v e r table® or by applying a waiting period to determine t h e n u m b e r of employees to be included for f u n d i n g purposes. I n the latter case, contributions are not made for employees until they have been with the employer longer than a specified period, generally one year. T h u s , the employer is able to discount his c o n t r i b u t i o n s for expected turnover and still avoid a controversy over the exclusion of some employees u n d e r the plan. T h i s is particularly advantageous u n d e r negotiated plans, where the employer wants to represent the plan as covering all employees in the bargaining unit a n d yet not make contributions for a certain n u m b e r of employees who will u n d o u b t e d l y withdraw from service before vesting or retirement qualifications are met. R e t i r e m e n t Age. U n d e r a deposit administration contract, it is possible to use an assumed distribution of retirements instead of a fixed normal retirement age. For example, it may be assumed, o n the basis of the employer's past experience that retirements will be distributed 5 per cent at each age from 60 to 64, 40 per cent at age 65, 5 per cent at each age from 66 to 69, and 15 per cent at age 70. T h i s assumption would give effect to a weighted average age at retirement which might more accurately reflect the p r o b a b l e experience and costs than would a single retirement age. U n d e r a regular deferred group annuity contract, this would not be feasible since deferred annuities could not be purchased at a fixed retirement age; there would be no way of knowing which employees would retire at any given retirement age. Since benefits are not actually purchased until retirement, the insurance company will permit an employer to use a set of arbitrary early retirement factors. For example, the employer might use a flat scale such as a small percentage discount for each year of early retirement, with no consideration given to the actuarial equivalent which is a necessity where the benefits have already been purchased. T h e employer may even waive any reduction in retirement income d u e to early retirement by paying the additional cost necessary to offset the indicated actuarial a d j u s t m e n t . β See p. 174.

98

Other Group Annuity Contracts

T h e insurance company can permit this since any added cost which might result from the use of factors more favorable than the actuarial equivalent would be charged against the employer and not the insurance company. Of course, whenever the contract calls for the purchase of deferred annuities upon discontinuance of the coverage or for other reasons, it is necessary to revert to the regular actuarial factors. Hence, most companies recommend that those factors be used from the beginning. As was pointed out earlier, under deferred group annuity contracts credits are not generally allowed for service beyond normal retirement date. 7 In contrast, many negotiated plans written under the deposit administration type of contract do provide credits for service for a limited period after the normal retirement date. T h i s is a reflection of the union belief that retirement should not be compulsory at a fixed retirement age. Benefit Formulas. T h e deposit administration group annuity contract lends itself to any type of benefit formula. T h e formula may provide a flat benefit or a percentage of earnings for some future period, such as the average earnings over the final five or ten years of service. T h e insurance company can permit the use of final earnings, even though they are indefinite, since its guarantee is effective only after retirement, when final earnings will be known. Social Security benefits may be included directly in the benefit formula. For instance, an over-all formula benefit may be reduced by all or a part of actual Social Security benefits—a procedure which could not be used under a deferred group annuity contract without administrative difficulties. Also, since the funds are not normally allocated prior to retirement, benefits at early retirement need not be limited to the actuarial equivalent of the benefits already accrued. Similarly, minimum benefits may be determined independently of the basic benefit formula. Optional Annuity Forms. Normally, the insurance company is willing to grant the same optional annuity forms upon normal retirement that it would grant under a deferred group annuity contract. As a practical matter, however, most employers who buy deposit administration contracts are either bound by a particular union agreement which may not have contained options, or they are very cost conscious and are happy to keep options at 7 See p. 63.

Deposit Administration

99

a m i n i m u m in order to simplify administrative procedures a n d thereby reduce administrative expense. As a result, not as many options are included, typically, u n d e r deposit administration contracts as u n d e r deferred g r o u p annuity contracts. In practice, the two most common optional annuity forms used with deposit administration contracts are the joint and survivor a n n u i t y a n d the Social Security a d j u s t m e n t option (temporary annuity). These two optional forms are the same as those offered u n d e r the deferred g r o u p a n n u i t y plan, b u t the restrictions placed on the joint and survivor a n n u i t y are slightly different. Contracts in which the monthly benefit will change automatically in the event of a change in Social Security benefits present a special problem. It is desirable to avoid optional annuity forms in such cases because of the complexities that arise in d e t e r m i n i n g the p r o p e r a d j u s t m e n t in the event of a change in Social Security benefits after the employee has retired. T h e joint and survivorship option is an example of how complicated that situation could become. Disability Annuities. R e t i r e m e n t plans sometimes provide for the payment of a pension to an employee on his becoming totally and permanently disabled, subject to service and, in many cases, age requirements. Since the employer is in a m u c h better position than is the insurance company to investigate claims, it is usually left to the employer to decide whether or not an employee is totally a n d permanently disabled a n d entitled to a disability benefit. T h e insurance company usually recommends that prior to normal retirement date the employer make payments directly to the disabled employee on a pay-as-you-go basis. If the employee has not recovered by the time he would normally retire, his earned retirement a n n u i t y is purchased by a withdrawal from the deposit f u n d in the same m a n n e r as for other employees. For larger cases, some insurance companies will make the disability payments prior to retirement directly f r o m the deposit f u n d . Again, at normal retirement date, the employee's earned retirement annuity is purchased, a n d the disability payments cease. For such cases, companies will calculate disability premiums on a m u t u a l l y satisfactory basis if the employer so desires. A third way of h a n d l i n g disability retirements is the purchase

100

Other Group Annuity Contracts

of a temporary annuity providing payments from the date of disability, as determined by the employer, to the employee's normal retirement date. If the employee recovers before his normal retirement date, the value of the temporary annuity at the date of recovery is credited to the deposit fund. If the employee remains disabled until his normal retirement date, however, the employer is required at that time to make a withdrawal from the deposit fund to purchase the life annuity necessary to provide the employee with the pension to which he is entitled. Life annuities at reduced rates can be purchased for employees for whom the insurance company has received satisfactory evidence of disability. 8 B u t this solution has the disadvantage that the group for whom annuities are purchased at regular rates thereby becomes superselect. Actually, this method of handling disability retirements is used very little today. Withdrawal. Under a deposit administration plan, most insurance companies keep individual records only for those employees for whom annuities have been purchased. Some companies, however, particularly under contributory plans, do maintain some individual records before annuities are purchased. Under any circumstances, the employer or the insurance company must maintain sufficient records to facilitate annual valuations and to determine the death and withdrawal benefits payable to individual employees under contributory plans. Since fewer records are maintained and no annuities are purchased prior to retirement, there is usually no charge of any kind at the withdrawal of an employee under a noncontributory deposit administration plan. If benefits are purchased upon the attainment of certain vesting requirements, the usual deferred group annuity provisions apply. In the case of contributory plans, the insurance company may make a surrender charge at the withdrawal of an employee for whom the employer has not purchased an annuity. T h i s surrender charge is generally 4 to 6 per cent of the employee's withdrawal credit, and, as in the case of the deferred group annuity contract, is usually paid by the employer. In some cases, n o charge is made 8 Blagden, Discussion of Dorrance C. Bronson, "Pensions—1949," actions of the Society of Actuaries, I (1949), p. 261.

Trans-

Deposit Administration

101

in the event of withdrawals which occur after the completion of a minimum period of service. Premiums. A deposit administration contract provides for the payment of estimated annual premiums by an employer which, at interest, will accumulate funds adequate to provide for the purchase of annuities for employees who remain in employment until their retirement date. Since the premiums paid are not applied immediately to purchase benefits for individual employees, employer contributions need not be based on given schedules of rates included in the contract, but can be estimated and adjusted from time to time as experience unfolds. This means that the employer may discount estimated premiums for death, turnover, disability and retirement rates, since all of these factors affect the number of employees attaining retirement age while in the service of the employer. A salary scale may also be applied to account for expected future salary changes. In addition, the employer may base his contributions on assumptions as to mortality, interest, and expense, less conservative than those employed by the insurance company in its guaranteed rates. Unlike the deferred group annuity contract, the deposit administration contract does not establish a fixed annual premium but merely indicates the maximum and minimum amounts which the employer may contribute without specific approval of the insurance company. Since deposits made under the deposit administration contract are only estimates and the basis of funding is largely a matter of judgment, actuarial advice and pension fund valuations are essential. T h e insurance company usually provides this service, but in some cases the employer retains an independent consulting actuary. T h e flexibility permitted with respect to contributions under a deposit administration contract is obtained by foregoing some of the insurance company guarantees. If experience indicates that the estimated deposits are too low, the employer must increase the rate of funding to offset the deficiency. If the experience is better than assumed, however, the excess funds can be used to reduce future deposits. This points up an important characteristic of the deposit administration contract, namely, that the employer and not the insurance company is responsible for the adequacy of the advance funds deposited with the insurance company.

102

Other Group Annuity Contracts

Discontinuance T h e discontinuance of a deposit administration contract does not affect the annuities purchased for employees previously retired. W i t h respect to funds that have not been applied, the employer is generally permitted considerable latitude. T h e r e is wide variation in discontinuance provisions, but it is important that whatever procedure is to be followed be explicitly set forth in the contract. Application of Deposit Fund. Generally, the employer can choose either of two basic methods of disposing of the deposit fund after discontinuance. He may simply discontinue contributions and continue operation of the deposit administration contract until the deposit fund is liquidated, or he may terminate the contract and apply the deposit fund to the purchase of paid-up vested deferred annuities. In the latter case, an attempt is generally made to purchase all accrued benefits, but if the funds are not sufficient, a previously agreed upon method of proration is followed. A system of successive preferential classes of employees, or of successive preferential classes of benefits, is usually provided for in the discontinuance provisions of the contract or the plan. For example, proration might be based on classes of employees as follows: Class (1), all employees eligible to retire early; Class (2), all employees who have fulfilled vesting requirements; and Class (3), all other employees. A system of successive preferential classes of benefits might be: Class (1), future service benefits; and Class (2), past service benefits. 9 "Cash O u t " and T r a n s f e r of Fund. Normally, the insurance company is willing to provide a "cash o u t " privilege, i.e., withdrawal of advance funds in "cash," only where it is absolutely necessary to carry out the terms of the pension plan and then only if adequate safeguards limit the possible extent of selection against the insurance company. 1 0 For example, where Social Security benefits are increased and a plan becomes overfunded, the employer is usually permitted to withdraw the excess if he does so without too much delay. Another situation where the insurance company β Blagden, op. cit., p. 263. 10 See D. C. Bronson, et al., Discussion of Pensions, Transactions Society of Actuaries, II (1950), pp. 476-84.

of

the

Deposit Administration

103

will permit withdrawal of funds is the case of a governmental corporation whose plan has become overfunded due to a reduction in the number of personnel. In general, insurance companies have been reluctant to grant a unilateral transfer privilege with respect to advance funds under a deposit administration contract. T h e pressure of competition, however, has led to a more liberal policy on the part of some companies. Most companies will permit the transfer of advance funds from the deposit f u n d to another funding agency where the contract covers a plan developed through collective bargaining. In the case of regular deposit administration contracts not arising from union negotiations, companies differ somewhat in their attitude. T w o surveyed companies permit the same freedom of transfer as under their negotiated contracts, while another refuses to permit a transfer under any conditions. Most companies pursue a middle course and do not grant a contractual right of transfer but will permit transfers on a negotiated basis. Normally, transfers are not permitted where employee contributions are involved. In many cases where a negotiated plan is involved, the contract will provide that the company has the right to effect a transfer of advance funds if the plan is changed in such a manner as to make it impracticable to provide the benefits under the deposit administration contract. A transfer of advance funds from one company to another funding agency in no way affects those annuities already purchased, which continue to be administered by the original company. In any case, where a "cash out" privilege is permitted or a transfer of funds is effected, a 5 per cent expense and liquidation charge is made. T h e expenses covered by the charge include not only the expenses incident to the liquidation and disbursement of money from the deposit administration fund, but the commissions, premium taxes and other expenses which have been incurred on amounts paid into the deposit administration f u n d as well. Moreover, this charge is intended to cover possible investment losses arising from the withdrawal of the funds. In addition to the liquidation charge, the company usually reserves the right to pay the funds out over a ten-year period if it so desires, with interest guaranteed at 2 per cent. At least one

104

Other Group Annuity Contracts

company requires a one-year notice, although its other provisions conform rather closely with those already discussed. It feels that the one-year notice requirement protects the insurance company against financial selection and precipitate action. Supplemental

Deposit

Administration

T h e use of the deposit administration principle as a supplement to a retirement plan written under a deferred group annuity or group permanent contract has probably been as important as its use as a basic contract. Those companies which prefer not to write a deposit administration contract as a general practice usually permit its use for special purposes. For instance, it may be used to accumulate a fund from which amounts may be withdrawn at retirement to purchase any credited past service benefits. Again, the final premiums which are necessary under group permanent contracts employing other than the retirement income form may also be taken from such a supplemental fund. Where an employer is supplementing the actuarial benefits available at early retirement or is providing a minimum benefit at normal retirement, a fund maintained on the deposit administration principle is frequently used. One surveyed company not writing deposit administration contracts as a regular form has been able to handle complicated benefit formulas by providing a basic benefit through a deferred group annuity contract and using a supplemental deposit administration contract to cover modifications in final benefits needed to meet the requirements of the plan. Negotiated

Plans

Since the deposit administration contract, unlike the deferred group annuity contract, offers the advantages of greater flexibility in plan provisions and funding procedures, it was natural that the insurance companies should adapt the deposit administration type of contract to the peculiarities of plans resulting from collective bargaining. Many companies had to revise their thinking radically in order to permit the modifications necessary to handle negotiated plans. A good example of this is the maturity or terminal funding technique which resulted from the collective bargaining in the steel industry. In order to underwrite this type of plan, the companies which had been selling the idea of full

Immediate Participation Guarantee

105

advance funding for over thirty years found it necessary to revert almost to a pay-as-you-go plan, which they felt was antiquated. With the banks standing ready to handle this and other modifications with a trusteed plan, a number of companies introduced a modified form of the deposit administration, capable of handling practically any negotiated type of p l a n . 1 1 IMMEDIATE

PARTICIPATION

GUARANTEE

A variation of the deposit administration type of plan is the immediate participation guarantee contract now offered by a number of companies. 1 2 T h i s contract is offered under various names but the most descriptive of these is the "Immediate Participation Guarantee." T h e fundamental characteristic of this form of contract is that it provides for a contractual immediate dividend formula; that is, it guarantees immediate participation by the employer in all of the experience factors affecting pension costs. Under this contract, the employer has the advantage of the insurance company's investment service; and the retired employees have the advantage of guaranteed benefits. In effect, the employer is bearing his own risks under the plan to almost the same degree as in the trusteed type of pension plan. It was the competition of the trusteed plan that caused the insurance companies actively to solicit this contract. Except for the method of reflecting experience, however, the immediate participation guarantee contract is essentially the same as the regular deposit administration contract, though in some cases the insurance company's underwriting rules are less restrictive than those imposed on the regular deposit administration contract. Immediate Participation

Procedure

Under an immediate participation guarantee contract, the employer makes payments to a deposit f u n d established under the contract. Unless the immediate participation guarantee contract is discontinued, no amounts are ever withdrawn from this deposit fund to purchase annuities. Instead, benefit payments and ex11 For an excellent discussion of the complex aspects of designing and bargaining on negotiated plans, see Boyce, How to Plan Pensions, op. at. 12 Four of the seven companies included in the survey offer this type of contract, while another is considering its adoption in the near future. Two of the companies adamantly oppose the contract.

106

Other Group Annuity Contracts

penses are paid directly from the fund and interest is credited to it. Thus, instead of the maximum cost guarantee with dividend participation provided under the deposit administration contract, the employer receives direct and immediate contractual participation in the actual experience as it develops; i.e., he is credited immediately with any mortality savings, interest earnings in excess of that guaranteed, and so forth. Just how this unique feature of the immediate participation guarantee contract is implemented can best be understood by examining the effect of interest, expense, and mortality experience. Deposits. As under the regular deposit administration contract, deposits to the fund are based on estimates of pension cost calculated in accordance with reasonable assumptions as to interest earnings, expenses, mortality, turnover, and so forth. T h e assumptions are normally determined by the employer's actuarial consultant, but are generally reviewed by the insurance company. While great flexibility is permitted in funding, there is usually some provision as to minimum and maximum payments, subject to negotiation in the individual case, but generally as flexible as the regulations of the Internal Revenue Service permit. T h e maximum limitation provision is intended to prevent the employer from exercising financial selection against the insurance company in an unfavorable investment market. Interest. Estimated premiums paid to the insurance company begin accumulating interest from the date received. T h e rate of interest earnings credited to the fund each year is essentially the rate of the insurance company's investment earnings for the year after taking into account capital gains and losses. This is in contrast to the deposit administration contract under which a fixed rate of interest is guaranteed, with excess interest being credited only through the operation of the dividend formula. Expenses. T h e insurance company has a system of cost allocation for determining expenses applicable to all its group annuity contracts. 13 Each immediate participation guarantee fund is charged directly each year with the expenses allocated to that particular contract according to this system. Again, the experience with regard to actual expenses under the deposit administration contract would be reflected through dividends. 13 See p. 192.

Immediate Participation Guarantee

107

Mortality. A certain portion of the fund under an immediate participation guarantee contract is held for retired employees and the remainder is held for active employees. T h e amount of the so-called "active life fund" available for nonretired or active employees is reviewed periodically by the employer's actuarial consultant to check its adequacy in relationship to the actual experience. As the following discussion indicates, the amount of the fund held for retired employees depends upon the number of retired employees and the applicable rate schedules. At the retirement of an employee, a reserve is set up as a liability against the fund, the amount of the reserve being the present value of the employee's annuity according to the annuity rate schedule set forth in the contract. T h e initial schedule is usually guaranteed for amounts contributed during the first five years, but the company reserves the right to change the rates with respect to contributions made after this period expires. 1 4 Annuity payments for retired employees are charged directly to the fund as they are made. T h e reserve initially set up for any employee is adjusted each year and as of any valuation date is equal to the reserve as of such date, determined from the table of annuity rates as though the employee were then being retired, but based on the table of rates originally effective for him at the time he was retired. In substance, a single premium annuity is purchased for all retired employees at the beginning and is cancelled at the end of each year. T h i s automatically accounts for employees who die during the year, and the employer receives the full and immediate effect of the mortality of his retired employees. T h u s , at any valuation date, the amount in the fund must be at least equal to the total reserves determined for all annuities then payable on retired lives plus any other current liabilities chargeable to the fund. If at any time the total funds would be insufficient for this guarantee, the insurance company actually purchases annuities for the retired lives and the contract reverts to a normal participating group annuity contract. By this scheme, the insurance company can provide a guarantee to retired employees that their benefits will be paid. 14 One surveyed company guarantees the initial schedule of rates for all annuities provided from the fund during the first ten contract years, a quite different type of rate guarantee.

108

Other Group Annuity Contracts

U n d e r a deposit administration contract, the insurance company also guarantees a schedule of annuity rates for each dollar of contribution at the time of receipt, and guarantees the payment of lifetime annuity benefits to annuitants. Actual mortality is recorded on the insurance company's internal record of the experience on the contract and any savings are made available to the employer through the operation of a normal dividend formula, instead of directly as under the immediate participation guarantee contract. Guarantees. T h e basic guarantee under an immediate participation guarantee contract is direct and immediate participation in all factors affecting the cost. In addition, for the money deposited in the first five years, an annuity rate basis is guaranteed for determining the amounts to be set aside for a pension when a plan member retires. 15 T h i s same rate basis is used for making the annual adjustment in the amount held for that employee. T h i s means that, should the plan terminate, each retired employee's lifetime benefits will be provided for on the rate basis originally used to set aside funds for him. As a practical matter, it is only when the fund for nonretired employees, the "active life fund," is exhausted that the rate guarantees assume significance. As mentioned above, immediate participation guarantee contracts require that the employer maintain his fund at a level sufficient to cover the reserves required to guarantee the continued payment of annuities to retired employees. T h e s e reserves are defined in terms of gross premium rates, and by virtue of this gross premium method of valuation, a built-in contingency reserve is available to offset any losses arising from the guarantee made to retired employees. 16 As a result of the requirement that the employer maintain his fund above the "critical point," the insurance company does in fact guarantee the payment of such annuities, and implements its 15 One company requires that expenses other than commissions and taxes be paid on a first-in, first-out basis. T h i s means that the money paid in during the guaranteed period will be completely used sooner, and not all such money will be available to purchase retirement benefits. T h e net effect is that the rate guarantees apply to a slightly smaller amount than would otherwise be the case. 16 T h e r e is a slight additional margin resulting from the adjustment made in the interest rate credited. See p. 164. T h e r e is also some margin in the loading of the funds allocated to retired lives, since expenses are charged to the unapplied fund.

Immediate Participation Guarantee

109

guarantee by providing that in the event of termination of the contract, or exhaustion of funds available for nonretired employees, annuities will be purchased for the retired employees and the contract will revert to the more usual form of participating group annuity contract. However, the value of these residual insurance company guarantees provided by the insurance company should not be underestimated. If a plan is terminated, the employer has no further responsibility under the plan, and yet is sure that the employee has what he needs most, namely, assurance that his annuity will continue for life. Under an immediate participation guarantee contract, as under the conventional deposit administration contract, the employer's fund consists of a share in the total assets of the insurance company rather than a segregated portfolio of wholly owned investments. This means, of course, that the employer does not have the same control over investment policy that he has under a trusteed plan. On the other hand, one of the reasons for buying an insured contract is to take advantage of the insurance company investment service. Flexibility Transfer to New Funding Agency. Under an immediate participation guarantee type of contract, some limitations are placed on the right of the employer to transfer his fund to another funding agency. Some insurance companies will guarantee a right of transfer subject to a surrender charge. Other companies take the position that if a transfer of funds to another insurance company or to a trustee should be desired at any time, it could be negotiated in the light of conditions then existing. In any event, the transfer would only apply to the active life fund. A contract of the immediate participation guarantee type can be used to fund any plan that can be handled under a trusteed plan. Features such as benefits based upon final pay, benefits subject to direct offset for Social Security benefits, disability benefits, and variable retirement ages, can be handled easily through an immediate participation guarantee contract. As in the case of regular deposit administration contracts, there is no requirement that features such as vested rights, and optional forms of annuities, customarily found in insured plans, be included in an im-

110

Other Group Annuity Contracts

mediate participation guarantee contract. T h e latter can be, but is not usually, written on a contributory basis.17 T h e immediate participation guarantee form of contract is, of course, still in the formative stage, and its provisions and limitations are subject to negotiation between the insurance company and the employer in each case. Because of the relatively small number of contracts written to date, it is dangerous to generalize. What has been done in such individual cases may not indicate a trend or an insurance company's basic thinking but may, in fact, be contrary to the pattern which will develop as more of these contracts are underwritten. GROUP

PERMANENT

A group permanent retirement income plan is actually group life insurance—other than yearly renewable term insuranceadapted to provide pensions at retirement in addition to life insurance protection during active employment. 18 T h e group permanent plan is particularly appropriate when substantial death benefits and retirement income benefits are desired under one and the same contract. T h e administration of the group permanent plan is somewhat more complex than that of other group annuity plans, and, consequently, the underwriting requirements are relatively strict. Because of the higher cost of terminations, it is desirable to avoid employment groups with large turnover. In practice, this plan is used only for the more stable employment groups. Retirement

Income

Basic Plans. T h e group permanent plan may be written with any one of a number of basic types of life or endowment plans. T h e most common types include ordinary life, life paid-up at 60 or 65, 17 O n e company p e r m i t t i n g employee contributions u n d e r this type of contract requires the employer to m a i n t a i n his f u n d at a level sufficient to cover r e q u i r e d reserves for retired employees, current liabilities, a n d 110 per cent of employee contributions. A n o t h e r company requires t h a t employee c o n t r i b u t i o n s be applied on a deferred g r o u p a n n u i t y basis, a n d p e r m i t s employer f u n d s only to be h a n d l e d on an i m m e d i a t e p a r t i c i p a t i o n g u a r a n t e e basis. 18 T h r e e of the seven companies included in the survey offer g r o u p p e r m a n e n t coverage as a general practice; a n o t h e r will issue it u n d e r certain circumstances; while t h e r e m a i n i n g three will not issue it u n d e r any circumstances.

Group Permanent

111 19

e n d o w m e n t at age 60 or 65, or—most frequently —retirement income at age 60 or 65. Regardless of the underlying form, it is usual to grant $1,000 of face a m o u n t of life insurance for each $10 of monthly income; a few companies offer some variations in the relative a m o u n t of insurance, such as $500 to $1500 for each $10 of monthly income. In addition, variations may be developed with other forms of life insurance or by combining two or more forms. Each plan requires the payment of a level a n n u a l p r e m i u m u n t i l the employee's normal retirement date, at which time, in all b u t the retirement income at 60 or 65 plans, a final p r e m i u m is d u e in an a m o u n t sufficient to convert each $1000 of insurance i n t o $10 of monthly income. T h i s is necessary since the cash values at retirement of all plans except the retirement income plans are not sufficient to provide $10 of monthly income. T h e accumulation by the employer of f u n d s to pay so-called final p r e m i u m s as they become due is normally handled by means of a f u n d m a i n t a i n e d by the employer with the insurance company on the deposit administration principle, in which event provision for the maintenance of such a f u n d is made by a rider attached to the master policy. If the employer desires, he may m a i n t a i n a f u n d for the payment of final premiums elsewhere than with the insurance company. Formulas. G r o u p p e r m a n e n t retirement income plans are sufficiently flexible to permit the use of a wide range of benefit formulas. If the retirement benefits are based on earnings, the a m o u n t of insurance in force on an employee is determined by assuming that his current rate of earnings will remain unchanged u n t i l retirement, the insurance being increased or decreased u p o n subsequent changes in earnings. 2 0 T h i s form of coverage lends itself most naturally to a benefit formula which provides for a fixed a m o u n t of monthly income at retirement regardless of length of service u n d e r the plan. T h u s , this type of formula, often called a level percentage type, might 19 This preference is due mainly to a tax ruling that the cost of current life insurance protection provided an employee under a life or endowment contract must be included in the taxable income of an employee. See P. S. No. 58 (Revised), Internal Revenue Service. 20 N o adjustments are usually made during the last five years prior to normal retirement age.

112

Other Group Annuity Contracts

provide that an employee would receive a retirement benefit of, say, 40 per cent of final earnings. A unit benefit formula may also be used with a group permanent plan. If the unit of death benefit is $1000 for each $10 of monthly retirement income, and the retirement credits are determined by a unit benefit formula, the death benefits provided will vary with the employee's age at entry into the plan; this resulting death benefit may or may not be considered desirable, depending upon the individual circumstances of the employer. It is possible to write a plan employing a money purchase type of formula as well as other variations and combinations. These formulas may be modified when the plan is intended to supplement Social Security benefits, by differentiating between annual earnings up to $4200 and annual earnings in excess of that amount. If desired, minimum benefits may be determined independently of the basic benefit formula. In arriving at a retirement benefit formula, it is important to make provision for avoiding small changes in benefit due to variations in earnings. Thus, the contract usually provides that increases in benefits due to increased earnings will be made effective only on a policy anniversary on which the employee becomes entitled to an increase in his retirement benefit of some minimum amount, typically, $5 or $10 monthly. Decreases due to decreased earnings are made only if the decrease in earnings exists for some minimum period such as two or three years. 21 Retirement

Age

T h e normal retirement age for all employees is 60, 65 or 70— 65 being the retirement age most frequently used for both male and female employees. Some companies, however, permit a differentiation between the normal retirement age for male and female employees. Also, some flexibility is permitted with regard to older employees in active employment at the inception of the plan. Early retirements are usually permitted. T h e normal procedure at the early retirement date is to apply the then accumulated cash 21 In (he event of a decreased earnings adjustment, the usual practice is to convert the withdrawal value of the a m o u n t by which coverage is decreased, to a form of p a i d - u p coverage. T h i s paid-up coverage is taken into consideration in the determination of f u t u r e changes in coverage applicable to t h e employee.

Group Permanent

113

value to purchase whatever benefit can be provided. Although the procedure is similar to that used in a deferred group annuity contract, the steps in determining the amount payable are different. T h e cash or withdrawal value is determined according to the employee's age at entry and his age at withdrawal. T h i s cash value is used to provide a retirement income based on the applicable settlement options under the contract. In effect, an immediate annuity is purchased according to the employee's age at the time of retirement. Due to the large death benefits before retirement in this form of coverage, the group permanent plan does not lend itself to delaying retirement and crediting the employer with the values of the benefits not received by the employee, although this procedure can be worked out if desired. 22 T h e usual practice is to start the annuity payments at the normal retirement date regardless of the time of actual retirement. T h e employer may adjust the compensation of any employee who continues to work, according to the individual circumstances. Forms

of

Annuities

Normal Annuity Form. Like other group annuity contracts, a group permanent retirement income plan is almost invariably written to provide only one normal annuity form. T h e most common normal annuity forms include life annuity with payments stipulated for ten years, life annuity with payments stipulated for five years, and a life annuity without stipulated payments. T h e latter type of annuity is usually permitted only in noncontributory cases. Optional Methods of Settlement. When an employee retires, a number of optional methods of settlement are usually available. Most plans provide for a joint and survivor annuity as well as the usual settlement options offered under individual life insurance policies. These settlement options include the instalment time option, the instalment amount option, and a life income with or without guaranteed payments. Naturally, the normal annuity form is not included under this last classification, since that form is automatically available. 22 For example, one company permits the withdrawal or termination value to be held at interest until the employee retires.

Other Group Annuity Contracts

114 Death

Benefits

Death Benefits Prior to Retirement. Upon the death of an employee prior to retirement, the death benefit payable is the face amount of his life insurance, or in the case of the retirement income plan, the cash value if greater. T h e normal form, as indicated above, will have a face value of $1000 of insurance for each $10 of monthly retirement income benefit. Under the retirement income form, the capital sum required to provide the monthly income will generally exceed the face amount of the insurance. This means that the accumulating reserve for each employee will eventually exceed the face amount of his coverage. Thereafter, the amount payable at death of the employee will be the cash value of his coverage. As indicated, the amounts of death benefits under this type of plan are substantial. These insurance coverages are granted under the group contract without medical examination, provided only that the employee be at work when the insurance becomes effective. T h e amounts which the insurance company will issue on an automatic basis without evidence of good health are limited by the same underwriting factors that apply to group life insurance on the term basis. U p to the limit established for the contract, coverage is granted automatically as the employee becomes eligible, provided only that he be at work when the insurance becomes effective. For the protection of the company and to conform with group insurance laws in many states, amounts of insurance provided for each life insured are determined by a plan which precludes individual selection. 23 Beyond the limit set for the contract, if an employee is entitled to more insurance by the benefit formula, he must pass a medical examination to secure the coverage. 24 Frequently, there are employees who fail to pass the medical examination, and there may also be some employees whose benefit under the formula would entitle them to more than $35,000 or $40,000 of insurance, which is usually the maximum amount of insurance that the insurance company will permit under any group permanent plan. Since 23 For an excellent discussion of the methods used to preclude individual selection, see Gregg, op. at., pp. 25-40. 24 However, there is usually an over-all maximum established as an underwriting restriction or required by state law.

Group Permanent

115

there is normally a direct tie between the amount of insurance and the retirement income provided, it is necessary to employ an alternative coverage in order to provide these employees with their proper retirement incomes. T h i s form, generally called retirement annuity, provides for the accumulation of the sums necessary to provide the additional retirement income needed. T h e death benefit payable under this form of coverage is equal to the cash value or accumulation of premiums to the date of death. Since the cash value is less than the total of the premiums paid during the early years of coverage of any individual, the death benefit payable during this period is the total amount of the premiums paid. T h e maturity value of the retirement annuity is identical with that of the retirement income form. Prior to retirement, however, there are differences in the reserve value under these two types of contract because of the difference in death benefits. T h e insurance contract may provide for the payment of these death benefits in a single sum, or by any one of the several optional settlement methods available in individual insurance contracts. T h e s e optional settlements will usually include: the interest option, the instalment amount option, the instalment time option, and a life income option with or without guaranteed instalments. 2 5 T h e death benefit is payable at an employee's death regardless of the cause, except in cases where amounts of life insurance in excess of the maximum available without evidence of insurability are written. In such cases, the excess amounts of life insurance requiring evidence of insurability are issued subject to a two-year suicide clause and a two-year incontestability clause, unless a shorter period is required by the state law. In some cases, an employer will provide death benefits on a one-year term basis for employees after three to six months of employment and until they are eligible to come under the regular retirement program. T h e amount of insurance usually selected is a flat amount or an amount approximating one year's salary. T h i s benefit is usually handled under a separate group life contract. 25 T h e s e options a r e i h e s a m e as those used as o p t i o n a l r e t i r e m e n t f o r m s , except t h a t t h e j o i n t a n d survivorship o p t i o n is n a t u r a l l y not a v a i l a b l e . Also, t h e r e may be some d i f f e r e n c e in t h e m o r t a l i t y a n d i n t e r e s t bases used.

116

Other Group Annuity Contracts

Death Benefits After Retirement. If the death of a retired employee occurs before all of the instalments due during the stipulated period of his annuity have been paid, the commuted value of the unpaid stipulated instalments, with interest, is paid in one sum to the beneficiary. In the event that the interest, instalment time, or instalment amount options have been elected, and death occurs before the entire proceeds have been paid out to the employee, either the commuted value with interest is paid to the beneficiary, or the original option is continued to the beneficiary if he or she so desires. 26 Withdrawal

Benefits

Cash Value. T h e amount available to an employee and employer together on termination of employment under this coverage is determined by the reserve or cash value just as in the case of an individual life insurance policy. T h e amount varies with the age at issue and the number of premiums paid. T a b l e 8 illustrates the reserve values which are available at the end of the specified number of years, and in accordance with the age at issue for each unit of coverage. Any part of this termination value which is paid to the employee as his withdrawal value is usually reduced by a surrender charge which is used to allocate a portion of the costs of administration to the terminated benefits. 27 T h e employee's share of the total termination value is usually his accumulated contributions with interest which will assure him a return of his own money. 28 T h e balance of the termination value not allowed the employee is available to the employer as a credit against future premiums required by the plan. Vesting. Like other group annuity plans, group permanent may provide for no vesting of benefits purchased by employer contributions, partial vesting, or complete vesting. In any case, the particular vesting formula developed will directly affect the 26 Decisions in this area d e p e n d upon t h e u n d e r w r i t i n g rules of t h e particular c o m p a n y involved. 27 T h e s u r r e n d e r c h a r g e usually decreases as t h e l e n g t h of t i m e t h e policy is in force increases, completely d i s a p p e a r i n g after five or ten years. 28 S o m e plans use an a l t e r n a t i v e e m p l o y e e w i t h d r a w a l benefit that gives h i m a part of t h e full t e r m i n a t i o n value e q u a l to t h e p r o p o r t i o n t h e employee's total c o n t r i b u t i o n s b e a r to t h e total p r e m i u m for his coverage.

Group Permanent

117

apportionment of the individual reserve or total termination value between the employee and the employer. Conversion Privilege. On termination of employment, the employee may convert his coverage to an individual contract on which he thereafter pays the full premium. T h e cost of the converted insurance to the employee may be substantially the same TABLE 8 ILLUSTRATIVE T E R M I N A T I O N VALUES UNDER G R O U P P E R M A N E N T INSURANCE $1000

AND I N C O M E O F $ 1 0

Termination Values End of Year

1 3 5 10 Age 65

PER

MONTH

AT A C E

OF

65*

Age at Issue

25 $ 12.24 62.28 114.44 246.83 1517.00

40

55

$ 32.60 124.72 221.00 474.77 1517.00

$ 116.67 387.88 681.55 1517.00 1517.00

• Normal form life with five years certain; annual premiums: Age 25, $29.98; age 40, $55.54; age 55, $156.26.

as the premium at his age at entry into the pension plan, because his withdrawal value can be used to provide some paid-up insurance benefits. Discontinuance T h e contract provisions regarding the effect of discontinuance or suspension of premium payments do not differ markedly from those of other group annuity contracts. One distinction, however, exists with regard to temporary suspensions of premium payments. While the company will permit the employer to suspend normal premium payments for a period of one year, they usually require that the employer pay a substitute premium sufficient to purchase term insurance maintaining each employee's death benefit and to complete the funding for all employees who retire during the period of temporary discontinuance of premium payments. Guarantees. T h e guarantees provided under the group permanent contract are similar to those provided under the deferred group annuity contract except that the initial guarantee period is sometimes three instead of five years. With respect to coverage

118

Other Group Annuity Contracts

becoming effective when the plan is installed and prior to the third anniversary of the plan, premium rates, values and coverage, rates for normal and optional forms of annuity, and rates for optional incomes at death are guaranteed for the full period during which the coverage is in force. T h i s means, then, that the premiums are guaranteed for life or until retirement for coverage issued during the guaranteed period. After the initial period, the guarantee is provided on a year to year basis and the company may change rates and values on any policy anniversary. SPECIAL

Profit

GROUP

ANNUITY

PLANS

Sharing

It is beyond the scope of this study to discuss profit sharing plans as such. It might be well, however, to comment briefly on a combination plan involving a profit sharing plan and a deferred group annuity contract. Such a combination has been adopted by a n u m b e r of employers. Basically, a profit sharing plan which is used to f u n d an insured pension plan is the same as a money purchase plan. T h e only difference is that the employer's contribution is determined by a profit sharing formula instead of as a percentage of compensation. T h e contribution made each year under the profit sharing formula is used to purchase benefits, and, naturally, the benefits purchased will vary from year to year. Many employers who want to provide substantial benefits for their employees are hesitant to do so because they fear that when business conditions become less favorable, pension contributions may be a serious drain on operating revenues. O n e way to provide such benefits and avoid having to discontinue the plan or limit benefits when earnings are off is to use the combination mentioned above. A basic benefit which the employer feels certain he can provide, regardless of normal fluctuations in his income, may be provided u n d e r a deferred group annuity contract. T h e n a profit sharing plan may be superimposed providing additional benefits, with such benefits depending on the profit sharing formula which can be geared to the employer's profit position. Here, then, the employee knows he will receive the basic benefit provided under the deferred group annuity contract but is informed

Special Group Annuity Plans t h a t the a d d i t i o n a l benefits are d e p e n d e n t on the

119 employer's

earnings.

Group Immediate

Annuity

Contract

An e m p l o y e r may wish to h a n d l e the funding of his plan on a self-insured basis or have n o f u n d i n g prior to an employee's ret i r e m e n t . In either case, the insurance company will issue a g r o u p i m m e d i a t e a n n u i t y c o n t r a c t which will permit the e m p l o y e r or trustee u n d e r the plan to purchase a single p r e m i u m i m m e d i a t e a n n u i t y f o r each employee at r e t i r e m e n t . T h i s type of plan may be used where the employer wants to retain control over the investment of funds prior to the employee's r e t i r e m e n t b u t still wants to provide the employee with the security of an insured contract a f t e r r e t i r e m e n t . A l t h o u g h the underwriting requirements are normally higher for this type of contract, essentially it is a deposit a d m i n i s t r a t i o n contract with no advance f u n d i n g . 2 9 Naturally, there are o t h e r plans which have been devised a n d are in use today. T h e many variations developed simply e m p h a size the p o i n t that a pension plan is always designed to m e e t the individual needs and circumstances of a p a r t i c u l a r employer. 2 9 Actually, this is the same type of contract as that developed to h a n d l e t h e m a t u r i t y or t e r m i n a l f u n d i n g a r r a n g e m e n t s negotiated in t h e steel industry. A l t h o u g h s o m e advance f u n d i n g was p e r m i t t e d , i m m e d i a t e a n n u i t i e s were usually p u r c h a s e d as each e m p l o y e e retired d u r i n g t h e life of t h e bargaining agreement.

Chapter Β

Underwriting Group Annuity Contracts All branches of private insurance use some method of selection in accepting a n d classifying risks; this is essential if the insurance p l a n is to succeed. In i n d i v i d u a l insurance the unit of selection is the i n d i v i d u a l , while in g r o u p insurance the unit of selection is q u i t e naturally the g r o u p . T h e objectives of any selection procedures apply to this g r o u p u n i t as well as they d o to the individual unit. T h u s , generally in g r o u p insurance an a t t e m p t is m a d e to o b t a i n the p r o p e r b a l a n c e between mass a n d homogeneity of risks, to afford predictability of f u t u r e results. It is in this sense that the u n d e r w r i t i n g of g r o u p annuities is the same as that of other forms of insurance. Between u n d e r w r i t i n g the g r o u p annuity business a n d other forms of g r o u p insurance, however, there are several very important distinctions. O n e distinction is dependent on the fact that the contingency covered u n d e r a g r o u p annuity is that of retirement f r o m service a n d is not, as with other forms of g r o u p insurance, one which may occur at any time. A second distinction lies in the p e r i o d over which the g r o u p annuity contract extends. Whereas g r o u p life coverage a n d forms of g r o u p insurance other than g r o u p annuities are usually written on a year-to-year basis, the purchase of a retirement income under a g r o u p annuity contract extends over the w o r k i n g years of an employee a n d the retirement income p u r c h a s e d is p a i d out over another period, the lifetime of the e m p l o y e e after retirement. It is entirely possible, therefore, that a p l a n m a y s p a n a period of fifty or sixty years in p r o v i d i n g a retirement i n c o m e to any individual employee. T h i s time element can scarcely be overemphasized. It magnifies the importance of interest e a r n i n g s a n d necessitates the inclusion of 120

Underwriting Group Annuity Contracts

121

many subsidiary features in the plan in order that the insurance company may be prepared for the various contingencies which may arise. In underwriting individual policies, the insurance company must be on guard for selection by the individual at the time the policy is taken out. In the case of group annuities, selection becomes a matter of concern only after the inception of the plan. Here the individual does not enter into the decision to install a plan and, consequently, selection by the employee at this point is not important. Again, since the contingency covered is not one which may occur at any time, the employee's decision to join or not to join the plan does not present a serious problem of selection. It is only after the employee has built up credits and is given a choice of several alternatives as to the use of these credits that individual selection becomes a problem under the group annuity contract. 1 T h e basic objectives of the underwriting process are simply the objectives of a sound retirement program. T h e underwriting rules must guard against selection under the plan both financially and with respect to mortality. It must be determined that the employer is able, financially and administratively, to handle and support the retirement plan proposed. 2 T h e stability of the employer is of paramount importance for the successful operation of such a long-term program. Another objective of a sound plan is that the plan shall meet the needs of the employees and, where employee contributions are called for, that the employees can afford them. These objectives shape and mold the basic underwriting rules employed by the several insurance companies writing group annuities. Naturally, no two companies will have identical under1 T h e insurance company may face some attempt at selection by the employer with regard to defining classes of employees to be covered. Usually, this arises in the case of overage employees, where an employer may attempt to draw the line so as to exclude several employees in poor health. T h i s has not been a serious problem, however. See p. 124. 2 Most companies look simply at the general financial condition of a prospective contractholder, since improvement in selection brought about by a thorough analysis of the employer's operations would wear off in a few years anyway. It should be remembered that the effect of any selection process, whether it be a medical examination or otherwise, tends to become less important over time. Again, the influence of the long-term nature of a retirement program is manifested.

122

Underwriting Group Annuity Contracts

writing rules, but, in most cases, there are common threads running through the underwriting procedures used. These basic rules are presented here and important deviations are discussed at various points. Underwriting regulations, like other facets of the group annuity business, are continually being altered and revised, and information regarding any specific problem should be discussed with a representative of the company concerned and should not be presumed to be exactly as presented here. DEFERRED GROUP ANNUITY

CONTRACTS

Eligibility Groups Eligible. Life insurance companies will issue a deferred group annuity contract only under conditions where the plan would seem to be a permanent undertaking. For example, the earnings history and earnings potential of the employer must indicate ability to maintain the proposed plan. For this same reason, a contract will not normally be issued to cover members of lodges, clubs, employee associations, and the like. These groups are also generally excluded because the very nature of such organizations suggest that the employer's administrative functions may not be handled efficiently. If other requirements are met, all corporate employers are eligible including a parent with subsidiary companies or affiliated companies owned or controlled by the parent corporation by stock ownership, contract, or otherwise. Generally, associated companies may be included regardless of their location or the industry in which they are engaged. Branches located outside the United States or Canada will normally be considered depending upon the facts of the individual case. Coverage in foreign corporations, however, is limited to United States citizens. Also, proprietorships and partnerships are eligible for group annuity coverage with most companies, though such employers are scrutinized closely by underwriters because the death of a sole proprietor or a general partner brings many problems to such a business which may well result in discontinuance of the plan. In any case, these types of employer are not the most receptive prospects, probably because the partners and individual proprietors them-

Deferred Group Annuity Contracts

123

selves d o not receive the favorable tax treatment afforded to the employee. Some states have laws specifically authorizing cities, counties, a n d other political subdivisions to take out group annuity contracts covering their employees. Normally, this class of employer will be accepted provided evidence is presented showing that the governmental unit is legally permitted to take out a group annuity contract and that the underwriting requirements of the insurance company can be fully met. T h e evidence required includes an opinion from the unit's legal counsel regarding its legal authority to enter into a contract, to pay its share of the premium, and to make any necessary deductions from the pay of the employee; a certified copy of the minutes of the meeting of the proper board or commission which authorizes the purchase of the contract; and other pertinent information. Because of possible complications which may ensue, this class of business is considered very carefully before acceptance and is not actively solicited. M i n i m u m Size. In establishing a minimum size below which the company will not offer deferred group annuity coverage, three criteria are used. Many companies set a minimum number of lives and may add a requirement that the plan produce a minim u m annual premium. Practically all companies will place a third stipulation on the case, namely, that at least 75 per cent of the eligible employees join the plan at its inception. While they usually desire that this participation be maintained as long as the plan is in force, this provision is not rigidly enforced except on smaller cases. Naturally, this third requirement is not applicable to noncontributory plans since under this type of plan all eligible employees would be included. In regard to the first criterion, most companies will issue a contract to employers with twenty-five or more employees. A few companies, however, will not accept contributory cases with fewer than fifty lives involved. A company that pools its mortality on small cases would be less concerned over this particular criterion than one that did not. 3 One of the surveyed companies has no minimum case requirements, provided that there are no unusual provisions requiring special rate tables or unusual administrative procedures. 3 See p. 191.

124

Underwriting Group Annuity Contracts

T h e r e q u i r e m e n t as to m i n i m u m p r e m i u m is considered to be highly important by most companies. Even with those companies that d o not establish a published m i n i m u m , this is a m a j o r consideration in accepting or rejecting a case. I n all cases, regardless of size, there are certain m i n i m u m fixed expenses which are incurred in establishing a plan; consequently, most companies feel that a certain m i n i m u m p r e m i u m is necessary to meet these fixed expenses. T h e m i n i m u m a n n u a l a m o u n t considered acceptable is $200 per life, b u t most companies prefer to have $300 to $400 per life on smaller cases. T a k i n g both the m i n i m u m life and the m i n i m u m p r e m i u m requirements, it can be seen that on a twenty-five life case, a m i n i m u m of $5000 a n n u a l p r e m i u m is r e q u i r e d , with $7500 or $10,000 preferred. If the companies will not accept a case with less than fifty lives, then the m i n i m u m p r e m i u m would be $10,000. It should be emphasized, however, that individual circumstances are controlling and, for a case that indicated only minor administrative difficulties, lower r e q u i r e m e n t s might be accepted. Employees Eligible. Subject to some very i m p o r t a n t exceptions, all full-time employees must be eligible for coverage u n d e r the plan. O n e company will not permit proprietors a n d partners to be included in the plan, b u t this is not the general rule. In designing the eligibility requirements for the plan, the company will usually recommend that employees who have been pensioned prior to the date of the contract or are within, say, six months of retirement, be excluded f r o m the plan. However, if the employer prefers to include all such employees in the plan, the company will usually permit him to d o so. Basically, this decision is influenced by the n u m b e r of such employees. Since the insurance company usually requires that a retirement income be fully f u n d e d when an employee retires, the past service liability can be extremely heavy if a large n u m b e r of employees are involved. As was pointed out earlier, selection by the employee becomes a matter of concern only after the inception of the p l a n . Although unusual, it would be possible for an employer to exercise selection against the company in h a n d l i n g older employees. An employer may try to draw a line which will leave out one or two

Deferred Group Annuity Contracts

125

employees in poor health and cover employees in similar categories who are in good health. Once the plan is in operation and the class of eligible employees is defined, this problem does not arise; but in setting up the plan there is always considerable flexibility in deciding where the line will be drawn with respect to older employees initially covered. Most companies will permit the use of a minimum age limitation up to age 40 and an eligibility period up to five years. As to the minimum age limitation, most companies feel that a minimum beyond age 40 excludes too many employees. It is also very likely that such a clause would be considered discriminatory by the Internal Revenue Service. Most companies will permit differentiation between salaried and hourly paid workers. Again, employees of certain specified plants or employees of certain specified affiliated or subsidiary companies may be excluded. Exclusions based on an earnings break of, say, $4200, are also permitted. In general, then, the insurance company will permit reasonable exclusions of classes of employees based on conditions pertaining to employment, length of service, age, and the like, but attempts to prevent exclusions of individuals on a basis that might be considered discriminatory. Employees who are sick or temporarily out of service for some other reason when they would otherwise be eligible for coverage are considered eligible for coverage following their return to active duty. Under unusual circumstances, a few companies will permit immediate coverage of such employees. Effective Dates of Coverage. A case is considered closed upon receipt at the home office of a completed application, and a premium deposit, usually $5 per eligible employee or $5000, whichever is less. This deposit is applied against the first premium due under the contract. This offer by the employer is based on a proposal which has been worked out in advance, and approval of the application by the home office constitutes acceptance, thus establishing a contractual relationship between the employer and the insurance company. T h e application must be signed by a responsible officer of the employer, and the directors or a similar controlling body must have previously approved the purchase of the group annuity

126

Underwriting Group Annuity Contracts

contract. Normally, it is suggested that stockholder approval also be secured either prior to the effective date of the contract or shortly thereafter. T h e application will usually include the effective date of the contract which is, ordinarily, any time suitable to the employer. T h e only exception to this is the requirement in contributory cases that the minimum requirement as to eligible employees be met on the effective date of the contract. A time limit of thirtyone days from the effective date of the contract is usually imposed for the completion of employee applications. T o facilitate administration, the effective date is usually made the first day of a calendar month. Coverage of the initial group of eligible employees is effective on the effective date of the contract, provided the employee completes the required application within the time limit. If an employee fails to complete his application until after the expiration of the time limit, he is treated as a new employee entering after the effective date of the contract. This is an important distinction, since ordinarily only those employees participating at the effective date of the contract receive credit for past service. Frequently, the preservation of past service credit is an important factor in obtaining sufficient participation under contributory plans. For new employees, the first contract anniversary date or other entry date 4 established for the plan following the completion of the eligibility requirements will be the effective date of coverage, provided that, in the case of a contributory plan, the employee has completed a written application. Retirement Age. T h e normal retirement date must be specifically defined in terms of the attainment of one specified normal retirement age, such as 65. For example, this will be either the first day of the month following the sixty-fifth birthday or the contract anniversary nearest the sixty-fifth birthday. In general, only two exceptions to this are permitted. Most companies will permit a normal retirement age for female employees different from that * T o facilitate administration, entry dates other than the contract anniversary are established for the plan, and new employees who have met Lhe eligibility requirements may enter the plan on any entry date so established.

Deferred Group Annuity Contracts

127

of male employees. Also, at the inception of the plan, an older normal retirement age may be used for employees close to the normal retirement age adopted for the plan. Most companies feel that age 70 is the highest normal retirement age which is practicable, although a few will permit an age as high as 75 for employees becoming participants after age 60. T o provide flexibility in the plans, all companies permit an employee, with the employer's consent, to retire before the normal retirement date and receive a reduced annuity. Where the annuity has already been purchased on a deferred basis, there is a considerable amount of antiselection exercised by persons who retire early. It should be remembered that employer contributions are usually discounted for mortality, i.e., contributions are made in such an amount that, at interest, they will accumulate to a sum at normal retirement age, say, 65, sufficient to provide benefits for those employees alive at age 65. Therefore, when an employee retires early because of poor health—the usual r e a s o n he will receive benefits which he would normally not have received. T h i s selection by the employee causes the total paid benefits to be higher than would be true if early retirement were not permitted. For this reason, the early retirement factors included in deferred group annuity contracts are based usually on a modified table reflecting the mortality anticipated with that class of risk. 5 Most companies restrict early retirement to a ten-year period prior to normal retirement date because retirement any earlier will produce an annuity too small to be practicable. In the case of deferred or postponed retirement, the insurance company usually will permit a postponement of no more than five years or until age 70 or 75, whichever is earlier. Normally, a company will permit greater flexibility in this regard for a noncontributory than for a contributory plan. Benefits Insurance companies will not ordinarily underwrite a plan providing for a benefit below a certain minimum. These miniis Most companies use their regular mortality table rated up five years in determining early retirement factors.

128

Underwriting Group Annuity Contracts

mums differ by type of plan, but have a similar objective—to provide a benefit sufficient to induce retirement and to be administratively feasible. Future Service. In plans of the unit benefit type, some companies will not permit a benefit of less than yi per cent of earnings for each year of service or its equivalent, regardless of whether or not the plan is integrated with Social Security. In practice, most companies do not set any arbitrary minimum benefit, but consider each case on its merits. A majority of the companies require a minimum over-all contribution of 6 per cent of earnings under contributory money purchase type of plans. They also require that the employer at least match the employee's contribution, which means that the employer contribution may never be less than 3 per cent of earnings. T h e minimum over-all contribution permitted under a noncontributory plan is the same as that for the contributory type of plan as far as the money purchase type of plan is concerned, the 6 per cent minimum being applicable to the employer's contribution alone in such case. Under a noncontributory unit benefit type of plan, however, the minimum is 1/2 per cent for each year of service as compared with s/4 per cent under a contributory plan, as pointed out above. T h e insurance companies feel that a benefit less than the foregoing will not produce, on the average, a retirement benefit sufficient to carry out the objectives of a retirement plan. Past Service. In general, the insurance company will permit any reasonable formula for past service benefits provided it does not permit the employer to select individual lives or amounts of income. Companies prefer, however, that past service benefits be a definite percentage of earnings for each year of credited service which is, of course, a unit benefit type of formula. A few companies set a minimum of i/2 P e r c e n t f ° r each year of service, but it is not customary for the companies to establish minimum past service benefits. In some cases, where most of the employees are comparatively young, a plan will not provide for past service benefits, and the occasional employee of advanced age is taken care of individually by the employer. But the majority of firms have a substantial number of older workers by the time a pension plan is considered,

Deferred Group Annuity Contracts

129

and most of the plans provide for past service benefits. One company surveyed will not underwrite a plan that does not provide past service benefits. Earnings Basis. In the past, actual basic salary, excluding overtime, bonuses, and other nonrecurring payments, has been used in computing future service benefits on a contributory basis. In recent years there has been a trend toward using total earnings in the benefit formula. Where such nonrecurring items are included, care must be taken that they do not produce discrimination in favor of supervisory and highly paid employees. In noncontributory plans, future service benefits are almost always based on the exact rate of earnings. With regard to past service, which is normally on a noncontributory basis,6 the exact rate of earnings for the year ending with the contract effective date is normally used. Most companies will permit use of an average over the five years previous to the effective date, but such practice is unusual, mainly because of the lack of earnings records. Minimum Retirement Annuity. If a minimum benefit is desired, it may be arranged under the contract by the employer's purchasing, at the time of retirement, whatever supplementary income is needed to provide the minimum. Such a benefit is used in many cases where limited or no past service benefits are provided for under the plan. Maximum Retirement Annuity. For many years insurance companies limited the amount of annuity which might be purchased for one employee according to schedules based on either the size of the group or the size of the group and the average earnings of the fifty highest paid eligible employees. This maximum was designed to prevent one or two lives with extremely high salaries and possible benefits from completely distorting the experience of the case. For example, if there are fifty lives involved, of whom five men each received a $100,000 annuity and the other forty-five $5000 each, one higher paid employee enjoying greater longevity 8 As with t h e o t h e r phases of the g r o u p a n n u i t y business, t h e r e h a v e b e e n e x c e p t i o n s to t h e general r u l e that past service benefits a r e o n a n o n c o n t r i b u t o r y basis. At least o n e c o m p a n y has a p l a n in force u n d e r w h i c h past service is provided on a c o n t r i b u t o r y basis. E v i d e n c e that it is u n u s u a l , however, is found in t h e fact t h a t t h e c o n s u l t a n t who set up this p l a n has copyrighted t h e tables he used in setting up t h e c o n t r i b u t i o n s .

130

Underwriting Group Annuity Contracts

than the average would completely distort the experience under the case.7 Since the passage of the Revenue Act of 1942, however, these schedules have not been used too frequently. Normally, in cases where the salaries grade smoothly from the executive group to the lower paid categories, no limitations are imposed. In fact, most companies today will not impose any limitation if the plan is approved as nondiscriminatory by the Internal Revenue Service. Restrictions on Optional Annuity Forms. T h e insurance company could not afford to allow any employee to elect an optional form of annuity with no regard for the possibility of adverse selection. T h e death benefit provided under the various optional forms varies, and it is necessary for the insurance company to place some restrictions on the election of such forms to insure that there will be an average experience thereunder. Provided he furnishes evidence of good health, an employee is permitted to elect any option permitted under the contract. In order to make the plan more useful as a solution to the retirement problem of the employer, most group annuity plans provide that the employee need not furnish evidence of good health, if the election is made a specified time prior to retirement. T h e usual limitation on the joint and survivor and life annuity certain options is five years prior to retirement, although some companies require only a three-year notice for the latter. In the case of the modified cash refund option the restriction is only one year prior to retirement, since the value of the death benefit under this option is considerably less than under the joint and survivor or life annuity certain options. Where advance notice is required, it is necessary to provide against the possibility that some individuals in the group may change their status because of the condition of their health. T h e election must be made with respect to a definite retirement date and unless satisfactory evidence of good health is furnished, changes are not usually permitted either in the form of annuity selected or in the person designated as joint annuitant. But under unusual circumstances the insurance company will per1 T h i s illustration brings out the point that it is not the rate of mortality which is important in determining mortality costs, but—as represented by the reserve released—the rate times the amount at risk.

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131

mit a change in the retirement date subject to stipulations as to the form of annuity which will protect it against severe adverse selection. In the case of a contributory plan where an employee retires one year or more prior to normal retirement date, he may elect the modified cash refund option without evidence of good health or previous election. T h e reason for this is that under group annuity plans a death benefit is always provided equal to the employee's contributions with or without interest. Therefore, when an employee retires at an early retirement date, the election of the modified cash refund option merely substitutes a death benefit where one would already be available had the employee not retired. Even with these limitations some selection still persists. But virtually all companies prefer to ignore the selection that remains and do not make a selection charge. Premiums Future Service. Under noncontributory plans, the employer pays the premium necessary to purchase the benefits credited during that year or, if the plan is on a money purchase basis, he pays a given percentage of salary. If the employees were called on to bear an excessive proportion of the cost of a plan, it would be difficult to enroll employees and maintain participation in the plan. For this reason, most companies place a limitation on the proportion of cost which the employee may be asked to bear under a contributory plan. T h i s limitation is generally effected by providing for various maximum " r " ratios 8 for different normal retirement ages. T a b l e 9 presents two typical schedules of maximum ratios permitted with three normal retirement ages. Basically, these ratios are established according to current economic factors and are considered the maximum proportion which the employee can be called on to contribute. If economic conditions were to change radically, these ratios would have to 8 T h e " r " represents the ratio between the employee contribution and annuity earned or credited for a given period of service. For example, if employee contributed 4 per cent of salary and the benefit credited for period is 2 per cent of salary, the ratio would be two to one, and would be two.

the the the "r"

132

Underwriting Group Annuity Contracts

be revised. Since they are only an estimate, however, a rather substantial change in conditions would be necessary to produce a revision. Again, since they are approximations, an underwriter may permit deviations from these ratios according to the circumstances. Some companies will permit a slightly higher ratio to be used for earnings over $4200 than for earnings under $4200 provided TABLE 9 T Y P I C A L SCHEDULES O F M A X I M U M R A T I O S O F E M P L O Y E E CONTRIBUTIONS TO B E N E F I T S C R E D I T E D FOR T H R E E

NORMAL RETIREMENT

ACES

Maximum Ratio for Plan Using Normal Retirement Age Schedule A

Β

60

65

70

4 -1 4>/,-l

3I/ 2 -1 3i/ s -l

2./rl 2>/,-l

a substantial number of lives are involved. Contrary to earlier practices, today n o company will permit an employee to contribute toward any additional income not under the regular program. 9 Also, no employee is permitted to continue contributions after termination of employment even though he does not take his contributions in cash. Past Service. As was mentioned earlier, most past service benefits are paid for by the employer. Generally, an employer may pay any part or the entire cost of past service benefits up to a maxim u m of, say, $300,000 in any one accounting year. However, since the tax law permits a m a x i m u m deduction in any one taxable year of only 10 per cent of the initial past service cost of the plan, most employers amortize this cost over a period of about eleven and one-half years. T h e only limitation imposed by the insurance company is that the cost be paid at a rate sufficient to purchase the full past service annuity of each employee at or before the time he is retired. A few companies require that the past service liability be completely amortized within thirty years, but such a rule is the exception. At present, when profit margins β T h e r e may well be a supplemental savings program, b u t it would not be a part of the group annuity contract itself. I n other words, discretionary employee contributions are not permitted under a group annuity contract.

Deferred Group Annuity Contracts

133

are high, most plans are being paid off over a much shorter period than thirty years. Some employers because of their profit position may want to pay the cost off over a shorter period than eleven and one-half years, since the tax laws do provide for a carry-over provision and the deduction is not lost even though excluded in the current tax year. In general, subject to the limitations on cash deposits, companies will permit almost complete flexibility in this regard. Where an employer pays only a part of the total past service cost at any one time, one of two methods is normally used in applying the premium. T h e first and most usual is known as progressive purchase. Under this method the past service benefits of those closest to retirement are purchased first. T h e n the group next closest to retirement have their benefits purchased, the process being continued until the premium is fully applied. In case there are a number of employees at the same point with relationship to retirement and the premium is not sufficient to purchase their full benefits, the premium is prorated and partial benefits are purchased for each such employee. T h e second method, known as prorata purchase, provides for the purchase of a specified percentage, say, 25 per cent of the past service retirement annuity of all the employees entitled to past service benefits. In the event a subsequent payment is not sufficient to make a prorata purchase of the same or a greater percentage, the premiums are automatically applied on the progressive purchase method discussed above, and all subsequent payments are similarly applied. Naturally, there are other methods which can be used in applying past service premiums. One surveyed company distributes each payment to the credit of each eligible employee in proportion to the number of years he will serve before retiring. 1 0 Again, an employer may accumulate past service premiums under a separate deposit administration contract and purchase past service benefits as each eligible employee retires. In most cases, the employer does not guarantee to his employees that the past service retirement annuities to which they are en10 This method is sometimes referred to as the "1/n method. For a more detailed description of this method, see Ilse, op. cit., p. 296.

134

Underwriting Group Annuity Contracts

titled will be purchased. Instead, the employer usually confines his statements to the effect that it is his intention to purchase all past service annuities, financial conditions permitting, and that it is also his intention to complete the purchase of any such annuity for an employee prior to the employee's normal retirement date. It is to be emphasized, however, that regardless of the method of purchase, the full past service annuity of each employee must be fully purchased at retirement. 11 Miscellaneous Transfers. Transfers of group annuity contracts from one insurance company to another are generally unsatisfactory both for the employer and for the employees. In many cases acquisition costs must be paid again, and the cost of establishing administrative procedures and records must be duplicated. From the employee's point of view his benefits are being handled at two different locations since the former company continues to administer benefits which have been purchased under the original contract. For these reasons most companies will not solicit business of employers carrying group annuities in another company. If an employer requests a proposal, the insurance company approached will usually submit a proposal in accordance with the employer's wishes and most companies will pay commissions on such business. One company surveyed handles such business on a level commission basis so that the agent receives little compensation unless the employer maintains his new contract in force for a number of years. Guarantees. Many of the group annuity contracts issued before 1935 were underwritten with a lifetime rate guarantee. Such a guarantee usually provided that rates could be changed on or after the fifth contract anniversary with respect to new employees but that no change in rates would apply to annuities purchased for employees covered under the plan before the date of change. Some contracts with lifetime guarantees provided that rates could not be changed for five years after a previous change. A few contracts with lifetime guarantees provided that rates could not be 11 Where the financial burden is particularly heavy at the inception of the plan, some companies will permit the purchase of past service benefits over a five or ten year period by using a series of temporary annuities. Even in this case the benefits purchased are fully paid for at all times.

Deferred Group Annuity Contracts

135

increased by more than a certain percentage of the original rates in any five- or ten-year period. T h e lifetime guarantee in g r o u p annuity contracts was an extension of the familiar lifetime guarantee under individual insurance policies. However, falling mortality and interest rates and increasing salary scales soon indicated that these guarantees were much too liberal, a n d the trend since 1933 has been to limit the guarantees in group annuity contracts. Most g r o u p annuity contracts issued in recent years contain a five-year term guarantee of rates and other provisions. On the fifth contract anniversary, the insurance company generally has the right to change any of the provisions of the contract, although in practice changes have been made mostly in those provisions which directly affect the cost. Changes in the rates usually apply to all purchases made after the date of change. But no change may be made in guarantees applicable to annuities purchased prior to the date of change. After the fifth contract anniversary, guarantees usually r u n from year to year, though in some instances rates may be guaranteed for a longer period than one year, particularly after a change in rates or a change in the benefit formula. Coinsurance T h e group annuity field does not use the reinsurance mechanism as it is used in most other lines of insurance. A n u m b e r of cases have been written on a joint basis, but the initiative has generally been taken by the employer and not by the insurance company. In other lines of insurance, reinsurance is used to make certain that an unusual fluctuation in experience will not disrupt the averaging process which is the essence of the insurance mechanism. T h i s is not a serious problem in the group annuity field, because of the size of the average risk as well as of the fact that there is averaging over time. 12 O n the other hand, some employers have felt that a plan written on a coinsured basis does have certain advantages for them. Usually, such employers are rather large and may desire to spread their business among two or more insurance companies for the sake of public relations. In addition, such a spread does provide greater diversification of risk. 12 Sec p. 189.

136

Underwriting Group Annuity Contracts

Normally, a coinsured plan is administered by one company, the participating companies sharing in the risk and income according to a given plan of proration. In operation, the administering company simply bills the other companies at the end of the year for their share of the cost of administration. Otherwise, there is no major difference between a coinsured plan and a plan underwritten by a single carrier. In general, insurance companies have not been anxious to participate in such arrangements, although all of the companies included in the survey have one or more contracts on a so-called coinsurance basis. Many problems can develop out of such an arrangement. Typical of these is the situation where one company wants to change its rate basis for the contract, but the other company or companies refuse to go along. T h e employer is then faced with the problem of either discontinuing the arrangement or continuing with two sets of rates and, consequently, with increased administrative costs. In addition, from the insurance company's point of view, its bargaining position is much stronger where it is underwriting its own contracts. Although the coinsurance method is still used in a number of cases which were written earlier, it does not appear to be gaining favor as a method of handling retirement programs. DEPOSIT

ADMINISTRATION

CONTRACTS

There is no fundamental difference in underwriting a case to be written on a deposit administration basis as compared with one to be written on a deferred group annuity basis. In each case, the insurance company is interested in a long-term contract and therefore seeks to screen out any employers who might not be able financially to carry the program under consideration or be suitably staffed to handle the administrative details efficiently. As a practical matter, the employers who request deposit administration funding are scrutinized somewhat more closely in these two respects. T h e basic questions in underwriting a deposit administration contract are the same as those for a deferred group annuity contract. T h u s , the stability of the employer and his ability both financially and administratively to handle the proposed retire-

Deposit Administration Contracts

137

ment program are the fundamental underwriting considerations, whether a deposit administration or a deferred group annuity contract is concerned. Minimum

Case

Requirements

Employer Eligibility. Generally speaking, the same type of employer is eligible for coverage under the deposit administration as under the deferred group annuity contract. Under a deposit administration contract, however, the insurance company depends upon the employer for the determination of the proper amount of annuity to be purchased when the employee ultimately retires. Therefore, it is essential that the employer's clerical staff be capable of keeping the pertinent records accurately and efficiently. Many deposit administration contracts arise as a result of union negotiations and the insurance company scrutinizes these carefully to avoid entering into a contract with an employer who has been pushed into a contract which he cannot reasonably hope to finance over an extended period of time. In addition to individual employers, most companies will issue a deposit administration contract to the trustees of a fund established for the benefit of the employees of a single employer or for the benefit of the employees of two or more employers or for the members of a labor union. T h i s type of "employer" is examined very carefully and most companies will not permit a quotation to be made on such a plan without special approval from the home office. Minimum Size. As far as minimum case requirements go, the number of lives required varies from 25 to 500. Again, as in the deferred group annuity contract, the minimum annual premium is probably more important than the number of lives. T h e minimum required premium varies rather widely. One surveyed company attempts to obtain $75,000 annual premium with past service included, 13 or $50,000 annual premium with past service included and 200 lives eligible with five years of service. Another surveyed company provides that a minimum annual premium of $25,000 is required. Others require simply that the future service cost and a certain percentage of the initial past service be deposited each year. One company surveyed, although it does set a 13 This means annual future service cost plus 2i/J per cent of the initial past service liability.

138

Underwriting Group Annuity Contracts

m i n i m u m p r e m i u m objective to meet the fixed expenses of establishing a n d m a i n t a i n i n g a retirement program, has n o formal m i n i m u m p r e m i u m requirement. It would seem, however, that some companies are attempting, in addition, to see that some reasonable basis of f u n d i n g is followed by the employer. 1 4 T h e question as to the need for such a control is of some concern today, and it is interesting to note in this regard, again, that one company sets n o m i n i m u m p r e m i u m requirement. Probably most companies will accept smaller cases t h a n these published m i n i m u m s provided the other aspects of the case are favorable. As in the case of the deferred group annuity contract, a basic consideration in this regard is whether the company pools mortality on small cases. From an actuarial point of view, a minim u m is not needed if there is an adequate rate structure and pooling of mortality on retired lives. 15 But other considerations, such as public relations, source of business, adequacy of employer's staff, and the like, indicate the desirability of a m i n i m u m size for this type of contract. Employee Contributions. A n u m b e r of companies will not issue a deposit administration type of g r o u p annuity where employee contributions are involved. Others will issue a deposit administration contract b u t only if the employee contributions are applied u n d e r a regular deferred g r o u p a n n u i t y contract. T h i s tends to offset some of the administrative advantages of the deposit administration contract, and a m a j o r i t y of the companies permitting employee contributions h a n d l e them in the same way as employer contributions until the employee either terminates, dies, or is retired. As a rule, most companies prefer to write the deposit administration contract on a noncontributory basis, a n d where employee contributions are involved, the m i n i m u m requirements are usually raised substantially. OTHER

CONTRACTS

I n u n d e r w r i t i n g g r o u p a n n u i t y contracts other than the deferred g r o u p annuity and deposit administration types, the general principles previously outlined are followed. Usually, the one 14 See p. 202. 15 S. L. Eisner, Discussion. " G r o u p Retirement Plans," Transactions Society of Actuaries, III (1951), p. 119.

of the

Other Contracts

139

or two important features that distinguish one contract from another will receive separate consideration but the normal underwriting rules are generally applicable. Immediate

Participation

Guarantee

T h e most important distinguishing feature of the immediate participation guarantee contract, which is really an adaptation of a deposit administration contract, is the provision, in effect, for an immediate contractual dividend. T h i s feature means that the employer is assuming practically all the risks of the plan. Hence, problems such as selection by the employee are viewed in a different light. Again, because of this feature, few insurance companies will issue this contract to any but the largest risks, to make certain that some sort of average experience may be expected. 16 Most companies will not issue an immediate participation guarantee contract unless the case involves at least 2000 lives. Usually also, the maximum and minimum payments under an immediate participation guarantee contract differ from those under the conventional deposit administration. These maximums and minimums are normally subject to negotiation, but generally fall within the limitations imposed by the tax laws. Thus, except for changes necessitated by this particular feature of the immediate participation guarantee contract, the normal underwriting rules used for the deposit administration contract are applicable. Group

Permanent

T h e most important distinguishing feature of the group permanent contract is the inclusion of substantial death benefits. Since this type of contract is in reality a form of group life insurance, group life insurance underwriting rules are usually applicable to the death benefits provided. 17 W i t h respect to retirement benefits, the same general underwriting rules used for deferred group annuity contracts are applicable. Only the most stable employments are ordinarily considered for this type of coverage because of the expense involved in shortterm enrollments, the problem of administering an excessive ιβ Another impelling force in this direction is the fact that the largest risks have more "weight" in the competitive situation existing today. 17 Gregg, op. cit., pp. 125-54.

140

Underwriting Group Annuity Contracts

number of small termination equities, 1 8 and adverse selection costs on conversions. Again, the necessity for stable employments is a result of the substantial life insurance benefits included in the group permanent contract. Space does not permit a thorough treatment of this particular contract, but, basically, the underwriting objectives are the same for this contract as for the other group annuity coverages, is See p. 174.

Chapter 9

Administration of Group Annuity Retirement Plans I n the administration of any group annuity retirement plan, some of the functions are assumed by the insurance company and others by the employer. T h e following discussion will describe broadly the usual role of the insurance company and that of the employer. INSURER

ADMINISTRATION

T h e administrative functions of the insurance company may be logically divided into the installation procedures used in establishing a new plan and those procedures employed after the installation. T h e s e latter procedures, which might be called in a general sense the servicing function, include the home office administration of the plan as well as the field services necessary for proper administration. Installation As soon as the negotiations have been completed, and a contract has been closed, the installation of the plan begins. T h e first step usually is to draw up an announcement letter and booklet. Sometimes the letter is included as the first page of the booklet, while in other cases a separate letter is distributed to each employee. Whether it is included as part of the booklet or not, the purpose of the letter and booklet is to inform the employees that a retirement plan is being adopted, and to explain the benefits and operation of the plan as they affect the individual employee. Just how elaborate the announcement booklet is will depend on the employer. T h e insurance company usually prepares the announcement booklet and submits it to the employer for approval. Large employers, however, frequently prepare their 141

142

Administration

own booklets, submitting them for approval by the insurance company to be sure that they are in accordance with the contracts negotiated. These booklets are distributed to all eligible employees regardless of whether the plan is contributory or not. In either case the employer wants the employees to know what the plan is doing for them, so as to maximize the intangible benefits such as improved morale and efficiency. In the case of a contributory plan, it is necessary to inform the employees, since they must enroll in the plan to be eligible for benefits. These booklets are distributed in advance of the enrollment procedure described below, to permit the employee time to study the plan. Once the plan has been announced to the employees, key personnel, such as foremen and supervisors, are briefed in meetings held with the company representative, who is usually a salaried specialist, although an agent or broker may be present or even handle the entire matter, depending on the circumstances. These key employees then discuss the plan with the employees under their supervision in preparation for the enrollment of individual employees in the plan. T h e actual enrollment procedure involves the signing of a card by each employee authorizing the employer to deduct contributions from the employee's pay and the naming of a beneficiary to receive any death benefits which may be payable under the plan. Usually, the company representative is present to answer questions regarding the plan and to follow through on this particular operation. Sometimes it may be a number of days after the effective date of the plan before a sufficient number of employees join the plan. As was mentioned earlier, most companies allow the employer thirty days after the effective date of the plan to obtain the minimum participation required. Naturally, under a noncontributory plan, this procedure is not necessary, although beneficiaries do have to be named where death benefits are involved. While the employees are being enrolled in the plan, the company home office administrative staff establishes routine administrative procedures and assigns responsibility for the plan to certain clerical groups. In addition to establishing proper procedures for handling the plan in the home office, an administration manual is prepared for the employer, explaining in detail the forms to be used and the procedures to be followed in the event

Insurer Administration

143

of terminations, deaths, retirements, new employees, a n d other r o u t i n e occurrences. Both the h o m e office procedures a n d the a d m i n i s t r a t i o n m a n u a l must be geared to the degree of administrative flexibility of the employer, and this part of the installation procedure is n o mean task. At times, an insurance company will recommend changes to the employer which will improve his accounting procedures and at the same time simplify the administration of the retirement plan. Like the plan provisions, the administrative procedures are designed to meet the individual circumstances of the employer. Servicing I n t e r n a l A d m i n i s t r a t i o n . T h e insurance company usually maintains most of the records in the h o m e office. T h e employer submits to the h o m e office each m o n t h pertinent data regarding new employees, retirements, terminations, deaths, and so forth. Details such as the preparation of certificates, change of name, and change of beneficiary are also referred to the insurance company. All such i n f o r m a t i o n is furnished on forms supplied by the company a n d in accordance with the administrative m a n u a l designed for the employer. From the i n f o r m a t i o n f u r n i s h e d by the employer, the company sets u p the following basic records: (1) a record card for each employee; (2) a p r e m i u m accounting card; (3) a commission accounting record; a n d (4) a retirement data card. T h e individual record card is p r e p a r e d in duplicate, one copy being sent to the employer for his records. T h i s form is used to keep a record of all data concerning employees participating in the plan and their contributions. T h e p r e m i u m accounting record, of course, is to record income a n d disbursements u n d e r each contract for a given year. As each p r e m i u m is received, it is recorded on the p r e m i u m card, showing the p r o p e r distribution of the p r e m i u m between f u t u r e and past service a n d employer a n d employee contributions. W i t h d r a w a l a n d d e a t h benefit payments are recorded as they occur d u r i n g the year. T h e commission accounting record is m a i n t a i n e d simply to account for the commissions u n d e r the contract. New employees entering the plan, as well as plan amendments, may p r o d u c e commissions even after the plan has been in force for a n u m b e r of years. T h e last record, the retirement

144

Administration

data card, is prepared for each employee as he retires. Only the data relating directly to the payment of retirement benefits are entered. Naturally, special circumstances require other records a n d / o r modification of these basic records. Of the administrative procedures necessary for the proper administration of a group annuity plan, three are extremely important: (1) annual premium reconciliation; (2) maintenance of the experience account; and (3) valuation of liabilities. As was pointed out earlier, the employer's premium is estimated by using a ratio between employee and employer contributions for the previous year, to simplify the premium accounting. At the end of each year, it is necessary to make a reconciliation and a proper adjustment in the employer's premium. This reconciliation involves considerable work and is a vital link in the proper administration of a plan. Maintenance of the experience accounts is a separate accounting function divorced from the routine accounting for the plan. T h e account maintained for each plan has benefit payments and expenses charged to it and interest income and premiums credited to it. It is this record which forms the basis for the determination of dividends and represents a running account of the experience of the plan. Rather elaborate reports—usually annual—are prepared for each employer presenting the experience of his own plan. A detailed statement of the experience account for the year is included as well as a running record of the account from the inception of the plan. T h e report usually includes also a statement showing the determination of the current dividend and all reserves established for the case and the basis on which they were established. Much time and expense are involved in the preparation of these statements, which are a product of recent years, and are viewed as an educational device by the insurance companies. In prior years, the employer never knew what was happening to his money and had no idea where his plan stood with regard to expenses or otherwise. Consequently, employers accepted as fact misinformation regarding expenses, reserves, and other matters. T h e use of this report has made for better relations between insurance companies and their group annuity clients.

Insurer Administration

145

T h e valuation of plan liabilities is closely related to the maintenance of the experience account, since the establishment of reserves for each case as well as the determination of dividends is an inherent part of maintaining these accounts. Valuation of liabilities is also necessary for annual statement purposes. T h i s function is performed by the group annuity actuarial staff and is very important. Most of the companies have simplified this work through the use of punch card machines for both calculation and tabulation work. Other routine administrative procedures are involved in the operation of a group annuity plan, such as those connected with calculating and disbursing benefits, but they are similar to those employed in paying other insurance benefits and need no elaboration here. T h e administrative procedures described above apply to the usual deferred group annuity case. In some instances a so-called "short method accounting" is used. Here the employer maintains most of the records, makes returns at time of death or withdrawal, issues and assigns certificate numbers, and makes routine changes in certificates. T h e employer reports premiums and data necessary to determine pensions, and generally handles much of the administration work prior to retirement. Under the selfaccounting method, the employer computes his own premium and sends it in month by month. T h e n at the end of the year, a reconciliation is made by the insurance company to account for salary changes, terminations, and other variable items. Field Services. T h e field services provided by the insurance company vary widely from plan to plan. Basically, field service consists of consulting with the employer to work out unusual problems as they arise. This may vary from simply providing certain information to a rather extensive amendment of the plan. As a specific example, to obtain an income tax deduction for his contributions to a group annuity retirement plan, the employer must file certain information with the Director of Internal Revenue. T h e insurance company normally prepares the information requested by the employer, although it must be filed by the employer himself. In addition, the insurance company will help the

Administration

146

employer with any accounting problems that arise from time to time. As to deposit administration funds, the insurance company does not have any responsibility for the adequacy prior to retirement and, consequently, does not need valuations. Where the employer so desires, however, valuations may be made by the company in accordance with the assumptions adopted by the employer and estimated premiums calculated. This type of valuation, namely, valuation of the employer's liabilities under his plan by reason of its terms, should be distinguished from the valuations made by the insurance company of its liabilities arising from money paid to it. At times, this field service involves a great deal of work because of the complexity of benefits usually funded under a deposit administration contract. T h i s function may be handled by the pension consultant if one is retained by the employer, but many companies prefer to make employer valuations themselves. EMPLOYER

ADMINISTRATION

Installation Just as the insurance company must establish office procedures, so must the employer establish routines for making payroll deductions, preparing reports to the insurance company, and making the various changes necessitated by employee terminations. T h e extent of the records maintained by the employer depends on the accounting system used. Naturally, where self-accounting is being used, all the personnel records for the plan are maintained by the employer, and setting up these records and a routine to handle them involves a great deal of work. T h e insurance company may render considerable help both through its representatives and through the administrative manual prepared for the employer. Regardless of the help, someone must be assigned the responsibility for the employer's functions in the administration of the plan. As part of the installation procedure, the employer must set up certain administrative policies as to leaves of absence, promotions, and military service. It is important that these policies be laid down from the beginning, to prevent the possibility of dissatisfaction at a later date.

Employer Administration

147

Servicing In addition to the necessary routine accounting, the employer has two other very important servicing functions: to keep the plan sold and to prepare employees for retirement. T h e importance of these functions cannot be overemphasized. Only if these functions are properly carried out will the plan attain the objectives for which it was established. It is shortsighted for an employer to spend hundreds of thousands of dollars for benefits and make every effort to attain 100 per cent enrollment at the inception of the plan, and then not carry through these functions, thus losing much of the value of the plan. For employers who wish to keep their plan sold, a n u m b e r of devices have been developed. Articles published periodically in the house organ have been very successful, as have posters located in strategic places. Many employers furnish a statement every year to each employee showing exactly what benefits have accrued to him under the plan. Naturally, some employees pay no attention to it, but experience has shown that this statement can be used to advantage. Some employers have chosen to dramatize the plan by giving a retirement dinner party for each employee as he retires, and such demonstrations have been very successful. Actually, there is no end to the devices that can be used to meet the problem of keeping the plan sold. In recent years, the employer has assumed another role perhaps more vital to the welfare of older people than might be generally realized. T h e preparation of employees for retirement has only recently begun to receive the attention it deserves. It is not within the scope of this study to dwell on this subject, but as the U n i t e d States population matures, this particular problem will assume ever greater importance. T h e employer's role is an educational one; he provides information regarding places where the cost of living is low, about good health practices, and other matters which are important to a retiring person. Most important is urging the employees to develop an avocation which will occupy their interest and provide an outlet for their energies after retirement. In many cases, this activity can be a source of income, and help meet the problem of decreased earnings after retirement as well as provide an interesting pastime.

148

Administration

Naturally, the employer must review his plan periodically to see if amendments are necessary. Normally, the employer will sit down with representatives of the company once or twice a year to work out problems which have arisen and to review the operation of the plan generally. If a pension consultant is retained, most of this type of servicing is performed by him.

Chapter ID

Analysis of Cost Factors T h e cost of any retirement plan is determined primarily by the benefits which the plan produces and not by the method of financing used. It is axiomatic that the cost of a retirement plan to the employer is the benefits paid plus the expense of administering the plan, less the amount of interest earned on the reserve, and less the amount of any contributions obtained from the employees. It must follow then that, other things being equal, the highest cost will be incurred by the plan producing the greatest benefits. In the following discussion, the cost referred to is the net financial outlay which an employer must make to provide a given set of benefits. T h i s is not, however, the true cost to the employer. In order to obtain the true cost of a plan, this cost or net financial outlay must be adjusted for such things as the net value, if any, of the loss of use of the cash investment in the plan, the value of income tax deductions, payroll savings, and intangibles such as improved efficiency, better employee morale, decreased turnover of employees, and so forth. T h e determination of such a true cost constitutes a difficult problem in accounting; it is practically impossible to reduce to a money value the gains from reduced labor turnover, retirement of inefficient employees, improved employee morale, et cetera. W h i l e these factors are difficult to evaluate, they have a very distinct bearing on the advisability of adopting a retirement program. T h u s , while the following discussion is concerned with the net financial outlays made by an employer, it should be recognized that the true cost of a plan will depend on these other additional factors as well.

149

Analysis of Cost Factors

150

MORTALITY

Mortality affects retirement annuity cost in two ways. T h e mortality rates prevailing before retirement age, together with the rate of withdrawal from employment, determine the number of persons who survive to collect an annuity at retirement age. Mortality rates prevailing after retirement, of course, determine how long an annuitant lives to receive benefits. Therefore, in order to determine the cost of providing retirement benefits, it is necessary to have a basis for estimating the future mortality of employees both prior to and after retirement. Normally, a mortality table is used for this purpose. Mortality experience varies among different groups of lives, and it is desirable to utilize that which appears to be most suitable for the given purpose. For example, the mortality among female lives has been much lower age by age than that of male lives. In recent years, mortality experience for females has conformed at most ages rather closely to that of males four to five years younger, and male rates with a corresponding five-year setback have been employed where female lives have entered cost calculations. 1 T h e mortality experience of the group of people who have bought life insurance has been different from that of the group who have bought annuities. T h i s indicates the necessity of using different tables for calculating the probable cost of life insurance and of annuities. T h i s distinction is also required by the fact that in order to provide a safety margin, a mortality table should tend to overstate the probability of the contingency for which it is used; for insurance purposes the table should indicate a higher mortality rate than will most likely occur, whereas for annuity purposes the table should indicate a higher survivorship rate than will most likely occur. T h e importance of this feature is magnified with respect to annuities because of the general trend toward increasing longevity. Mortality

Improvement

So long as mortality is improving—that is, so long as death rates are becoming lower and lower each year—the mortality element 1 By employing one scale and a shift for female lives, administration simplified.

is

Mortality

151

in t h e p r e m i u m s f o r life i n s u r a n c e causes l i t t l e c o n c e r n . O n the contrary,

a

steadily

increasing

margin

of

safety

is

produced.

W h e r e annuities and pensions are involved, however, mortality i m p r o v e m e n t m e a n s a steadily d e c r e a s i n g m a r g i n in t h e rates o r n o m a r g i n at all. P e n s i o n l i t e r a t u r e a b o u n d s w i t h r e f e r e n c e s to t h e i m p r o v e m e n t t r e n d in m o r t a l i t y . T h i s i m p r o v e m e n t t r e n d is c o m m o n l y r e f e r r e d t o as a s e c u l a r t r e n d , i.e., " t h e

cumulative

effect of all the l o n g - t e r m forces o p e r a t i n g to c h a n g e the m o r t a l i t y p a t t e r n in a given p o p u l a t i o n w i t h the passage o f t i m e . " 2

The

effects of s h o r t - t e r m forces such as e p i d e m i c s , w e a t h e r c o n d i t i o n s , wars, et c e t e r a , a r e s u p e r i m p o s e d u p o n this l o n g - t e r m t r e n d . T h i s s e c u l a r t r e n d is to be d i s t i n g u i s h e d f r o m o t h e r i n f l u e n c e s w h i c h affect the c h a r a c t e r o f m o r t a l i t y e x p e r i e n c e o f

insurance

companies under life insurance policies and annuities. In case o f life i n s u r a n c e , t h e r e is t h e selective effect of

the

particular

p r a c t i c e s a n d p o l i c i e s o f an i n s u r a n c e c o m p a n y in u n d e r w r i t i n g its business. A n d , t o o , the g e n e r a l c h a r a c t e r i s t i c s of the p e o p l e w h o b u y life i n s u r a n c e affect the m o r t a l i t y e x p e r i e n c e . O n

the

o t h e r h a n d , even t h o u g h t h e c o m p a n i e s d o n o t r e q u i r e a m e d i c a l e x a m i n a t i o n , p u r c h a s e r s of a n n u i t i e s a r e usually o n l y those w h o b e l i e v e themselves t o b e in e x c e l l e n t h e a l t h . T h i s self-selection by t h e p u r c h a s e r may b e c o m e less i m p o r t a n t d u r i n g a p e r i o d when m a n y a n n u i t y p u r c h a s e s are m a d e o n a c c o u n t of loss of c o n f i d e n c e in o t h e r c h a n n e l s o f i n v e s t m e n t . T h i s s e c u l a r t r e n d o f i m p r o v e m e n t is most clearly seen in areas o f m o r t a l i t y e x p e r i e n c e such as t h a t o f the g e n e r a l

population,

i n d u s t r i a l life i n s u r a n c e , g r o u p l i f e i n s u r a n c e , a n d g r o u p a n n u i ties, n o n e of w h i c h is s u b j e c t a p p r e c i a b l y to t h e selective influences a p p l i c a b l e to m e d i c a l l y e x a m i n e d i n s u r a n c e a n d to individual

annuities.

The

long-term

general

population

trends

are

believed to f u r n i s h t h e best a v a i l a b l e i n d i c a t i o n of the l o n g - t e r m trends u n d e r l y i n g

the mortality

decreases

among

annuitants.3

A l t h o u g h t h e r e has b e e n a c o m m o n i m p r e s s i o n t h a t f o r ages over 65 t h e r e has b e e n n o d e c r e a s e in m o r t a l i t y rates in the g e n e r a l p o p u l a t i o n , this is c o n t r a r y to the facts. T h e l o n g - t e r m decreases in m o r t a l i t y rates o f t h e w h i t e p o p u l a t i o n o f the U n i t e d States 2 Peterson, Future Mortality Rates and Pension Costs (printed privately, n.p., n.d.), p. 18. 3 W. A. Jenkins and E. A. Lew, "A New Mortality Basis for Annuities," Transactions oj the Society of Actuaries, 1 (1949), p. 401.

152

Analysis of Cost Factors

are shown in Table 10 for the period from 1920 through 1947. T h e data show that with advancing age there is a reduction in the rate of decrease and that female mortality, for each age group, has improved more than the male. T A B L E 10 LONG-TERM

D E C R E A S E S IN

U N I T E D STATES W H I T E

POPULATION

MORTALITY

RATES—AVERAGE R A T E OF DECREASE PER YEAR (GEOMETRICAL

Average Age

Group 15-24 25-34 35-44 45-54 55-64 65-74 75-84

Male 3-4% 3.7 2.1 0.4 0.1 0.1 0.3

BASIS)

Rate of Decrease 1920 to 1947 Female 5-5% 5.5 3.5 2.1 1.6 1.1 0.8

Source: Jenkins and Lew, op. cit., p. 399.

A recent survey of the general population experience at ages 65 to 84 years by sex since 1900 indicates that: (1) for both males and females at age 65-74 and also at 75-84 years there has been a substantial reduction in mortality since 1900; (2) for males this reduction has been uneven, with the rates stabilized at one level from 1900 to 1910, at a lower level from 1920 to 1940, and at a still lower level from 1945 to 1949; and (3) for females, the reduction has been quite consistent since 1900, and at a much greater rate than for males. 4

An examination of other areas of experience also indicates a trend of mortality improvement. For the period, 1935-40 to 194550, the mortality rates at ages 70 to 85 among males retired under the Federal Civil Service Retirement Plan showed an average annual decrease of at least per cent and there was even some improvement at the extreme old ages. For females, the annual decrease in mortality rates ranged from 1% per cent to 234 per cent for ages 60 to 85.5 T h e experience under group annuity con< Mortimer actions of the 5 Peterson, Actuaries, IV

Spiegelman, Discussion, "Annuitant Mortality Trends," TransSociety of Actuaries, IV (1952), p. 348. "Group A n n u i t y Mortality," Transactions of the Society of (1952), p. 266.

Mortality

153

tracts of all companies for roughly the same period displayed a similar pattern. 8 T h e experience for ages 65 to 74 among male industrial policyholders of the Metropolitan reveals about a 10 per cent drop from 1920 to 1940 and a 16 per cent drop from 1940 to 1950. In the case of females, the decrease from 1920 to 1940 for ages 65 to 74 was about 18 per cent and from 1940 to 1950, about 28 per cent. 7 Still other areas of mortality experience, such as group life insurance and the Railroad Retirement Plan, reveal varying degrees of mortality decreases in recent years. Although a review of the past reveals a steady decline in the mortality experienced by annuitants, the important point in estimating future annuity costs is the validity of the assumption that the recent past can be taken as a guide for the future. Will the rate of mortality stabilize at the level indicated by the most recent experience or will the death rate continue to decline as it has in the past? There is no certain answer to these questions. It is the consensus of informed opinion on this subject, however, that mortality rates at all ages, and certainly at the older ages, will continue to decrease in the future at a moderate, although somewhat irregular, rate. Typical of these opinions is the one expressed by Dr. Louis I. Dublin, Second Vice-President and Statistician of the Metropolitan Life Insurance Company in a recent paper: 8 Other areas of the public health, heretofore neglected, will certainly receive more concentrated attention in the future. T h e gains in longevity of which w e are so proud have greatly increased the numbers of older persons in the p o p u l a t i o n and have given greater emphasis to the diseases of middle life and old age, such as heart disease, arteriosclerosis, cancer and arthritis. W e have been p r o n e to consider these conditions the inevitable consequence of the aging process and as such beyond preventive or remedial measures. T h i s view has been shortsighted and not at all in line with the most recent developments in medicine. But we have at last awakened to the urgency of the situation, and a vast amount of research is now g o i n g o n to discover the causes β Ibid. 7 Spiegelman, op. cit., p. 348. 8 Dublin, "A Centennial of Public Health," American Journal of Public Health, December, 1949, p. 1641. For a rather extensive view of the informed opinion in this field, see Jenkins, and Lew, op. cit., pp. 407-13.

154

Analysis of Cost Factors

of cancer and of the other degenerative processes. With all this activity, it is only a question of time before their vital secrets will be revealed. Once they are known, it should be possible to determine the measures best adapted to counteract, or at least to postpone, the afflictions of old age.

Thus, there is much evidence to indicate a rather definite secular improvement in mortality, and the weight of informed opinion seems to predict a continuance of this trend. Since insurance companies are in the business of guaranteeing annuities and pensions, this is a factor which must be evaluated carefully. T h e following excerpt from a paper by Mr. R. D. Murphy, President of the Equitable Life Assurance Society of the United States, emphasizes this point: 9 . . . it becomes clear that one of the essential problems that has to be solved for the successful management of the annuity business is the forecasting of future mortality at lower death rates than have been experienced in the past. . . . it is a problem which necessarily involves a careful study of past experience, educated technique, judgment in projecting a forecast and courage to face the facts and their implications.

Current Mortality

Tables

T h e mortality table in use currently by the majority of companies is the 1937 Standard Annuity T a b l e in either a rated or unrated form. 1 0 T h i s table was based on the then most recent group life clerical experience at the younger ages (generally below 60) and individual annuity experience for the older ages. Although the use of individual annuity experience for the older ages did provide margins in that area, at the younger ages no basic safety margin was introduced and no provision was made for mortality improvement. T h e only margin at the younger ages was that which was implicitly provided by the inclusion of female lives in the group life experience and that which may have been provided by the use of clerical experience. Due to the continued mortality improvement at the younger ages, this 8 "Mortality A m o n g A n n u i t a n t s , " Journal of the American Society of Chartered Life Underwriters, II (1949), p p . 356-57. io See p . 179. Prior to the a d o p t i o n of the 1937 Standard Annuity T a b l e , the A m e r i c a n A n n u i t a n t s T a b l e a n d the C o m b i n e d Annuity T a b l e were used in that o r d e r by m o s t c o m p a n i e s writing g r o u p annuities.

Mortality

155

t a b l e was o u t of date, as f a r as mortality at such ages is concerned, shortly after it c a m e into general use. 1 1 In a noncontributory g r o u p a n n u i t y plan, the e m p l o y e r pays all of the cost a n d in a contributory plan the greater p a r t of it. If the individual a n n u i t a n t contributes, the a m o u n t he pays u n d e r the usual u n i t benefit p l a n is merely a percentage of his salary a n d does not d e p e n d on the rate basis. T h e r e f o r e , the p r o b l e m of equity a m o n g i n d i v i d u a l employees is not too i m p o r t a n t ; rather, the i m p o r t a n t thing is to m a k e each employer's contract self-supporting. In the past, this has been d o n e by k e e p i n g close watch on the experience of each contract a n d periodically adj u s t i n g the basis of rates a n d reserves to m a i n t a i n a m a r g i n of safety. It has also been the c o m m o n practice of insurance companies, in order to p r o v i d e a m a r g i n for i m p r o v e m e n t in f u t u r e mortality, to use a lower rate of interest than they w o u l d have used h a d a satisfactory mortality table been a v a i l a b l e . In s o m e companies, this practice may have taken the f o r m of simply being m o r e conservative in constructing a n n u i t y p r e m i u m s than in calculating p r e m i u m s for life insurance, where mortality improvement operates to increase m a r g i n s rather than to decrease them. O t h e r companies m a y have m a d e a rather c a r e f u l effort to cover a certain degree of mortality i m p r o v e m e n t in selecting the rate of interest used. In any case, it is true that the rate structure of the insurance c o m p a n i e s today generally involves a lower rate of interest for annuity contracts than for life insurance contracts. T h u s , a l t h o u g h there has been some a t t e m p t to meet the problem of mortality i m p r o v e m e n t , until recently no a n n u i t y mortality table forecasting mortality in a satisfactory m a n n e r has been developed in this country. In 1949, however, Messrs. W i l m e r A. J e n k i n s a n d E d w a r d A. L e w developed a new mortality basis for individual annuities in which they advocated the use of projection factors to allow for mortality i m p r o v e m e n t . 1 2 In substance, they presented an up-to-date mortality table together with several sets of alternate a d j u s t m e n t s to be used with the basic static table. T h e s e alternate a d j u s t m e n t s or projection factors m a k e specific allowance for f u t u r e decreases in mortality a n d each set varies by H Peterson, " G r o u p A n n u i t y M o r t a l i t y , " p. 246. 12 J e n k i n s a n d L e w , op. cit., p p . 369-466.

156

Analysis of Cost Factors

age, by the time that will elapse before annuity payments begin, and by sex. T h u s , J e n k i n s and Lew offered a method of forecasting mortality on a more explicit basis than had ever been used before. T h i s mortality basis was not designed with an eye to the group annuity business, but there has been much discussion regarding the possibility of application of the principles which J e n k i n s and Lew developed to group annuity problems. In 1950, at the meeting of the Society of Actuaries, 1 3 Mr. Henry E. Blagden, Second Vice President and Associate Actuary of the Prudential Insurance Company, presented a new mortality table—the 1950 Group Annuity Valuation T a b l e . While this table is more conservative than the 1937 Standard Annuity T a b l e , particularly at the younger ages, the only provision for mortality improvement at ages under 55 is that available in the basic safety margin and in whatever margin was introduced by the use of "predominantly clerical" experience for non-clerical employee categories. At the older ages, this table has margins over current experience, since the mortality rates were roughly equivalent to the 1937 Standard Annuity T a b l e with ages set back one year. In the discussion following the presentation of Mr. paper, the use of a conservative interest rate to provide improvement in mortality was criticized by the late ace R . Bassford, Actuary, Metropolitan Life Insurance as follows:

Blagden's for future Mr. HorCompany,

. . . I think we actuaries are prone to take the easiest way of arriving at a general result without thinking of the possible consequences. Group annuities offered at an extremely low interest rate are not attractive to many employers. It seems advisable to use a mortality table which will provide such margins. Moreover, the use of the low interest rate will make it seem as if there were a larger interest margin than is really the case. For many practical reasons, we should not use a margin in one factor for application to any other factor. 1 4

It was also suggested that this new static table would become unsatisfactory with the passing of time, and continued mortality improvement. 1 5 I n his reply to the discussion, Mr. Blagden acknowledged that " t h e use of the 1950 Group Annuity Valuation 13 "Actuarial Note: A New Mortality Basis for Group Annuities," Transactions of the Society of Actuaries, II (1950), pp. 322-27. 14 Discussion, "Actuarial Note: A New Mortality Basis for Group Annuities," op. cit., p. 330. 15 Peterson, Discussion, "Actuarial Note: A New Mortality Basis for Group Annuities," op. cit., p. 329.

Mortality

157

t a b l e is to some extent a stopgap measure." H e pointed out that h e agTeed entirely with Mr. Bassford as to the desirability of establishing a mortality margin, b u t that the only satisfactory m e t h o d of establishing a mortality margin is through the use of forecast tables. 1 6 T o date, only the P r u d e n t i a l Insurance C o m p a n y has adopted the 1950 G r o u p Annuity V a l u a t i o n T a b l e , b u t its adoption served to emphasize the urgent need for the development of a modern mortality table, and of some m e t h o d to allow for future mortality improvement. I n 1952, before the Society of Actuaries, Mr. R a y M . Peterson, V i c e President and Associate Actuary, E q u i t a b l e L i f e Assurance Society of the U . S., presented a paper on " G r o u p A n n u i t y M o r t a l i t y . " T h e purpose of M r . Peterson's paper was to e x a m i n e " t h e application to group annuity problems of the principles and approach developed by J e n k i n s and L e w . " 1 7 His p a p e r consisted of an u n p r o j e c t e d mortality table representing conservatively the current level of group annuity mortality experience, and a study of two alternative scales of mortality improvement associated with the unprojected mortality table. T h e u n p r o j e c t e d table was based on the latest available group annuity experience a n d would, for mortality rates c o n t i n u i n g indefinitely at the 1951 level, "provide an adequate mortality basis for p r e m i u m s and reserves for deferred annuities b e g i n n i n g at a fixed retirement age (and for immediate annuities provided at the inception of a plan or as supplements at retirement) with respect to a typical group of employed persons . . , " 1 8 T h i s basic static table when associated with the projection factors produces a series of generation tables which vary by year of issue and year of exposure. M r . Peterson's paper included a comparative reserve study to " e n a b l e the actuary to consider whether the c o n t i n u e d use of the 1937 Standard Annuity T a b l e is appropriate for group annuity purposes, to determine whether an interest differential is a satisfactory means of allowing for mortality improvement, and to e x a m i n e the adequacy in the future of individual and aggregate reserves computed by static mortality t a b l e s . " 1 9 W h i l e Mr. Peterson expressed the hope that his paper would 1β Blagden, op. cit., p. 330. 1 7 "Group Annuity Mortality," op. cit., pp. 246-307 18 Ibid., p. 247. ie Ibid., p. 248.

158

Analysis of Cost Factors

b e of value in helping the actuary select a mortality basis for g r o u p annuities a n d pensions which is entirely self-sufficient, he pointed out in his concluding comments that it remains for the individual actuaries to d e t e r m i n e whether the use of a static table, with or without an ultra conservative interest rate, or a table with projection using a self-sufficient interest rate, will best serve their purpose. W h i l e it was not his intention to draw specific conclusions or develop specific recommendations, Mr. Peterson felt as a result of his study that there is much to be gained by using a mortality table with projection, together with a loading a n d interest rate which a p p e a r reasonable to the layman. Comparison of 1937 Standard Annuity Table ivith Group Annuity Mortality Table for 1951 with Projection T h e majority of companies use the 1937 Standard Annuity T a b l e in their current rate bases. In view of the secular trend toward improvement in mortality, it might be well to compare this static table with a table based on more recent experience and m a k i n g allowance for f u t u r e mortality improvement, to determ i n e if the static table still provides a satisfactory basis for estim a t i n g mortality. T h e standard of comparison used is the G r o u p A n n u i t y Mortality T a b l e for 1951 with Projection, which is based on the most recent group a n n u i t y experience and makes a reasonable assumption as to f u t u r e mortality improvement. As m e n t i o n e d earlier, the mortality factor in pension plans may be divided into two parts: first, the n u m b e r of persons that may be expected to survive to retirement age a n d secondly, the p r o b a b l e average f u t u r e lifetime of those who do survive. Regarding mortality prior to retirement, the 1937 S t a n d a r d Annuity T a b l e indicates that of a g r o u p of 1,000 males alive at age 35, 718 will survive to age 65. If the ages are set back one year, this table produces a figure of 735 o u t of 1,000 at age 35 as survivors to 65. Based u p o n the G r o u p Annuity T a b l e for 1951, representing conservatively the 1951 level of mortality rates u n d e r g r o u p a n n u i t y contracts, the n u m b e r of m e n at age 35 w h o may be expected to reach 65 is 787. However, this figure does not allow for any f u t u r e decreases in mortality rates below the 1951 level. W h e n a reasonable allowance is m a d e for such decreases, the n u m b e r that may be expected to live to 65 out of

Mortality

159

1,000 males is 833. In other words, the improvement that may reasonably be expected to occur over the next thirty years would be such that 833 males out of 1,000 alive in 1952 should survive the period from 35 to 65. It is evident from these figures that the 1937 Standard A n n u i t y T a b l e , even with an age setback, is not a satisfactory basis for predicting the n u m b e r of persons w h o will survive to 65. As to the probable average f u t u r e lifetime of those w h o reach 65, the expectation of life for m e n based on the 1937 S t a n d a r d A n n u i t y T a b l e is 14.4 years with n o setback in age a n d 15 years with a one-year setback. T h e G r o u p Annuity 1951 T a b l e , representing conservatively current levels of mortality, shows a life expectancy at age 65 for m e n of 14.2 years. 20 Again, this figure does not allow for probable f u t u r e decreases in mortality rates. A f t e r m a k i n g reasonable allowance for such decreases, a g r o u p of men age 65 in 1952 may be expected to have an average f u t u r e lifetime of 14.8 years. But, this is not the whole story. As mortality continues to improve, persons u n d e r 65 today may be expected to have, w h e n they reach 65, a greater average f u t u r e lifetime than those w h o are 65 in 1952. A new table, with reasonable allowance for f u t u r e mortality decreases, produces for a g r o u p of males reaching 65 in 1972 (now age 45) an average f u t u r e lifetime of 16.1 years a n d for a similar g r o u p reaching 65 in 1992 (now age 25) an average lifetime of 17.2 years. It is evident that in figuring pension costs for persons w h o are well u n d e r 65 today, allowance must be m a d e for an average f u t u r e lifetime after 65 considerably greater than t h a t according to the 1937 S t a n d a r d Annuity T a b l e with or without a one-year setback in age. T a b l e 11 illustrates the need for a reconsideration of the mortality bases in use today. It shows the ratio of reserves in 1952 and 1962 c o m p u t e d on the 1937 Standard A n n u i t y T a b l e with per cent interest to reserves on the G r o u p A n n u i t y T a b l e for 1951 with reasonable allowance for f u t u r e decreases in mortality with an interest rate of 2i/£ per cent. T h e s e are 20 T h e reader may wonder why the life expectancy under the 1937 Standard Annuity T a b l e at age 65 is 14.4 years, whereas under the G r o u p Annuity 1951 Table, which is based on later experience, the life expectancy at age 65 is only 14.2. This a p p a r e n t inconsistency is due to the fact that the margins at the older ages in the 1937 Standard Annuity T a b l e are still relatively conservative.

160

Analysis of Cost Factors

reserves for deferred annuities without death benefit beginning at age 65. 2 1 Where the ratio is less than 100 per cent, it means that reserves or rates on the assumed rate basis of 1937 Standard Annuity T a b l e and 2|4 per cent interest are less than those on an up-to-date mortality table with 2i/ 2 P e r cent interest. T h e preceding discussion indicates that the 1937 Standard Annuity T a b l e is probably not a satisfactory basis for estimating mortality in computing guaranteed rates. Commenting on Mr. Peterson's paper, Mr. C. A. Siegfried, Associate Actuary of the T A B L E 11 R A T I O OF RESERVES ON 1 9 3 7 STANDARD ANNUITY T A B L E AND 2'/i% INTEREST TO RESERVES ON G A - 1 9 5 1 T A B L E WITH PROJECTION AND 2 1 , 4 % INTEREST

Male Age in 1952 25 35 45 55 65 75

Calendar 1952 79.84% 82.96 87.52 92.03 99.36 106.55

Year of

Comparison 1962 78.82% 82.91 88.32 95.68 102.86 110.18

Source: Peterson, op. cit., p. 276.

Metropolitan L i f e Insurance Company, stated: 2 2 " . . . it seems to me that an effective demonstration is made that the 1937 Standard Annuity T a b l e with ages set back one year is far from the excessively conservative table some critics of insurance company rates have maintained. T h e converse seems to be the better view . . ." Certainly, if mortality continues to improve, a new basis for estimating mortality will have to be adopted. T h i s demonstrated need for a new mortality basis has focused attention on two possible methods of handling mortality improvement. T h e first and the one currently used is to employ a static table and a relatively conservative interest rate. Gradually, as mortality improves, the static table becomes less satisfactory and companies either set back the table or depend upon the 21 For annuities where contributions are returned in event of death, these ratios would be somewhat greater for ages under 65. 22 Discussion of R . M. Peterson, "Group Annuity Mortality," Transactions of the Society of Actuaries, IV (1952), p. 726. Mr. Siegfried feels that the 1937 Standard Annuity T a b l e rated one year combined with a 2i/i per cent interest rate is a satisfactory basis.

Mortality

161

margin provided by the conservative interest rate to make up the deficiency in provision for mortality. Eventually, the table becomes completely unrealistic and a new static table is developed. T h e other approach, which is receiving serious consideration today, is to employ a mortality table which is self-sufficient and automatically provides for mortality improvement together with a more realistic interest rate. T h i s latter approach is implemented through the use of forecast tables employing the projection principle. Advocates of the use of a static table point out that the static table works satisfactorily and must be revised only infrequently. T h e y argue that the rates of improvement employed to develop the forecast tables are only estimates and will have to be revised in any event, and that if changes in mortality occur at rates which differ from the assumed rate of change, it may well be more difficult to defend the continuation of a particular table. T h e y also point out that in dealing with an element such as rate of mortality which is likely to move irregularly, it is better to deal with it at more extended intervals when there is greater knowledge as to what changes are occurring than on an automatic year-byyear basis. In addition, they assert that in practice the administration of a static table is easier than that of a table with projection. 2 3 T h o s e who favor the use of the projection principle point out that revision of a static table requires positive action which may be delayed for one reason or another. On the other hand, forecast tables automatically provide for mortality improvement, and it is easier to achieve reasonable equity between different contractholders than if static tables are used. For example, if an ultraconservative interest rate is used in conjunction with a static table, there is the problem of equity between annuity forms with no mortality risk before retirement and those with full mortality discount prior to retirement. W i t h a self-sufficient mortality table and a realistic interest rate, this problem is obviated. T h e y point out also that rates and reserves will have desired margins, so that losses will not develop as a result of mortality improvement. It should be remembered that rates used for immediate annuities under deposit administration contracts may be guaranteed for 23 ibid.

162

Analysis of Cost Factors

purchases extending over a period of fifteen to twenty-five years. Advocates of the use of a mortality table with projection, together with a loading and interest rate which appear reasonable to the layman, feel that any administrative and other problems can be worked out and that the effort is a small price to pay for making proper provision for mortality. 24 In the long run, it would seem more equitable and reasonable to attempt to establish a mortality basis which is realistic and which automatically provides for the future improvements in mortality that seem practically certain to come. Naturally, the administrative problems and cost of employing forecast tables must be weighed against the advantages to be gained. Certainly, the interest rate is an important consideration competitively; it is the one factor that employers fully understand. It would seem important, from a sales viewpoint, to have an interest assumption which appears reasonable to the layman. Most companies are concerned over the present mortality experience and are considering steps to be taken to meet the problem of mortality improvement. While there has not been time as yet for a complete evaluation of the study made by Mr. Peterson, the projection principle has aroused a great deal of interest. 25 Effect of Mortality Improvement

on Pension

Costs

When reasonable allowance is made for probable mortality decreases in the future, the figures given for the expectancy of life at age 65 indicate an increase of about one and one-fourth years every twenty years. As a further indication of this steady increase in pension costs, T a b l e 12 shows the ratio of reserves on the 1937 Standard Annuity T a b l e with 2\/2 P e r c e n t interest to reserves on the projected table with an interest rate of 2ΐ/£ per cent for a group of males attaining age 65 in 1952, 1962, 1972, 1982 and 1992. These figures demonstrate the steadily increasing value of a pension beginning at age 65, and it can be observed that this 24 Peterson, op. cit. 25 It is interesting to note that the Province of Alberta, Canada, is employing mortality tables in its retirement annuity program which make specific allowance for anticipated improvement in mortality. They do this by making separate tables of rates according to ten-year groups of year of birth. See L. E. Coward, "New Annuity Tables Allow for Improvement in Mortality," Employee Benefit Plan Review, Fall, 1951, p. 22.

163

Interest

increase is at the rate of about .38 per cent a year. In other words, a n a n n u i t y at 65 in 1962 is worth 3.8 per cent m o r e t h a n an a n n u i t y falling due at 65 in 1952. For deferred annuities where the mortality rate before retirement is involved, the increase in value is even greater. For example, at age 45, the value of a def e r r e d a n n u i t y ten years from now is 5 per cent greater t h a n it is today. If the assumptions as to mortality decreases are realized, T A B L E 12 R A T I O O F RF.SF.RVES ON

1937

R E S E R V E S ON G A - 1 9 5 1

STANDARD A N N U I T Y TABLE

WITH

TABLE

PROJECTION

AND 2 I / I > %

AND 2 I / J %

Year of Attaining Age 65

Ratio

1952

97.31%

1962

93.71

1972

90.50

1982

87.65

1992

85.10

INTF.RF.ST

TO

INTEREST

Source: Peterson, op. cit., p. 276.

increases in pension costs at a fixed retirement age are inevitable a n d must be faced w i t h realism a n d prudence. 2 6 INTEREST

A second factor affecting a n n u i t y costs is the interest rate earned on the funds held by an insurance company. Any earnings produced through the investment of such f u n d s by the insurance company naturally reduce the a m o u n t necessary to provide a given set of benefits. T h i s reduction in cost is substantial a n d is a very i m p o r t a n t factor in m a k i n g the decision to f u n d a retirem e n t benefit in advance. T h e annuity f u n d s held by the company are merged with the other assets of the company and are invested jointly with these other assets. T h i s provides a greater measure of protection against adverse investment fluctuations because diversification can be carried m u c h f u r t h e r than if the f u n d s of each plan were invested separately. A l t h o u g h these f u n d s are jointly invested, a separate 26 T h e previous discussion has been based in the m a i n on the a s s u m p t i o n s as to mortality decreases developed by Peterson in his study, "Group A n n u i t y Mortality." T h e validity of the discussion rests on the realization of these assumptions. T h o u g h there is a difference of o p i n i o n regarding the a m o u n t of improvement and m e t h o d s to provide for it, there is agreement that s o m e i m p r o v e m e n t will take place.

164

Analysis of Cost Factors

record of the financial experience under each group annuity contract is maintained by the insurance company. 27 Each year, the insurance company credits the various accounts with their proportionate share of interest earnings based on the average or effective size of the fund for a given calendar year and the interest rate credited to the group annuity business. The Experience

Rate

T h e earnings rate credited to the group annuity business is basically the over-all net investment earnings rate for the company. This over-all net rate usually takes into account capital gains and losses, although at least one large company handles the capital gain or loss adjustment through a separate charge or credit to the experience accounts. A majority of the companies adjust this net over-all rate to exclude interest on individual policy loans since this interest arises through a source peculiar to individual policies. 28 This final adjusted net rate, the group annuity experience rate, is credited each year to all experience accounts, thus increasing each asset share or fund with respect to each group annuity contract by the proportionate earnings for that year. In the case of immediate participation guarantee contracts, a few companies also make a slight additional adjustment in the experience r a t e — o f 1 per cent in one company and 1 per cent of the experience rate in another company. 28 This adjustment is made to provide for contingencies. Although the immediate participation guarantee contract is self-rated, there is a residual guarantee since the insurance company must provide lifetime benefits for those who have already retired in the event the employer stops payments to the plan. In examining the earnings rates of different companies, care should be taken that they are calculated on a comparable basis. For example, as mentioned earlier, at least one company does not adjust its earnings rate directly for capital gains and losses; this can make a substantial difference in the final rate. Similarly, if 27 This record is variously called the experience account, internal record account and other descriptive titles. 28 In the past, this adjustment has run from .03 per cent to .05 per cent. 29 jn this latter case, if the experience rate before this adjustment is 3 per cent, the adjustment referred to would be .03 per cent (.01 χ .03).

Interest

165

a company considers Federal income tax as partly investment expense a n d partly operational expense, comparing its experience r a t e with that of a company which handled such taxes as investm e n t expense only produces a distorted picture of the investment ability of the two companies. T h e individual company rates underlying T a b l e 13 have been adjusted to a c o m p a r a b l e basis 30 a n d weighted by each company's investment income. T h e resultant average rates should not be considered typical for any particular company, b u t they illustrate the trend in investment earnings which have been credited to g r o u p a n n u i t y contracts. T A B L E 13 EARNINGS CREDITED TO GROUP ANNUITY BUSINESS—AVERAGE FOR SEVF.N LEADING COMPANIES FOR PERIOD 1 9 4 2 1 9 5 3

Year 1942 1943 1944 1945 1946 1947 1948 1949 1950 1951 1952 1953

Rate

Credited

3.14% 3.86 3.99 4.08 3.08 2.90 2.93 3.03 3.12 2.95 3.11 3.10

Source: O p e r a t i o n a l Records of Seven C o m p a n i e s Surveyed.

T h e rates included in T a b l e 13 do not necessarily agree with the usual published rates since the group annuity experience rates shown here include capital gains a n d losses whereas the companies' published rates d o not. T h i s fact also explains the substantial year to year changes. T h e insurance company's continual inflow of cash f r o m new business enables it to avoid large cash reserves and permits t h e m to concentrate on long-term securities. T h e r e is very little lag between receipt of f u n d s a n d their investment by the insurance company. So far as the employer is concerned, there is n o lag, since the effective rate credited is applied to the actual a m o u n t 30 All rates were a d j u s t e d to i n c l u d e capital gains a n d losses a n d F e d e r a l income taxes.

166

Analysis of Cost Factors

of his experience f u n d from the date of receipt at any particular time. This may not be true of other investment outlets for pension plans. Effect of Interest

on Pension

Costs

It should be remembered that although the insurance company guarantees an interest rate of, say, 2}4 or 2i/ 2 P e r c e n t ' n ' t s rate structure, earnings in excess of this are credited to the individual funds or experience accounts and returned to the employer through the operation of the dividend formula, or an experience rating formula if the company is not a mutual company. 3 1 T A B L E 14 A P P R O X I M A T E E F F E C T O F V A R I A T I O N S IN I N T E R E S T A S S U M P T I O N T O T A L SINGLE P R E M I U M

S.A. S.A. S.A. S.A. S.A.

Source: A d a p t e d Crosby, Inc.

Loading 00 00 00 00 00 S3

Mortality

from chart prepared

ON

COSTS

Interest

Relative Cost 108%

2 %

100

'2 Ά 2 Ά

92 85 79

3

by Towers,

Perrin,

Forster

and

A dollar invested at 3 per cent compound interest will double itself in twenty-four years. Therefore, assuming a 3 per cent rate, if a person comes into a plan at age 40 and is retired at age 65, any a m o u n t set aside for him at age 40 will be more than doubled by the time he has attained age 65. Roughly, therefore, amounts put into the f u n d for him uniformly over the twentyfive-year period may be considered to increase by some 46 per cent on account of interest. It can be seen, then, that the factor of interest over a long period of time can be a most important one in reducing the a m o u n t necessary to provide a given level of benefits. T a b l e 14 presents the approximate effect of variations in interest assumption u p o n total single premium cost for an average group of employees with definitely determined net deferred benefits. 31 T h i s excess interest is available for dividends, b u t may n o t be r e t u r n e d immediately, d e p e n d i n g on t h e experience u n d e r the case. See p. 188.

Expenses

167

As a rule, a differential of

per cent in earned interest rate

will produce a differential of a b o u t 6 to 7 per cent in the long r a n g e cost of a plan. T h e above

figures,

however, assume ad-

v a n c e f u n d i n g . Actually, the effect of the interest factor depends on the age distribution and the m e t h o d of f u n d i n g employed. 3 2 D e p e n d i n g on these factors, a 1 per cent differential in earned interest rate may m a k e as m u c h as a 2 0 to 4 0 per cent difference in cost. 3 3

Effect of Federal The

favorable

Income

Tax

treatment granted " q u a l i f i e d "

pension

plans

u n d e r the Federal income tax law has been described. T h e same r e q u i r e m e n t s and tax status are a p p l i c a b l e whether the plan is f u n d e d t h r o u g h a trust or through the m e d i u m of a g r o u p ann u i t y c o n t r a c t , e x c e p t that the investment earnings of a trust are t a x e x e m p t whereas the investment earnings of a life insura n c e c o m p a n y are taxed. Because of the growing i m p o r t a n c e of the Federal i n c o m e tax since 1948 on the earnings of insured pension plans, and, consequently, on their competitive position with regard to uninsured plans, it might not be amiss to examine briefly the effect of this t a x on the earnings of the insurance company. T o illustrate the effect of the Federal income t a x on the experience rate, one company's interest record before and after Federal i n c o m e tax for the last twelve years is presented in T a b l e 15. Table

15 shows clearly that the weight of this t a x has been

particularly heavy since

1949, d u r i n g a period when

pension

activity a n d c o m p e t i t i o n have been at a very high level. A difference of .18 per cent may not seem large, but when it is applied to a large f u n d over a period of years, the burden is a substantial one.34 EXPENSES

T h e expenses i n c u r r e d in the group a n n u i t y business may be 32 See p. 180. 33 W i l l i a m W. Fellers, "How Much Is It Going to Cost?", Handbook for Pension Planning, p. 158. 34 T h e Federal income tnx applicable to life insurance companies for 1953 was 334 per cent of the first $200,000 of net investment income and 6 y 2 P e r cent of net investment income in excess of $200,000.

168

Analysis of Cost Factors

classified into three major categories: acquisition costs; administrative costs; and taxes. Acquisition

Expense

T h e acquisition expense category includes two main types of expenses: (1) commissions and (2) other sale and solicitation expenses. Because of the technical nature of the group annuity business, the typical agent is not qualified to handle the details T A B L E 15 ILLUSTRATION OF THE EFFECT OF FFDFRAL INCOME T A X ON INTEREST EARNINGS OF ONE LARCE COMPANY FOR PERIOD 1 9 4 2 - 1 9 5 3

Year 1942 1943 1944 1945 1946 1947 1948 1949 1950 1951 1952 1953

Earnings Before Federal Income Tax 3.56% 3.79 4.16 4.20 3.25 3.04 3.09 3.12 3.22 3.28 3.35 3.25

Earnings After Federal Income Tax

Difference

3.46% 3.70 4.07 4.25 3.21 3.04 3.09 3.04 3.11 3.09 3.14 3.07

•10% .09 .09 .05 .04 .00 .00 .08 .11 .19 .21 .18

Source: Operational Records of O n e Large Insurance Company.

involved and normally a salaried representative will take over after a prospect has been contacted, and carry the negotiations to a conclusion. For this reason the commission scale paid on group annuities is considerably lower than that for individual policies reflecting a selling commission as such. In addition, of course, a group annuity contract represents a collection of annuities sold on a wholesale basis, and this factor also affects the level of agent compensation. There are, however, numerous brokers who are not only capable of carrying on the negotiations but have a large staff capable of providing many of the administrative services provided by the insurance company. T h i s is significant inasmuch as a large majority of the group annuity business arises through brokers rather than agents. 35 These 35 This, of course, is not true for every insurer. At least one large company obtains better than 70 per cent of its business through its own agency force.

Expenses

169

brokers usually receive service fees from the employer who retains them, however, and the commission paid on the contract is not their main source of income. Naturally, the services provided by the brokerage firm (and paid for by the employer) affects the administrative work of the insurance company and the expenses charged against the employer's contract are reduced accordingly. Basically, the broker and the agent receive the same commission on group annuity business. 3 6 TABLE

16

T Y P I C A L C O M M I S S I O N S C A L E S FOR G R O U P A N N U I T Y

Scale A

Portion of Annual Premiums I'i i-5i 5 20,000 Next 30,000 Next 450,000 Over 500,000

CONTRACTS

Scale

Commissions Percentage Premiums

as of

First Year

2nd to 10th Year

7.0% 3.0 1.0 0.4

1.5% 1.5 0.6 0.3

Portion of Annual Premiums First f 100,000 Next 400,000 Over 500,000

Β Commissions Percentage Premiums

as of

First Year

2nd to 10th Year

3.0% 1.0 0.4

1.0% 0.5 0.2

T a b l e 16 presents two commission scales in use today. Examination of this table will indicate that there is a difference between the two scales in the treatment given small cases. In Scale A, a case providing annual premiums of $20,000 will provide a first year commission of $1400 ( 7 % χ 20,000) whereas a similar case under Scale Β would provide a first year commission of $600 (3% χ 20,000). However, in the case of a plan with annual premiums of $500,000, the commissions would be $6800 (1400 - f 900 - f 4500) and $7000 (3000 - f 4000), respectively. W i t h respect to renewal premiums, Scale A provides a higher commission than Scale Β on both small and large cases. In general, the patterns of commission scales employed by the company surveyed are essentially the same as Scales A and B, although in individual cases there are slight deviations from the renewal scales shown here. 38 Some companies will m a k e payments directly to a consulting firm that has relieved it of a specific function it normally provides, but this is not a general practice. T h e r e has also been some consideration of a c o n t i n u i n g contractual service fee to compensate for specific functions assumed by the consulting firm. T h i s is a p r o b l e m that has not been solved completely, and the future may see some a d j u s t m e n t in the practices of t h e companies.

170

Analysis of Cost Factors

T h e only other important points illustrated by the table are the fact that the commission is graded by size of premiums a n d that a renewal commission is paid for the second through the tenth year. T h e gradation is due to the tremendous premiums involved in some cases and the renewal commission is used to mitigate somewhat the substantial expense burden of first year expenses. For example, take a small case with annual premiums of $20,000. If the company has an 8 per cent loading for expenses and contingencies, after paying the first year commission of 7 per cent, only 1 per cent would be available to meet all other first year expenses and provide for contingencies as well. Needless to say, many small cases are in the red for the first few years of the contract. This deficit is gradually recovered from f u t u r e premiums and within a few years, if the experience on the case is average, the dividend formula will usually produce a dividend. W h e n a contract is amended, the agent usually receives a commission only on that a m o u n t by which the revised a n n u a l prem i u m exceeds that paid in the year previous to the a m e n d m e n t . T h e salaried specialists mentioned above usually receive a basic salary, with a bonus for participation in successfully closed cases. T h e relationship between salary and bonus varies rather widely among companies; several companies employ a straight salary basis for this class of employees. T h e other sale and solicitation expenses include expenses on cases not closed, the expense of drafting and printing contracts and certificates, and the expense of installing contracts or extensions. Installation expenses usually include any item of expense which is incurred during the first policy year or during the first year of an extension, but which does not normally recur u n d e r the f u t u r e administration of the contract. Administrative

Expense

Basically, this classification embraces those expenses involved in the accounting process. Such items as establishing records a n d procedures for individual plans, maintenance of experience or f u n d accounts, premium accounting, payments of benefits, and other routine administration comprise the internal administration of the business. T h e external administration involves mostly checking on employer administration, reviewing the plan periodi-

Expenses

171

cally with the employer, and other service calls which vary rather widely from plan to plan. Taxes Included in this category as major items of expense are state p r e m i u m and income taxes, Federal income taxes, 37 and Social Security taxes; included as minor items are licenses, fees, and o t h e r taxes (except those included as an investment expense). Most of these items are self-explanatory and, except for the FedT A B L E 17 STATE TAXES COMPARED WITH T O T A L GROUP ANNUITY EXPENSES—AVERACE FOR SEVEN LEADING COMPANIES FOR PERIOD 1 9 4 2 - 1 9 5 3

Year

Percentage State Taxes of Total Expenses

1942 1943 1944 1945 1946 1947 1948 1949 1950 1951 1952 1953

33.2% 34.2 35.2 28.4 30.9 29.7 30.7 35.5 35.0 35.2 38.1 29.2

Source: A n n u a l Statements of Seven C o m p a n i e s I n c l u d e d in Survey.

eral income tax and state premium tax, are not substantial in amount. W h e n taken together, state taxes represent a substantial part of the total expense of operating the group annuity business. T a b l e 17 shows that state taxes have consistently run about onethird of total group annuity expenses. As mentioned above, premium taxes represent a large proportion of the state taxes imposed on the group annuity business. In all, thirty-three states and the District of Columbia currently impose a tax on group annuity premiums. Expense

Record

T h e only expense statistics available to the public are those included in the annual statements filed with the state insurance 37 Federal i n c o m e taxes a r e usually charged against investment income.

172

Analysis of Cost Factors

departments. In these statements, expenses are broken down into commissions, taxes, and "all other." Table 18 presents a twelveyear record taken from the annual statements of the seven leading companies. 88 These figures indicate that group annuity expenses have consistently run less than 3 per cent of annual premiums. However, expense figures and other data taken from the annual statements of the various companies must be interpreted with great care. In view of the different characteristics of their group annuity business, such as distribution of contracts by size, T A B L E 18 GROUP ANNUITY EXPENSES AS A PERCENTAGE OF N E T PREMIUMS—AVERACE FOR SEVEN LEADING COMPANIES FOR PERIOD 1 9 4 2 - 1 9 5 3

Year

Total Expenses

Com missions

Taxes

1942 1943 1944 1945 1946 1947 1948 1949 1950 1951 1952 1953

2.83% 2.78 2.50 2.54 2.69 2.69 2.61 2.87 2.40 2.56 2.57 2.57

.53% .50 .49 .48 .42 .43 .38 .40 .32 .33 .32 .31

.94% .95 .88 .72 .83 .80 .80 1.02 .84 .90 .98 .75

All

Other

1.36% 1.33 1.13 1.34 1.44 1.46 1.43 1.45 1.24 1.33 1.27 1.51

Source: A n n u a l Statements of Seven Companies Included in Survey.

type, number of years in force, varying accounting practices, and so forth, annual statement figures do not provide a reliable comparison of performance for the various companies. Table 19 illustrates the possible effect of such variables. It shows a detailed statement of expenses, exclusive of state taxes, as a percentage of annual premium varied by number of lives involved, and number of years the contract has been in force. Several interesting facts regarding group annuity expenses are illustrated by Table 19. T h e first is the fact that expenses as a percentage of premium income grade downward both as the size of case increases and with the passage of time. T h e reduction in 38 See A p p e n d i x C.

Expenses

173

the percentage of expense as the size of the case increases is due simply to the fact that certain fixed expenses do not vary with premium income. T h e grading of expense over time is, of course, due to the fact that renewal commissions are graded downward over a ten-year period, as well as to the fact that certain nonrecurring expenses are incurred in the early years of the contract. It will be noticed that this grading over time is not completely uniform, since expenses, percentagewise, increase when the contract moves from the two- to five-year to the five- to ten-year bracket. T h i s increase is due to the fact that at the end of five years, the guarantee period ceases and, in many cases in the TABLE

19

G R O U P A N N U I T Y EXPENSES FOR O N E C O M P A N Y

E X P R E S S E D AS A

P E R C E N T A G E O F A N N U A L P R E M I U M FOR O N E

Number of Lives Covered Under Contract Less T h a n 100 101- 250 251- 500 501-1000 1001-2000 Over 2000 All Contracts

Number Less

2

Than

7.00% 6.05 5.25 4.45 3.80 2.25 4.00

of Years Contract -

in

2 to 5

5 to 10

3.80% 2.90 2.40 2.00 1.65 .90 1.40

5.60% 5.00 4.10 3.30 2.20 1.20 1.70

YEAR

Force More

I han 10

5.00% 3.90 3.00 2.30 1.75 1.00 1.25

All Contracts 5.80% 4.50 3.50 2.60 1.80 1.10 1.50

Source: Operational Records of One Large Insurance Company.

past, new tables, rates, and other actuarial work were involved and charged to the contracts in that year. In addition, after a rate change becomes effective, the administration of the contract becomes more complicated. In the past several years, largely because of the impact of inflation, amendments to the plan were quite often made after a contract was five years old, with resulting increases in administrative expenses. One other important fact illustrated by T a b l e 19 is that expensewise the loading on small cases is not too conservative. 3 9 For most companies the loading on group annuity rates is 8 per cent. In view of the fact that many of the companies feel that a 4-to-6 per cent contingency reserve is necessary, it can be seen that margins are relatively thin on small cases. T h e answer to this problem may lie in some form of graded expense loading. See p. 180.

Analysis οί Cost Factors

174 OTHER

FACTORS

Turnover It has been pointed out that the mortality prior to retirement, together with the rate of withdrawal from service, determines the number of employees who survive to collect an annuity at retirement age. T h e more direct way of taking into account this rate of withdrawal or turnover is to include in the cost computation a discount for expected turnover for the employer concerned. T h i s is a matter which is subject to considerable judgment, particularly at the installation of a pension plan, for it is obvious that the very fact of having a pension plan may well serve to change the rate of withdrawal. In fact, one of the reasons generally given for establishing a pension plan is that it will reduce turnover. Another difficulty involved is that from the economic, political, and labor aspects, past experience may be very little indication of what may be expected in the future. Since the insurance companies do not feel that a risk which is within the control of the employer and employee should be included in any guaranteed rates, premiums for deferred group annuity plans are not discounted for employee turnover. Under such plans, employee terminations are accounted for as they occur. T h u s , when an employee withdraws before vesting occurs, the employer receives a full refund of his premium payments adjusted for the expense of termination as well as credited interest. T h i s refund is credited against future premiums and immediate effect is thus given to the experience for this cost item. In the case of a deposit administration plan, since no employee credits are purchased until retirement, turnover of employees does not involve the cancellation of annuities and records which occurs under the deferred annuity plan. If, in deciding what estimated premiums to pay into the deposit fund, the employer desires to consider turnover in the calculations, the insurance company will help him develop a table of withdrawal rates to be used. T h i s is not inconsistent with insurance company policy on turnover, however, since here and in the case of immediate participation guarantee plans the insurance company is not affected

Other Factors

175

in any way if the turnover experience differs from the forecast table. W h e t h e r discounted for, as it might be under a deposit administration contract, or otherwise, turnover has a very marked effect on the cost of a plan. It is generally recognized that only a relatively small number of those in a typical employee group at any given time are likely to remain employed by the same employer until they attain their normal retirement ages. Notwithstanding that labor turnover can only be estimated, it is a d o m i n a n t factor in pension costs. Whereas labor turnover reduces costs, vesting has the opposite effect. If the employer's contributions are fully vested in an employee, termination of the employee's service does not produce a credit for the employer, since the insurance company must continue to consider the employee as a member of the plan, the only difference being that there will be no more credits earned by the employee. Where the plan provides for conditional vesting, a credit will arise if an employee takes his contributions in cash. However, to the extent that vesting occurs, the savings in cost brought about by labor turnover is reduced. Depending on the liberality of the vesting provisions, vesting can materially affect the net financial outlay of the employer. Employee

Contributions

Another factor which has an important effect upon the net financial outlay which an employer must make to provide a given set of benefits is that of employee contributions. An employer's cost is never reduced by 100 per cent of the employees' contributions because employee contributions are always returned to the employee in the event of his withdrawal or death prior to retirement. Although the reduction in cost varies somewhat, depending on the age distribution and benefits provided, it usually runs from 60 to 70 per cent of the employee contributions. A plan could be written which did not return such contributions, but it is not considered practicable. A few states require the return of such contributions and, in addition, it is felt that the employees would not understand or tolerate a plan which did not return their contributions.

176

Analysis of Cost Factors

Other factors such as salary scales and level and type of benefit have a bearing on the cost of a plan, but these may all be traced back, ultimately to the factors which have already been considered. 40 In any given case, the age distribution, proportion of female workers, normal retirement age selected, and so forth, have a direct bearing on the cost of that particular case, but, again, the factors previously discussed are basic. Contingencies In underwriting a group annuity plan, an insurance company assumes a contractual obligation extending as long as eighty or ninety years into the future. In order to protect itself against possible losses, the company must accumulate surplus reserves to provide for various contingencies such as reduction in value of investments, failure to earn the guaranteed rate of interest, adverse mortality experience, and unforeseen expenses and taxes. Therefore, in computing its rates the insurance company makes provision for contingencies. Usually, the provision for expenses is combined with that for contingencies in what is called the "loading." There is much misinformation in pension literature regarding the term loading. T h e loading is not for expenses only, as is often implied if not implicitly stated. Earlier, it was seen that the average expense cost for the group annuity business has run between 2i/2 and 3 per cent. In computing premiums, the insurance companies use a loading—generally 8 per cent—to cover current and future expenses as well as contingencies. This means, then, that 5 per cent of the loading, on the average, is for contingencies, and it is not correct to term the 8 per cent loading as the "expense loading." In the event the contingencies provided against do not occur, the portion of the 8 per cent loading not used for expenses and contingencies is released through the operation of the dividend formula and used to reduce current premiums. 40 O n t h e average, an employee's salary will increase with length of service. Salary scales are simply assumed rates of increase e m p l o y e d in c o m p u t i n g p r o b a b l e cost of f u t u r e r e t i r e m e n t benefits. T h i s would not be used with a deferred g r o u p a n n u i t y c o n t r a c t , b u t can b e used with t h e deposit a d m i n i s tration type of p l a n , w h e r e t h e i n s u r a n c e c o m p a n y does not p r o v i d e any g u a r a n t e e of benefits prior to r e t i r e m e n t .

Other Factors

177

In this regard, there might be some merit in calling a spade a spade. If the companies employed realistic assumptions for mortality and interest, the loading could be materially reduced a n d at least some misunderstanding avoided. In any case, stating the present 8 per cent loading as 3 per cent for expenses and 5 per cent for contingencies might mitigate the terminology problem.

Chapter 11

Premiums, Dividends, and Reserves In the preceding chapter, the factors conditioning cost were reviewed. It was pointed out that in computing initial premium rates the insurance company considered only the factors of interest, mortality, and expenses, the other factors not being of such a nature as to be accurately forecast and included directly in the rate structure. Rather, these other factors are either accounted for as they occur, as in the case of turnover, or are reflected in the dividend formula. It might be well to point out that whereas under a deposit administration contract the insurance company will take turnover rates, salary scales, and delayed retirements into account in arriving at an estimated premium, the resulting premium is not guaranteed. It is merely the sum calculated to be adequate to accumulate a fund in a practicable manner. It is only when sums are removed from the deposit fund to purchase single premium immediate or deferred annuities that guaranteed rates enter the picture. It is these latter rates that are discussed here. T h e y take into account only the factors of mortality, interest, and loading for expenses and contingencies. Rate

Bases

In establishing a rate basis for the group annuity business, a company must make provision for three factors: (1) mortality, (2) interest, and (3) expenses and contingencies. T h i s involves adopting a mortality table which represents conservatively the future mortality experience which can be expected under the contract, 1 a guaranteed rate of interest which the company feels l As was pointed out in the discussion on mortality, this involves some method of accounting for mortality improvement.

178

Premiums, Dividends, and Reserves

179

certain it can earn over a period of years, a n d a loading for expenses and contingencies. A rate, no matter what the line of insurance, must first be adequate, but of necessity must also be equitable. T h i s is particularly true of the g r o u p annuity business. Since contracts are essentially self-rated, 2 however, equity can be produced t h r o u g h a detailed dividend formula. T h e usual practice is to c o m p u t e a net single or net level p r e m i u m which represents an a n n u i t y benefit of one dollar per year discounted for T A B L E 20 GROUP ANNUITY

RATE

B A S E S F O R S E V E N L E A D I N G C O M P A N I E S AS O F AUGUST 2 0 ,

Company A Β C D Ε F G

Mortality S.A. S.A. S.A. S.A.-l S.A.-l GA 1951-1 1950 G.A.V.

1954

Interest

Loading

2%% 2 Ά 2 Ά 2 Vi 2'Λ 2 Ά 2'Λ

8% 8 8 5 8 5* 5··

Single premium to purchase f l payable annually from Premium in previous age 65 for male now column as a age 45; non- percentage contributory of f6 J J $5.95 6.16 6.16 6.39 6.51 6.28 6.21

91.4% 94.6 94.6 98.2 100.0 96.5 95.4

• T h e r e is a c o n t r a c t charge of $600 if t h e a n n u a l p r e m i u m is less t h a n $200,000. ** In a d d i t i o n , a n a d m i n i s t r a t i v e expense charge of $20 a year p e r life is levied u n d e r all contracts u p to a m a x i m u m of $1000.

mortality and interest. T h i s p u r e p r e m i u m is "loaded" for expenses and contingencies to produce the final p r e m i u m rate. T a b l e 20 presents the rate bases used by seven leading companies for deferred g r o u p annuities. T a b l e 20 indicates that there is some variation in assumptions a m o n g the companies, although not too marked. It should be emphasized, however, that these are gross p r e m i u m rates, and since all contracts are essentially self-rated, the dividend or experience rating f o r m u l a is important in terms of final cost. T h e mortality and interest assumptions were discussed in the preceding chapter a n d need n o f u r t h e r elaboration, except to say that they should a p p e a r reasonable to the layman. T h e loading 2 See p. 189.

180

Premiums, Dividends, and Reserves

formula used by Company G deserves some comment. As indicated in the table, this formula involves an annual charge of $20 per life for the first fifty lives in addition to a basic 5 per cent loading. T h i s formula recognizes the fact that expenses vary with the size of the risk, and the flat charge of $1000 diminishes as a percentage of premium with an increase in the size of the risk. W h e t h e r this refinement in gross premium rates is necessary is a question for the individual company and competition to decide. Company F also has a contract charge provision in the rate basis. One other company included in the survey has such a provision, although it is not included directly in the rate basis. 3 METHODS OF

FUNDING

Assuming a given schedule of rates, the annual premiums paid under a contract will depend on the method of funding employed. Basically, the funding of a pension plan involves anticipating, by advance payments into a reserve, the future benefits that will result from the operation of the plan. From an actuarial standpoint, funding involves essentially a forecasting of future benefit payments, the determination of a present value of such benefits and redistribution of that present value in accordance with some systematic procedure. T h e r e are five fundamental methods of funding for pensions prior to retirement of employees, namely, unit purchase, money purchase, entry age normal, attained age, and aggregate cost methods. T h e first two may be classified as single premium methods while the latter three are on a level premium basis. In the following description of these methods, it should also be noticed that the unit purchase, money purchase and entry age normal cost methods are on what might be called a separated cost basis. T h i s means simply that the initial past service liability is not amortized directly by these methods but is provided for separately. T h e other two, attained age and aggregate cost methods, recog3 T h i s e x t r a c h a r g e is c o m p u t e d as the d i f f e r e n c e b e t w e e n $ 1 0 0 0 a n d t h e l o a d i n g p r o d u c e d by t h e a n n u a l p r e m i u m a c t u a l l y p a i d . T h u s , if t h e a n n u a l p r e m i u m were $ 1 2 , 0 0 0 and the l o a d i n g a s s u m p t i o n was 8 p e r c e n t , t h e c h a r g e would b e $ 4 0 [ 1 0 0 0 - ( . 0 8 χ 12000)]. T h i s p r o v i s i o n s h o u l d be d i s t i n g u i s h e d f r o m t h a t o f C o m p a n y G , w h e r e t h e c h a r g e is m a d e e a c h y e a r regardless of t h e size o f t h e a n n u a l p r e m i u m .

Methods of Funding

181

nize both past and future service, and separate provision for the initial past service liability is not necessary. Unit Purchase

Method

T h e normal or future service premium under this method is the sum of the individual single premiums necessary to purchase a specified deferred annuity credit for each employee entering into the funding calculations, such as 1 per cent of the employee's earnings for the year. T h e cost of the deferred annuity credits to be purchased for employees entering into the funding calculations because of employment prior to the effective date of the pension plan is generally referred to as the initial past service cost. T h e initial past service cost, therefore, consists of the single premiums necessary to purchase at the effective date of the plan the deferred annuity credits that arise out of employment prior to that date. T h i s initial past service cost is provided for separately and does not affect the normal premium paid every year for current credits as they are earned. T h i s method is generally used in connection with deferred annuity plans, although it is applicable to any plan under which benefits are directly related to service and under which complete funding is desired as credits are earned. T h e cost of a unit of annuity deferred to retirement increases as age increases. Hence this method is sometimes referred to as a step-rate method. It is also sometimes called the unit credit cost method. Money Purchase

Method

T h e money purchase method consists of using the amount of contributions made every year for an employee as a single premium to purchase a paid-up deferred annuity credit. T h u s the pension credit of an employee for any year is determined by the amount contributed for him in that year, 4 and not by reference to a specific benefit formula. T h e designation "money purchase method" is usually applied only to certain deferred group annuity plans. In the sense that * N a t u r a l l y , the benefit or pension credit which a given a m o u n t of contributions will p u r c h a s e d e p e n d s on the rate s c h e d u l e in the contract, as well as the a t t a i n e d age a n d the sex of the individual e m p l o y e e concerned.

Premiums, Dividends, and Reserves

182

the premium paid is usually a level percentage of salary, the money purchase method might be considered a level premium method. However, the contributions actually made are applied as single premiums to purchase deferred annuities of whatever amount the contribution will purchase. Where the money purchase method is used, the initial past service liability is handled separately. For many reasons this method of funding is not as popular today as it was earlier. Entry Age Normal

Method

Under the entry age normal cost method, the contribution for each employee is determined as a level amount or percentage of pay from "entry age" to retirement, sufficient to provide the estimated amount of his pension at retirement. T h e expression "entry age" means the age at entry into employment or fulfillment of the eligibility requirements for participation in the plan on the assumption the plan had always been in effect. T h e sum of these level annual contributions is the normal premium under the contract. When a plan is first adopted, the contribution for each employee is based on his "entry age" and not on his attained age. Any deficiency on this account becomes part of the accrued liability. Thus, the initial past service cost is the sum of the reserves, as of the effective date of the plan, which would have accumulated with respect to each employee included if the pension plan had been in existence throughout his entire period of past employment. T h i s method also lends itself to a benefit which is a percentage of salary or a flat benefit and not directly tied to service. It may be used with the deposit administration type of plan, but does not lend itself to use with the deferred group annuity plan. Attained

Age

Method

T h i s method consists of determining for each employee entering into the funding calculations the level annual payment, starting with the attained age at date of entry into the plan and continuing until his retirement date, that would be required each year to provide the estimated amount of his pension at retirement based on the assumptions made as to the several cost

Methods of Funding

183

factors. T h e sum of these level annual amounts is the normal premium under this method. For those employees who are entitled to past service credits, a level annual amount is determined which includes both past and future service credits. Since the level annual premium is based on the full estimated retirement benefit of each employee, those employees who are entitled to past service credits automatically have both past and future service credits included directly in the level annual premium determined for them. Thus, under the attained age method, it is not necessary to make special provision for the initial past service liability; technically, there is no initial past service liability. T h e attained age method, or individual funding to normal retirement age method, as it is sometimes called, is used with group permanent plans but can also be used with deposit administration plans. T h i s method lends itself most naturally to a benefit formula which sets the benefit as a percentage of salary or flat amount and does not relate the benefit to service. T h e entry age normal method and the attained age method are identical once the initial past service liability has been liquidated. T h i s is due to the fact that once the initial group of workers with service prior to the inception of the plan are retired, or have withdrawn through death or termination of service, "entry age" and attained age become identical. 5 At this point, each employee entering the plan will have his full retirement benefit funded by a level annual premium over the remaining years until retirement. Aggregate

Cost

Method

Under the aggregate cost method, the total employer cost of all future benefits for present employees, less employer funds on hand, is expressed as a level percentage of future payroll of present employees. Each year as new employees enter, the "level" percentage must be recalculated. T h e actual calculation is made by dividing the present value of the future compensation of the employees entering into the funding calculations, or the present value of the appropriate portion thereof, into the present value of the estimated amount of benefits, less any employer funds on 6 T h i s would not be true, of course, if an "average" entry age were used.

184

Premiums, Dividends, and Reserves

hand. T h i s determines what is generally called the accrual rate or aggregate cost ratio. T h e annual premium is determined by multiplying the compensation, or appropriate portion thereof, paid during the year to employees entering into the funding calculations, by the accrual rate. T h i s aggregate cost method is not very common under insured plans, but can be used under deposit administration and immediate participation guarantee contracts. As mentioned above, this method includes past service directly in the premium and, consequently, no separate provision for the past service liability is necessary. The Effect of Funding

Methods

on

Premium

It is important to distinguish between the annual premium or initial cost and the ultimate cost of a pension plan. T h e ultimate cost of any plan is the excess of the amounts paid as benefits and expenses over investment income earnings. (The employer's cost would, of course, also be reduced by employee contributions.) T h e amount of the investment income earnings will depend upon the rate at which reserves accumulate; this rate will be influenced by the particular funding method chosen. If an initial annual premium is calculated under several different funding methods, the premiums will differ in amount. T h e difference in premiums, however, does not necessarily represent a differential in ultimate cost to the employer. T h e difference in premiums indicates primarily that reserves accumulate at different rates under different funding methods and that a larger initial normal premium will merely result in relatively smaller premiums being required later. Regardless of the method of funding, all other things being equal, exactly the same amount must be accumulated at retirement age to provide a given benefit for any employee. Thus, the funding method is more concerned with the incidence of costs than with the level of costs. Other

Methods

T h e methods of funding already discussed include the basic methods employed in what is generally known as true funding, that is, accumulating the reserve over the employee's active working lifetime, or during all of such lifetime except for a moderate

Methods of Funding

185

initial waiting period. O t h e r f u n d i n g types, however, frequently have a proper and important place in pension f u n d i n g as a means of overcoming special financial problems peculiar to the employer or of a transitional nature. For example, an employer may not desire to accumulate any funds in advance of the employee's retirement as u n d e r a terminal f u n d i n g arrangement;® or he may desire to do so only over a limited period of years prior to retirement such as ten or twenty. T h e only limitations to the variations which can be developed are those imposed by practical administrative considerations. Limitations

on Funding

Due to Tax

Requirements

Other things being equal, an employer will f u n d a pension plan in a m a n n e r which will give him the greatest tax advantage. T h e conditions under which deductions for contributions to a pension plan are permitted are spelled out in the provisions of Section 404 of the Internal Revenue Code of 1954 and the limitations on such contributions are set forth in Clause (A), Clause (B) and Clause (C) of the first subsection of that section. 7 T h e first of these three different and alternative tests laid down in the law is known as the Clause (A) or the 5 per cent method. T h i s provision of the law states that the employer shall be presumptively entitled to deduct 5 per cent of covered compensation each year as pension costs. T h e law provides, however, that the trust must be reviewed at least once every five years, and that the commissioner shall be entitled to reduce the permissible amount if it appears that the cost of the pension will be less than 5 per cent. 8 T h e Clause (B) or straight-line method, as it is sometimes called, permits a contribution of any excess over the a m o u n t allowable u n d e r Clause (A) which is necessary to provide with respect to all employees covered u n d e r the plan the remaining β Terminal or maturity funding has been used frequently for negotiated plans. T h e problem involved was that the employer did not want to accumulate funds for employees who could not retire during the foreseeable lifetime of the bargaining agreement. Thus, under terminal funding, the employer simply puts up a single premium when an employee retires. 7 Strictly. Sec. 404(a)(1) (A), (B), (C) and (D) govern trusts, and Sec. 404(a)(2) governs annuity plans. However, if an annuity plan meets the requirements of Sec. 404(a)(2), then the limitations of Sec. 404(a)(1) apply to the annuity plan. 8 Section 404(a)(1)(A), Internal Revenue Code of 1954.

186

Premiums, Dividends, and Reserves

u n f u n d e d cost of their past and current service benefits distributed as a level amount or a level percentage of compensation over the remaining future service of each such employee. Under this clause, the cost of the retirement benefit is determined 9 and the amount which must be contributed each year, between entry into the plan and retirement, to accumulate this necessary fund at retirement age is calculated. T h e employer may make this contribution and take it as a tax deduction. 1 0 T h e attained age and aggregate cost methods of funding are acceptable under these first two clauses. In addition, contributions on a money purchase basis are permitted under this section of the law, a method acceptable under the Clause (C) section also. Under the Clause (C), or "past service" method, the initial past service liability is determined and a deduction equal to 10 per cent of this sum plus the normal or current cost of the plan is permitted. T h e entry age normal and unit purchase methods of funding as well as the money purchase method are acceptable under this clause. Under Clause (C) plans, 1 1 the tax law limits the deduction which may be taken in any one taxable year to 10 per cent of the initial past service liability. For this reason, many plans amortize the initial past service liability over an eleven and one-half year period. 1 2 However, the law permits the employer to pay more or less than 10 per cent, but simply limits the deduction permitted to 10 per cent for any one taxable year. Where amounts in excess of 10 per cent are contributed in any one taxable year, carry-over provisions 1 3 protect the taxpayer from a loss of the amounts paid in but not currently deductible. T h u s , under the tax law, the employer has almost complete flexibility in funding initial past service benefits. 14 β In d e t e r m i n i n g the v a l u e of the benefit, the assumptions as to mortality a n d interest must be acceptable u n d e r Sec. 404, Internal R e v e n u e C o d e of 1954. 10 Bulletin on Section 29.23(p) J u n e 1, 1945, B u r e a u of Internal R e v e n u e . 11 T h e s e p l a n s employ f u n d i n g methods which make s e p a r a t e provision for the initial past service liability, such as entry age, unit p u r c h a s e , a n d money p u r c h a s e plans. 12 D u e to the loss of interest earnings, eleven a n d one-half years are req u i r e d under a 2i/ 2 per cent interest a s s u m p t i o n to amortize the initial p a s t service liability in accordance with the 10 per cent limitation. 13 Section 404(a)(1)(D), Internal R e v e n u e C o d e of 1954. κ T h e employer must always pay at least e n o u g h to keep the u n f u n d e d past service from exceeding the initial past service liability.

Methods of Funding

187

Under plans where the method of funding automatically includes provision for the initial past service liability, the amortization of the initial past service liability will depend on the age distribution and credited past service of the employees covered. T h e tax law permits the annual premium calculated under these methods to be deducted, with no limitation as to the past service liability. 1 5 Normally, the underwriting rules of the insurance company also permit complete flexibility in funding past service benefits, although at least one company surveyed will not permit an amortization period in excess of thirty years. Also, the basic rule that the benefit of each employee must be fully funded by his retirement date is usually applied by all companies. However, where there is a substantial number of older workers retiring immediately or shortly after the inception of the plan, most companies will make arrangements to alleviate the financial burden through the purchase of temporary annuities. Individual circumstances are controlling in the choice of a funding method. In general, the unit purchase method is probably the best and most widely used method of funding. Under this method the past service cost is handled separately, which means that during the first ten or fifteen years of the plan (the usual period of amortization of past service), the employer can obtain as much flexibility as is permitted under the tax law. Particular conditions, however, may dictate the use of a different funding method. For example, a small employer with a large number of older employees (the case in many closely held corporations) can use the attained age method of funding and write off his past service cost in less than the minimum period permitted under the unit purchase or entry age normal methods, which determine past service separately. Although the attained age method is more rigid, a situation of high profits and taxes would warrant its use. Regardless of the funding method chosen, the ultimate cost of a plan must always equal the benefits paid plus the expense l 5 T h e Internal Revenue Service has attempted to limit the amount deductible in such cases, but the T a x Court has overruled the Service and has sustained straight-line amortization even if it results in funding of benefits over a period of less than ten years. See Saalfield Publishing Co. v. Commissioner, 11 T . C. No. 92. T h e Commissioner appealed the decision but later acquiesced; see Internal Revenue Bulletin No. 21, Oct. 13, p. 1.

188

Premiums, Dividends, and Reserves

of administration, less any interest earned on the accumulated fund. DIVIDENDS

In practice, the various assumptions in the rate basis as to mortality, interest, and expenses made by the life insurance company are never exactly realized. In general, the rate bases employed by the companies are relatively conservative, and, as a result, surplus funds usually develop under the contracts. Such funds, after allowance for future contingencies, are credited to the employer under a dividend formula, in the case of a mutual company, or a premium rate adjustment formula, in the case of a stock life insurance company. T h e s e two formulas can be made to produce nearly identical results, and to simplify the following discussion, the term "dividend formula" will be used throughout; nevertheless, the discussion is applicable to premium rate adjustment formulas as well. T h e group annuity business is extremely competitive, and the objective of all companies is to provide contractual benefits at the lowest possible cost consistent with security. T h e dividend policy of any company is determined by the Board of Directors and is under the general supervision of the insurance department of the state in which the company is domiciled. Before reviewing the dividend practices of the group annuity writing companies, it may be well to distinguish between the group annuity risk and the individual annuity risk. In the latter case, the company usually sells the individual only one policy, and this policy is pooled with all other individual policies to produce averaging and, consequently, insurance. In the determination of dividends, the experience of this one risk clearly cannot be considered because it is not credible. Therefore, in calculating the dividend for an individual policy, the over-all experience of a class of individual policies is considered. 1 6 T h e group annuity risk, on the other hand, is represented by an employer who is consistently buying annuities for both new 18 T h e reader may question the use of the individual annuity in discussing dividends. It is recognized that most individual annuities are nonparticipating, but the principles illustrated are still valid.

Dividends

189

and old employees. Hence, if experience is not as favorable as the rate basis assumed, rates can be revised upward and the employer will continue to purchase annuities. Under this procedure, there is a merging of the experience of the individual risk over a long period, which enables the company to obtain averaging of the experience of the individual risk. In addition, the individual risk under a group annuity contract is in many cases very large, and the experience of a group annuity risk can—and competition insists that it must—be considered in establishing a dividend policy. In practice, therefore, as the following discussion will bring out, the determination of whether or not a particular group annuity contract will receive a dividend, and the amount of that dividend, if any, depends mainly on the experience under the contract. Experience

Accounts

A record of the experience under each contract is maintained on a calendar or contract year basis. In operation, this experience record or account is quite simple. All premiums received are placed in a fund which accumulates at interest and is reduced by disbursements. As far as the experience account is concerned, no annuities are ever purchased; instead, annuity payments are charged as they are made. In this way, actual mortality is recognized. T h e interest rate used is the experience rate credited to the group annuity business by the company rather than that guaranteed under the contract. T h e expenses charged to the experience account of any contract are the expenses actually incurred under that contract. So far as possible, each case is charged with its own expenses, but the allocation of some expenses must naturally be approximated. Established cost accounting techniques are used in these allocations, as will be described below. T h e employer's fund, which is the excess of receipts plus interest over disbursements, is the starting point in the application of the dividend formula to any contract. At the end of each calendar or contract year, a study is made of each contract which has been in effect for more than one year. T h e financial condition of the contract is evaluated by comparing the fund accumulation, represented by the experience account, with the actuarial liability for future benefit payments under the contract. In general, a contract is considered for a dividend if

Premiums, Dividends, and Reserves

190

the f u n d accumulation is at least equal to the actuarial liability for future benefits a n d any other liabilities applicable to the contract. On a contract that qualifies for dividend consideration, the experience as of the calendar or contract year just ended is analyzed to determine the a m o u n t of the dividend, if any. 1 7 Analysis

of

Surplus

H a v i n g determined that a contract is eligible for a dividend, the company usually analyzes the experience of the latest calendar or contract year to determine the sources of surplus balance. 1 8 T h e r e are three main sources of surplus, namely, (1) excess mortality, (2) excess interest a n d (3) excess of the provision for expenses and contingencies over the actual requirements. For each source of surplus, the results obtained are compared with the results expected. Generally a portion of the surplus derived from each source in any year is set aside to b u i l d u p a reserve for possible losses in later years. Mortality. U n d e r a deferred group annuity contract, mortality is a source of surplus on all employees, active as well as retired. U n d e r a deposit administration group annuity contract, however, mortality is not a source of surplus for active employees, since no benefits are purchased prior to retirement. Actually, the employer is bearing the risk until the employee reaches retirement and an annuity is purchased for him. Similarly, under an immediate participation guarantee contract, there are no sources of surplus 1 9 17 Some companies credit the dividend on the contract anniversary following the calendar year for which the experience is analyzed. For example, dividends payable on 1953 contract anniversaries would be based on the experience through calendar or contract year 1952. There is, then, a one-year lag in the payment of a dividend based on a given period of experience. This is, of course, not the practice of all companies. Many companies credit dividends based on the experience through the end of the latest contract year. In such cases, the 1953 dividend would include the experience of the contract year ending in 1953. In these cases, there is about a three- or fourmonth lag in the payment of the dividend. 18 Many companies do not bother to analyze the separate sources of surplus, but rather note the combined effect only. They simply set aside certain parts of the balance available for contingencies and dividends as dividend reserves, and pay the remainder as a dividend. T h e final dividend, assuming no differences in reserves established, would be identical. 18 This is not quite true. Such contracts, with companies which make a slight adjustment in the interest rate, participate in surplus distribution; but any participation will be slight, since this small adjustment is the only possible source of surplus.

Dividends

191

and, consequently, no dividends, since the employer is receiving the immediate effect of all experience factors. Some companies pool the mortality experience on small cases, feeling that there is not a sufficient volume of experience in such cases to produce average results. A majority of the companies, however, make each case stand on its own experience as far as dividends are concerned. T h i s decision is, of course, influenced by the m i n i m u m size case which the company will accept. T h e mortality gain for the calendar year is the difference between the reserves released by deaths and poor health surrenders a n d the reserves expected to be released if mortality were in accordance with the mortality basis established for dividend purposes. 2 0 T h i s gain—or loss, depending on the experience—will be included as a part of the surplus for dividends and contingencies in either case and represents a part of the balance available for contingencies and dividends. Since the mortality experience under a contract may be expected to fluctuate from year to year, the credence which can be given to the recorded mortality experience of a contract depends largely on the volume of that experience. T h e dividend formula recognizes this fact in determining the portion of the current year surplus from excess mortality which shall become available as a dividend. Usually, depending on the size of the fluctuation, excessive mortality releases are amortized over a period u p to, say, ten years. In some cases, a "credibility factor" which depends on the accumulated deaths and poor health surrenders 2 1 is calculated and applied to reduce the amount of the gain or loss. Both methods represent an attempt to smooth the mortality experience and thus prevent an unusual fluctuation from completely distorting the over-all experience of a case in any one year. Interest. T h i s source of surplus is simply the excess interest earnings over and above the a m o u n t assumed. For example, if the company earned 3.0 per cent and guaranteed 2.5 per cent, there 20 T h e mortality basis established for dividend purposes is usually the mortality basis underlying the current rate structure. 21 Since rates are discounted for mortality, when an employee terminates e m p l o y m e n t in poor h e a l t h , the employer is not g r a n t e d a return of contributions a n d a p o o r health termination has the s a m e effect as a death so far as the operation of the p l a n is concerned.

192

Premiums, Dividends, and Reserves

would be a gain of 0.5 per cent. As will be pointed out later, not all of these gains or surplus contributions are declared as dividends; they merely represent the a m o u n t of excess interest available for contingencies and dividends. Companies differ in their h a n d l i n g of capital gains a n d losses. Realized capital gains a n d losses, consisting of various sources of profit a n d loss in connection with investment transactions—chiefly f r o m the sale or maturity of securities as well as f r o m p e r m a n e n t a d j u s t m e n t s in the book value of securities—are reflected t h r o u g h an a d j u s t m e n t to the earned interest rate credited to the g r o u p a n n u i t y business. While most companies h a n d l e such gains a n d losses in this manner, one company surveyed prorates the actual gain or loss over all its g r o u p annuity contracts. In either case, the end result is basically the same. Regardless of the m e t h o d used, as in the case of mortality, most companies amortize excessive fluctuations over a period of years. If the interest guarantee for the accumulation of deposit administration f u n d s is less than that guaranteed for the a n n u i t y rates, an a d j u s t m e n t is included to account for this difference. For example, if only 2|4 per cent interest is required to m a i n t a i n active life deposit administration reserves, the net gain w o u l d b e 0.75 per cent instead of the 0.5 per cent gain made on the o t h e r reserves which are on a 2'/2 per cent basis. L o a d i n g . T h e surplus arising from the loading factor is the loadi n g provided from premiums less expenses charged for the year. I n allocating expenses to the contracts, the several companies writing g r o u p annuities use somewhat different methods, alt h o u g h all companies, to some extent at least, have applied cost accounting techniques to this problem. T h e r e are two philosophies regarding expense allocations, one using a simple f o r m u l a a n d the other a more detailed system of allocation. Advocates of the simple formula feel t h a t it is easier to administer and, in the long r u n , works out as well as a more detailed f o r m u l a . T h i s formula provides for the direct allocation of expenses which are chargeable to a specific contract. For instance, the cost of p r i n t i n g a n n o u n c e m e n t booklets can be charged to the specific case concerned. Similarly, the commission paid on a case can be allocated directly to that contract. For those expenses which cannot be allocated directly, this m e t h o d levies charges per

Dividends

193

contract and per certificate, graded by size of case. T h e usual procedure is to take the total expenses incurred during the year and compute unit charges per contract and per certificate, these unit charges forming the basis for individual contract levies. T h e other formula used by most companies is rather detailed and varies in complexity from company to company. T h e advocates of this formula, while recognizing that it is more difficult and expensive to administer, point out that, in the long run, it produces greater equity among policyholders and more satisfactory results generally. Here, as in the case of the simple formula, expenses which can be allocated directly are so handled. For allocating those expenses which cannot be allocated directly, this second formula provides certain bases which are intended to provide a reasonably accurate and equitable method of spreading these expenses over the various group annuity contracts. T h e basis of acquisition expenses is a percentage of premiums which is graded by size of case. Commissions are paid over a tenyear period and are computed as a graded percentage of premium. In order to simplify administration, some companies have established tables of standard commission charges which are a function of premiums and commission rates. These tables produce charges that approximate the commissions obtainable by applying the first renewal year commission rates directly to the premiums received in a given year. In either case, the commissions incurred on a given case are allocated directly to that contract. In addition to agents' commissions, allowances to managers and retired agents, as well as the salaries of supervisors, managers, and agents, are normally included in this category. These latter items are allocated in proportion to the commissions charged. Acquisition expenses other than commissions include those expenses which are incurred in connection with the solicitation, sale, and installation of group annuity contracts. T h e y include such items as drafting and printing contracts and certificates, and solicitation expenses on cases not closed, as well as the various non-recurring expenses during the first policy year. In the case of these other acquisition expenses, two approaches are followed. O n e makes a single heavy charge in the first year; the other allocates such expenses to all cases for a period of years. Acquisition expenses incurred during the first year may be much greater than

194

Premiums, Dividends, and Reserves

the loading for b o t h expenses a n d contingencies included in the first year p r e m i u m . In later years, however, the loading is less t h a n is needed, a n d the deficiency can be recovered gradually f r o m f u t u r e premiums. A contract which has an excellent over-all experience may not produce a dividend d u r i n g the early years because of this incidence of expense. Some companies feel that by amortizing these acquisition expenses over a period of ten or fifteen years, a more reasonable picture of the experience of a contract is obtained. 2 2 O t h e r companies feel that the expense should be charged as incurred even if as a result no dividends can be paid for several years. Since the contracts are long term a n d are essentially self-rated, it probably does not make a great deal of difference which method is used, except that it is good sales psychology to be able to point o u t that assuming normal experience dividends will be paid in the earlier years of the contract. I n the case of administrative expenses, the most common bases for allocation are time analysis, n u m b e r of lives or certificates, n u m b e r of transactions, and n u m b e r of withdrawals a n d deaths. From 40 to 60 per cent of all expenses are allocated on the basis of time analysis. Some companies break the n u m b e r of lives i n t o active a n d retired. T h i s might be a very realistic distinction in the case of a deposit administration contract, since administrative expense is m u c h less on active lives than for retired lives. A few companies charge valuation work on the basis of the a m o u n t of reserve, since as a case gets older the valuation work becomes more complicated. Supervision is usually charged in p r o p o r t i o n to the n u m b e r of hours charged to each contract. Practically all companies a p p o r t i o n taxes on the basis of premiums. T h e most i m p o r t a n t state tax is, of course, the p r e m i u m tax. In h a n d l i n g this expense, premiums are allocated to the several states in which employers are located and the applicable percentage is applied. T h e resulting tax expense is then allocated on the basis of the proportion of premiums derived f r o m each state u n d e r the various contracts. Other companies spread 22 Most companies, however, do not write these expenses off on a straightline basis. In many cases, 40 per cent of such expenses will be charged in the first year, 20 per cent the second year, and the remainder written off over the next eight years.

Dividends

195

this tax expense over all contracts on the basis of premium income. T o summarize, then, it can be stated that a majority of the companies are applying cost accounting techniques, in varying degrees, to the problem of allocating expenses to individual contracts. Once these expenses are charged, the excess of the loading for expenses and contingencies over these expenses is available for contingencies and dividends. Surrender. Surrenders may be another source of surplus but they arise only under deferred group annuity contracts. Unless there are large amounts of withdrawals, the gain from surrenders is not a significant part of the dividend. T h i s gain is the excess of reserves released by withdrawals in good health over the amount paid to the employee and any credit granted to the employer. It results in effect from the difference between the method of valuing the reserve and that of determining withdrawal benefits. If all employees stayed until death, there would be no surrender gain. A loss may develop from surrenders if the reserves released are less than the amounts paid on withdrawal. It is possible in the early years of an employee's coverage for the reserves released to be less than the amounts paid on withdrawal because only 92 per cent of the premiums received are set up as a reserve. Dividend

Reserves

Having determined the surplus available for contingencies and dividends, the next step is to establish the various dividend reserves. These usually include a future expense reserve, a basic contingency reserve, and temporary reserves for the gradual release of capital gains or other fluctuations. Future Expense Reserve. Once an employee retires, the insurance company guarantees that he will receive a certain income as long as he lives. T h e contract reserve is available to provide these benefits; the expense of disbursing these benefits must come from some other source. Under normal conditions, new premiums are continually being received and expenses may be paid out of these funds. If the contract is cancelled, however, all benefits purchased must be continued and expenses must be paid regardless of the fact that no new premiums are forthcoming. Consequently, all

196

Premiums, Dividends, and Reserves

companies establish as a reserve a percentage of the contract reserves, usually 2 per cent. A few companies refine this somewhat by using a formula which includes a percentage and an amount related to the number of certificates. T h i s latter method is logical, since the expenses to be incurred vary directly with the number of certificates. Contingency Reserve. T h e insurance company provides in its rate structure for possible contingencies such as mortality fluctuations, mortality improvement, investment fluctuations, and so forth. Most companies gradually build the reserve up to what is called a "contingency reserve objective," which is a contingency reserve sufficiently large to provide for all contingencies that might reasonably be anticipated. Once this reserve objective has been reached, it becomes unnecessary to set up the temporary reserves discussed in the next section. T h e actual size of this contingency reserve objective is based on a rather complicated formula, but generally results in a reserve that is about 4 to 6 per cent of the contract reserve. 23 Temporary Reserves. Periodically, an individual case will have a greater than normal mortality release in a given year, normal release depending upon the size of the case, and the reserve released is spread over future years. T h u s , a temporary reserve is established with this excess mortality release and is amortized over a period of years. T h e total reserve established is, naturally, the sum of those determined for each unusual fluctuation. Similarly, the insurance companies amortize large capital gains and losses over a period of years, usually ten. Again, this tends to smooth the experience; excess gain is set up in a reserve and released gradually. Another possible temporary dividend reserve which occurs only during the early years of a contract is that established to release gradually the loading on payments for past service liabilities. These payments may be substantial, and the loading for future expenses and contingencies is released gradually to prevent an extreme distortion of the experience. 23 See p. 198. Some companies do not hold any contingency reserve as such. If the mortality and interest assumptions are sufficiently conservative, no separate contingency reserve is necessary. However, whether called a contingency reserve, a margin, or otherwise, the basic purpose is to implement the guarantees provided by the company.

Dividends

197

T h e difference between the available surplus and the reserves established is the a m o u n t that may be paid as a dividend. Generally, each formula provides that no dividend will be paid unless it is in excess of a certain m i n i m u m a m o u n t established in the f o r m u l a . Also, if a dividend is payable, it becomes d u e as of the contract anniversary following the calendar year of experience analyzed. Naturally, interest is paid on the dividend f r o m the end of the experience period until the due date. 2 4 Below is presented a summary of the determination of an actual dividend based on the 1951 experience. It was secured from the operational records of one large insurance company. D E T E R M I N A T I O N OF DIVIDEND F O R YEAR E N D I N G DECEMBER 31, 1952 F u n d Accumulation, December 31, 1951 Actuarial Liabilities for F u t u r e Benefits on C u r r e n t Dividend Basis

$8,354,135

Balance Available for Contingencies and Dividends Dividend Reserves as of December 31, 1951: F u t u r e Expense Reserve T e m p o r a r y Reserve for Gradual Release of Capital Gains Contingency Reserve T o t a l Dividend Reserves Dividend as of December 31, 1951

$ 583,842

7,770,293

$155,406 23,547 306,959 ' $

485,912 97,930

T h u s , o u t of the $583,842 available for dividends and contingencies, this particular contract received a dividend of $97,930 which would be credited against f u t u r e premiums. T h e smallness of the dividend is a reflection of the fact that the g r o u p a n n u i t y business has developed d u r i n g a period of improving mortality a n d decreasing interest earnings, both of which increase pension costs. Since much of the earlier business was written at rates which are quite inadequate today, insurance companies have had trouble in building u p adequate contingency reserves, hence dividends have been small and in many cases nonexistent. Some companies, particularly those which have been in the field for many years, are paying dividends today, b u t the total a m o u n t compared with the dividends being paid 24 Not all companies have this lag between the experience period and the payment of dividends. A n u m b e r credit dividends or experience rate adjustments at the end of each contract year, based on the most recent experience.

198

Premiums, Dividends, and Reserves

under the other group coverages is relatively small. 2 8 With the upturn in the interest rate, it is expected that dividends will increase in the future. This situation will vary from contract to contract, however, since the individual experience of a given contract is controlling. It must also be remembered that the margins in g r o u p annuity rates are much smaller than in other lines of insurance. It is natural that the amount of dividends paid on this class of business be relatively smaller than those paid on lines employing a redundant premium structure. RESERVES

T h e reserves of any insurance company are of two principal types. One type is that established on the basis of certain assumptions as to mortality and interest, to represent the liability for present or future claims against the company's assets. T h e other type is that established from allocations of surplus against potential future claims arising as a result of deviations from the assumptions made. In the other group coverages, where the coverage is primarily on a year-to-year basis, liability reserves are relatively unimportant; the liability reserves in the group annuity business, on the other hand, are of such size as to have an important effect on every phase of the companies' activities. T h i s is apparent from T a b l e 21 which shows the relationship between the group annuity reserves and the total reserves of the seven leading g r o u p annuity companies. T h e table shows that the group annuity reserves range from a low of 9.6 per cent to a high of 37.2 per cent of total reserves. Thus, it is rather obvious that the liability reserves in the group annuity business are not only important but may pose a serious investment problem as they continue to grow in size. Contract

Reserves

For annual statement purposes, the contract reserves are usually maintained on the same basis as the applicable rate schedule. T h i s usually means that a company will have several classes of contracts for valuation purposes. In recent years, however, reserves which had been on a liberal interest and mortality basis, relative to current experience, have been strengthened to a more 25 Ilse, op. cit., p. 303.

Reserves

199

conservative basis. A few states have minimum valuation requirements, but practically all companies are on a more conservative basis than that required. T h e reserve basis employed for dividend purposes may be more conservative than that used in establishing contract reserves for annual statement purposes. T h e reason for this is that in establishing reserves for annual statement purposes, the emphasis is on aggregate liability, whereas in the case of dividends the individual contract is the focal point. Because the size of the individT A B L E 21 GROUP ANNUITY

RESERVES COMPARED WITH T O T A L R E S E R V E S FOR

L E A D I N G C O M P A N I E S AS O F D E C E M B E R

Company A β C D Ε F G

31,

Total Reserves (000 o m i t t e d )

Group Annuity Reserves (000 o m i t t e d )

$11,080,227 9.939.950 6,210,667 3,270,576 1,881,966 1,687,661 938,480

$1,633,720 1.209.951 1,963,548 639,573 699,092 161,628 299,692

SEVEN

1953

Ratio Annuity to Total

Group Reserves Reserves

14.7% 12 2 31.6 19.6 37.2 9.6 31.9

Source: A n n u a l Statements of Seven Companies Surveyed.

ual contract is much smaller, there is a much greater possibility of an adverse fluctuation than in the case of the over-all business of the company. Hence, a more conservative basis is dictated for dividend purposes. With respect to deposit administration and immediate participation guarantee contracts, most companies set up 95 per cent of the advance funds as a reserve liability. One company holds only 92 per cent of the accumulated funds as a reserve if the contract does not permit the transfer of advance funds to another funding agency. Here, the insurance company obligation is simply to protect the principal of the advance funds plus the guaranteed interest accrual, since the company is assuming n o mortality risk on active lives. Contingency

Reserves

In addition to contract reserves, some companies maintain a contingency reserve for annual statement purposes. For example,

200

Premiums, Dividends, and Reserves

the State of New Jersey requires companies to maintain a contingency reserve equal to at least 5 per cent of the contract reserves for all classes of business. Naturally, a portion of any aggregate contingency reserve would apply to the group annuity branch of the company. In other cases, where no formal contingency reserve is established, that portion of the surplus available for dividends and contingencies not paid out as dividends to policyholders would appear as an increase in the surplus account of the company.

Chapter 12

Evaluation of Group Annuities T h e first section of this chapter is devoted to a comparative analysis of the four main group annuity contracts which have formed the basis for this study. Following this, significant trends are indicated and briefly discussed. COMPARATIVE

ANALYSIS OF GROUP

ANNUITY

CONTRACTS

In this section the advantages and disadvantages of the four basic group annuity contracts are examined from the viewpoint of (1) the employee, (2) the employer, and (3) the insurance company. For the purpose of this discussion it will be assumed that the employer can afford to provide adequate benefits under any of these contracts. Also, to avoid complicating the argument, it will be assumed that the plan is noncontributory. Employee Clearly the central objective of the employee is to have a maximum dependable benefit. T h e employee does not want to reach retirement age only to find too late that the promise of retirement benefits is illusory. Therefore, the employee wants to be able to rely on the expectation that the retirement income which he has earned will begin at retirement and will continue for his lifetime. Both the deferred group annuity and the group permanent retirement contracts provide such guarantees to the employee. Since the group permanent plan provides substantial death benefits in addition to the retirement income, employees might be expected to prefer that contract. However, if group life insurance is provided with the deferred group annuity contract, there may be no essential difference between the group permanent and deferred group annuity contracts. But there is a difference in the 201

202

Evaluation of Group Annuities

manner in which the two contracts are taxed. In the case of the group permanent contract, the employer's contributions used to purchase life insurance benefits represent taxable income to the employee in the year of contribution. 1 If the life insurance benefits are provided separately under a group term life policy, the premiums do not constitute taxable income to the employee. I n the case of the deposit administration and immediate participation guarantee contracts, the insurance company provides a guarantee to an employee only upon retirement. Although estimated premiums are deposited prior to retirement, they are not allocated to individual employees but are held in a deposit fund. T h e n as each employee reaches retirement age, sufficient funds are set aside to purchase an immediate annuity for the retiring employee. From this point on, the employee has the guarantee of the insurance company that his benefits will continue for life. Although the benefit formula may produce an earned pension credit for the employee each year, he does not have complete assurance that he will receive these credits as income until he actually retires and an annuity is purchased for him. T h e underwriting rules of many insurance companies require at least a minimum level of funding under deposit administration contracts. T o some extent this provides reasonable assurance that sufficient funds will be available when the employee retires to purchase his accrued benefits. Still, such underwriting requirements cannot replace the guarantee of the life insurance company provided under the deferred group annuity and group permanent contracts. In the case of the immediate participation guarantee contract, the funding arrangements are normally even looser; hence, this contract is even weaker than the deposit administration contract as far as the employee is concerned. Therefore, from the employee's viewpoint, either the deferred group annuity or the group permanent contract will best meet his objective of a maximum benefit which becomes fully guaranteed as it is earned.

Employer T h e employer's major objective in financing a retirement prol Section 402, Internal Revenue Code of 1954.

Comparative Analysis of Contracts

203

gram for his employees is to provide an adequate program to meet his employees' needs and to keep his annual commitment at a level which will not impair the solvency of the firm. In many cases, the problem of funding a retirement program is, to a great extent, the timing of the cost rather than the ultimate cost itself. It is relatively easy to determine what level of benefits the employer can afford to pay over a period of years, but since the profit margins in most industries fluctuate, the amount the employer can afford to pay in any one year is not always the same. In the case of a well-established employer with a dependable income and relatively low turnover, this problem is minimized. Such an employer can establish a funding program with less concern for a reasonable group annuity premium than a newer company which has much promise but a relatively thin working capital margin. In the latter case it may not be possible to meet the full cost each year, but over a period of years even an employer with relatively small working capital inay be able adequately to fund a retirement program. It is this latter type of firm, which must have a reasonable element of flexibility, to which the deposit administration type of contract is attractive. T h e most important advantage of the deposit administration contract is its flexibility. T h i s element is due to the fact that no amounts are allocated to the individual employee's benefit prior to retirement. Since the insurance company is not guaranteeing the benefits promised until an employee retires and his annuity is actually purchased, the employer can fund on a group rather than an individual basis. Hence, he can suspend premium payments, reduce his contributions, or increase them beyond the normal annual premium within the limits set by the insurance company's underwriting rules. In addition, the employer can adjust his contributions for expected turnover and future salary increases. In computing the required deposits, he can also employ assumptions which are less conservative than those used in the insurance company's guaranteed rates. T h e assumptions used in computing the estimated premiums can make a large difference in the amount necessary to "fully fund" the plan; they are a subject of serious negotiation under the deposit administration

204

Evaluation of Group Annuities

type of contract. It should be remembered, however, that the funding flexibility permitted under the deposit administration or other gTOup annuity contracts is limited by the requirements of the Federal income tax law. Under the deposit administration contract the employer also has complete flexibility in the choice of a benefit formula. Other provisions can also be varied from the conventional deferred group annuity pattern if the employer desires. For example, provision can be made for a flexible retirement age, disability payments from the fund, and arbitrary early retirement factors. Changes in the plan are also facilitated; this is particularly important where a negotiated plan is concerned. Another advantage stemming from the fact that no amounts are allocated prior to retirement is a saving in administrative expense and record keeping. It is usually possible for the insurance company to administer such a plan without maintaining a file of records on individual active employees. T h i s is particularly valuable under plans having a high rate of employee terminations. Advocates of the deferred group annuity contract point out, however, that someone must maintain a set of records on individual active employees, whether it be the employer or the insurance company. T h e y believe the saving involved is probably not substantial, particularly where an eligibility period is used. Although the employer derives a number of advantages by using a deposit administration contract, there are certain disadvantages. I n the first place, the employer loses the assurance that his pension obligations will be fully met as they accrue. In the case of the deferred annuity, the employer has definite amounts to pay and he can leave the problem of determining the premium to the insurance company. Although the employer with a deposit administration contract can employ an actuary to recommend the proper deposits, the decision in the final analysis must rest with the officers of the corporation. Aside from the time spent in making such decisions, there is always a possibility that the assumptions employed will not be realized and that additional funds will have to be paid into the fund at some future date. 2

2 In recent y e a n , because of high taxes and profits, some employers have tended to use as conservative assumptions as posssible to increase their tax deductions during this period, and also to provide a margin for the future.

Comparative Analysis of Contracts

205

Moreover, funding flexibility, an important advantage of the deposit administration contract, provides a strong temptation to underfund the plan, with serious consequences. Such flexibility is, of course, advantageous only if properly used. A deposit administration plan may be discontinued, with criticism of both the employer and the insurance company, if the plan becomes underfunded to any great extent. From a public relations viewpoint, the employer must, of necessity, introduce all of his statements with protective comments such as "the company hopes and expects" and similar phraseology but cannot safely use the stronger and more assuring words "will" and "shall." T h i s can be an important factor in diminishing the morale value of the retirement program. Since the immediate participation guarantee contract is essentially an adaptation of the deposit administration contract, much that has been said about the latter applies to the former. From the employer's viewpoint, however, there is an additional advantage in using an immediate participation guarantee contract. It has a contractual immediate dividend formula included in the contract. T h e employer is credited annually with the results of the actual experience under his plan, including that for mortality on retired lives. There are no contingency reserves, as such, which meets one of the employer's major objections to the deposit administration and other g r o u p annuity contracts. Most employers eligible for immediate participation guarantee coverage are large enough to obtain a certain amount of averaging from their own experience. T h e contingency reserves held to implement the insurance company guarantees under the other group annuity contracts represent sizable amounts in large cases, and such employers feel that these reserves will not be needed in the long run. They point out that if additional funds are needed, they can supply them. Most employers have unlimited faith in their ability to make a substantial return on the operation of their businesses. They prefer to invest in their own businesses the funds which the insurance company would set u p as contingency reserves, since they feel that they can earn much more than the rate credited to such funds by the insurance company. T h e size of this contingency reserve will depend primarily on the rate basis employed for immediate participation guarantee contracts. If the

206

Evaluation of Group Annuities

rate basis is sufficiently conservative, an employer may find that the contingency reserves are higher than for deposit administration. T h e immediate participation guarantee contract goes a little further than the regular deposit administration contract toward a self-administered plan. Admittedly, the insurance company guarantees lifetime benefits to employees once they have retired, by providing that unless the fund is at all times sufficient to provide for such employees it will revert to a regular group annuity contract. However, discontinuance is more likely under this contract if unfavorable experience develops, and in this respect the contract provides a less secure basis for a retirement program than other group annuity contracts. From the point of view of the employer, either the deferred group annuity or group permanent contract permits him to discharge completely and finally his pension obligations as they accrue. T h e employer can assure his board of directors and the stockholders that there is no possibility of a request in the future for additional funds to cover accrued pension promises. Again, if a sale or merger of the company is contemplated, there are no pension obligations to consider. T h u s , the major advantage of the deferred group annuity or group permanent contract to the employer is the knowledge that the accrued pension obligation is fully liquidated each year. T h e advantages of this contract, arising from the guarantees provided, tend to limit the flexibility of the contract, particularly with regard to funding. Although complicated benefit formulas and other unusual plan provisions can be worked out under a deferred group annuity contract, 3 they increase the administrative cost rather substantially, with the result that most employers use a deposit administration type of contract with such plans. Many such programs, however, can be worked out with a deferred group annuity contract providing the basic benefits and a supplemental deposit administration contract providing the unusual benefits. In summary, then, from the position of an employer to whom funding flexibility is important, the immediate participation guarantee and deposit administration contracts have certain advan3 W. K. White, "Pensions," Actuaries, I I (1950), p. 483.

Discussion,

Transactions

of

the

Society

o]

Comparative Analysis of Contracts

207

tages. T h e needs of well-established businesses, where a low rate of turnover exists, are perhaps best met by a deferred group annuity or g r o u p p e r m a n e n t contract. But as a rule, employers are very conscious of the need for flexibility both in f u n d i n g and in plan provisions. Insurance

Company

T h e entire background of the life insurance industry has been closely associated with the interest of the employee. T h e early g r o u p annuity literature repeats over and over the importance of protecting the employee against illusory promises. In many ways, the interest of the insurance company and the employee have been the same. T h e m a j o r objective of the insurance company, then, would seem to be m a x i m u m security of benefit to the employee. O n the other hand, the insurance company has an obligation to meet the needs of the employer as well. In general, the life insurance industry has an enviable record of safeguarding the interests of the insured. Life insurance companies, however, want to write business. W h e n g r o u p annuities were introduced in the 1920's, there was little competition other than that between the few life insurance companies in the field. Consequently, insured pension plans developed a r o u n d the pattern of deferred g r o u p annuities. But in the early 1940's a new source of competition, the trusteed pension plan, developed. T h i s approach, which permitted complete flexibility in f u n d i n g and plan provisions, soon made serious inroads in the field. Not only was this new approach securing a good proportion of new business written, b u t many plans which had been insured for years were being switched to a trusteed basis. T h u s , the insurance companies f o u n d themselves with conflicting objectives and, as is usual in such a situation, a compromise resulted. Because of this competition and the changing needs of the employer, the insurance companies began actively to write plans on a deposit administration basis and, even more recently, on an immediate participation guarantee basis. From the insurance company's viewpoint, the deferred group annuity contract is eminently satisfactory. T h e benefit is definite, fully paid, a n d easily explained and defended. T h i s contract enables the insurance company to make a real contribution to the

208

Evaluation of Group Annuities

security and welfare of the employees through the guarantees which it is especially fitted to provide. In addition, the contract is in accord with the traditional importance attached to the interest of the insured. Perhaps the m a j o r disadvantage of the deferred group annuity contract is that it is relatively rigid, and does not always permit the modifications that the peculiarities of a given plan may demand. W i t h the deposit administration contract, the insurance company is able to handle most any type of plan provision and can permit a reasonable amount of flexibility in funding as well. T h i s enables the company to meet the reasonable demands of competition without removing all of the guarantees to the employee. T h e employee upon retirement receives a guarantee that his income will continue for life, and the underwriting rules requiring a certain m i n i m u m level of funding give some assurance to the active employee that this pension benefit will be purchased on retirement. In this regard, it is advisable for the insurance company to insist on advance funding sufficient to approximate the probable future requirements. It would seem that the insurance company's responsibility to the employee dictates this as a m i n i m u m program. Any employer may, of course, keep a deposit administration plan as fully funded as a deferred group annuity plan, but some insistence on the part of the company may be necessary. Aside from the loss of security offered the employee as well as the employer under the deposit administration method, the insurance company is faced with other problems. T h e most important of these is the possibility that the employees will assume that the insurance company is responsible for the funding and is guaranteeing the benefits promised under the plan. It is doubtful that all the employees of the plan will fully understand the conditions of the insurance company guarantees and responsibility. It is highly likely that the underwriting of a pension plan by an insurance company will, in itself, lead the employee to believe that full and exact coverage is guaranteed. T h i s is the direct result of the concerted efforts of the insurance company over the years to convince people that where an insurance company is involved, the m a x i m u m security of benefits results.

Comparative Analysis of Contracts

209

T h e insurance company frequently provides actuarial service, in many cases indicating the minimum and maximum annual deposits that are practicable. Presumably these deposits would generally tend toward the minimum level, since low initial cost is usually an important reason for adopting a deposit administration plan. W h i l e these estimates may be adjusted periodically as experience develops, there will be instances where the insurance company will eventually be faced with a real dilemma, having either to explain to the employees why their benefits must be reduced or else to explain to the employer's board of directors why the cost is so much higher than was formerly indicated. 4 T h e immediate participation guarantee contract presents other possible complications. In the event that the fund under an immediate participation guarantee contract does fall below the critical point 5 and annuities are actually purchased for the retired lives, a guaranteed scale of rates applies. T h e r e is the same need for a contingency reserve with respect to such guarantees as there is for similar guarantees under other group annuity contracts. W h i l e a gross premium valuation is used to determine the critical point, thus providing an automatic built-in contingency reserve, the safety margin may prove inadequate. T h e importance of this point is magnified by the fact that the most likely reason why an employer would discontinue such a contract would be poor experience. Actually, the greatest disadvantage of this contract to the insurer lies in the opportunity provided the contract holder of exercising financial selection against the company. If experience is very favorable, the employer receives the immediate effect of this experience, and his future premiums can be reduced. On the other hand, if the experience is poor, the employer can discontinue the contract, leaving the insurance company with the results of the poor experience. If the rate basis is conservative, however, this problem is somewhat mitigated. As was pointed out earlier, the insurance company implements its guarantee to retired employees by requiring that the employer maintain his deposit fund at a level sufficient to purchase immediate annuities for all retired employees according to certain * White, op. cit., p. 484. β See p. 108.

210

Evaluation of Group Annuities

schedules of rates. T h e administrative problem in determining the moment when the fund reaches the critical point at which the contract reverts to a conventional retired life group annuity contract is an additional difficulty. T h e public relations problems which can arise from inadequate funding a n d / o r discontinuance are also a matter of serious concern. From the company's viewpoint, the group permanent contract does not pose any serious problems. Many companies do not write this type of contract, however, since they feel they can provide the same benefits with increased flexibility through a deferred group annuity contract combined with a group term life policy. Perhaps the most important problem with the group permanent contract from the company's viewpoint is the fact that commissions are higher than for other group annuity contracts. I n some cases, this has caused agents to be dissatisfied with the regular group annuity commissions, and has perhaps resulted in the use of this type of contract in cases where it did not necessarily fit the individual needs of an employer. As must be apparent at this point, the basic objectives of the several parties concerned with a group annuity contract are different and even conflicting. T h e employee is, of course, interested in obtaining the m a x i m u m dependable benefit. In contrast, the employer usually attempts to keep his annual commitment at a m i n i m u m and to retain the m a x i m u m flexibility possible in funding the plan. T h e life insurance company is interested in providing the greatest protection for the employee; this is in accord with its traditional interest in the security of the individual's benefit. On the other hand, in recent years the insurance company, because of the competition of the banks and trust companies under trusteed plans, has been faced with the practical problem of meeting the reasonable demands of employers or of losing such business entirely. Since these objectives are, in a sense, mutually exclusive, no one contract could be developed to meet them all. T h e compromise which has developed has led to the increased use of the deposit administration contract and more recently to the introduction of the immediate participation guarantee contract. Under both of these contracts, the benefit guarantees prior to retirement have been withdrawn to permit

Important Trends

211

additional flexibility in funding and plan provisions, while retaining those guarantees normally provided after retirement. IMPORTANT

TRENDS

A number of trends in the field of group annuities are discernible at this time. T h e more important of these seem to be: (1) increased benefit levels; (2) an increasing emphasis on deposit administration plans; and (3) a rising ratio of annuity reserves to total reserves of companies active in the group annuity field. Increase in Benefit

Levels

In a stable economy without inflation, there is only one test of retirement income adequacy: the number of dollars provided. But in an inflationary period, a second test must be applied: adequacy of purchasing power. Because of the decline in the purchasing power of the dollar over the last twenty years, practically all plans have needed revision when the test of purchasing power was applied. T h e failure to give pensioners a constant volume of buying power is recognized as a major weakness of existing pension plans.® In recent years, attempts to bolster the buying power of the retired employee have led to increases in the benefit level of existing plans as well as of those now being established. Existing Plans. Many private pension plans have been revised to liberalize the benefits as an offset to the decline in purchasing power which has occurred over recent years. Periodically, these plans have been reviewed in the light of changing circumstances and benefits have been adjusted to meet the need. Sometimes, benefits have been supplemented by giving additional recognition to prior service. Final earnings formulas, which base benefits on the earnings of the last five or ten years of employment so as to relate the pension more closely to price and wage levels prevailing at time of retirement, have been used with increasing frequency. In other cases, additional annuities based on current rates of earnings directed toward some over-all minimum at normal retirement date have been provided. New Plans. T h e trend toward higher benefit levels is evidenced β "Pension Payments: Dollars or Buying Power," The TPtirC published by Towers, Perrin, Forster & Crosby, Inc., December, 1951.

Letter,

212

Evaluation of Group Annuities

in all new plans. In the case of unit benefit plans, there is a definite swing toward a formula which provides 2 per cent of annual pay instead of the currently predominant li/2 per cent benefit. It is interesting to note that usually the more liberal annuity is provided at no additional cost to employees, even where the old plan is contributory. In the case of union plans, the former $100 a month after twenty-five years of service including Social Security has given way to a $125 a month benefit and, in some cases, a $150 a month benefit, including Social Security. This same trend is discernible in other types of formula arising from current negotiations. 7 A great deal of attention has been directed toward the development of some pension procedure which would provide a hedge against fluctuations in purchasing power. Attempts that give some promise of success include plans which tie the pension dollar to a cost of living index and those that relate the annual benefits to the changing values of the securities in the fund supporting the retirement benefits. 8 T h e ultimate success of these techniques may have an important effect on the group annuity business, since it does not appear that the group annuity medium, at least in its present form, could underwrite such plans. Executives and Key Personnel. There has also been a definite trend toward raising the maximum annuity benefits for executives and key personnel. All well-designed pension plans have a benefit objective which is usually expressed as a percentage of earnings. T h e plan formula may not incorporate this percentageof-pay goal directly, but an effort is made to produce pensions at retirement which will not involve financial hardship. In the past, the imposition of $10,000 or $15,000 maximum limits has resulted in pensions for key men of 10 per cent or even less of their final pay. T h e raising of maximum limits and, in some cases, the complete removal of limitations of this nature is indicative of a more liberal approach to executive pensions. 9 τ Edwin C. McDonald, Pensions and Croup Insurance, Printed Privately, T h i r d Revised Ed., March, 1952, pp. 18-19. 8 "Pension Payments: Dollars or Buying Power," op. cit.; see also William C. Greenough, A New Approach to Retirement Income; C. R . Henderson, "A Better Pension Program," Harvard Business Review, J a n u a r y a n d February 1952. β Ibid.

Important Trends Growth of Depont

213

Administration

Only within the last decade has the deposit administration type of group annuity begun to assume any major importance. As was indicated earlier, this type of coverage is not new; a pension plan was underwritten on this basis as early as 1929. It was not until the post World War II period, however, that business began to be actively solicited on this basis. It is estimated that about twenty-six companies were writing deposit administration contracts at the end of 1953, and it is known that all the major companies writing group annuities, except one, will write the contract. Some of these companies have entered the field only recently and, therefore, have insignificant amounts of deposit administration coverage in force so far. Several of the smaller group annuity companies have been very active in promoting deposit administration plans and have written a large number of cases in relation to their total business. Recent Stimulants to Growth. Several reasons have been advanced to explain the increased emphasis on the deposit administration contract since World War II. In the first place, the wage stabilization and tax policies adopted by the Federal Government and the general business boom since the war have stimulated the use of pension plans in general. Secondly, the increase in benefit levels which has come about as a result of inflation since World War II has tended to cause employers to stress the greater flexibility in funding permitted under a deposit administration contract. Of course, the increase in union negotiated plans, which are usually complex, has also placed an emphasis on the flexibility in plan provisions provided by the deposit administration type of contract. Finally, and probably of greatest importance, is the aggressive competition of banks with the trusteed type of plan. Under this plan, the employer assumes all the risks, and consequently has almost complete flexibility in regard to funding 1 0 and plan provisions. It was to meet this competition, perhaps more than for any other reason, that the insurance companies began actively 10 It should be r e m e m b e r e d that this flexibility is limited by the Federal income tax law.

214

Evaluation of Group Annuities

to underwrite business on the deposit administration basis after World War II. Implications of Trend. In the past, the major distinction between the insured and the self-administered or trusteed plan has been that the insurance company provided guaranteed protection for a premium, whereas the trustee accepted contributions but could give no assurance that these funds would be sufficient to provide the benefits promised under the plan. T h e increased emphasis on the deposit administration type of plan has made this distinction much less clear. T h e insured plan under the deferred group annuity contract offers specific protection to both active and retired employees. T h e active employees' accrued benefits are guaranteed by the insurance company and retired employees have assurance that their retirement incomes will be continued for life. Under the deposit administration contract, the active employee does not have complete assurance as to the later receipt of his retirement income or other promised benefits; the full guarantee has been dropped. As far as contributions for active employees go, the insurance company is, in effect, simply offering an investment service similar to that of a trust department of a bank. Further evidence of this is the inclusion in some recent contracts of a provision permitting transferability of advance funds to another insurance company or trustee. 11 The most recent step in this direction has been the development of the immediate participation guarantee contract, an adaptation of the deposit administration contract. Under the immediate participation guarantee contract, the employer assumes practically all the risks, the insurance company providing only the residual retired life benefit guarantee that goes into effect only on the discontinuance of the immediate participation guarantee contract. These changes, first to the deposi* administration and then to the immediate participation guarantee plan, make the distinction between the insured and the trusteed plan much less clear today than in former years. Certainly, the deposit administration and immediate participation guarantee contracts are being written to meet the demands 11 Bronson, "Pensions," Discussion, Transactions I I (1950), p. 477.

of the Society of

Actuaries,

Important Trends

215

for such coverage by employers. It would seem, however, that the insurance companies have backed away from their strongest competitive argument, namely, that benefits provided under an insured plan are fully guaranteed. It is this capacity to guarantee benefits that characterizes the life insurance industry and differentiates it from the other pension financing mediums. T h e deposit administration and immediate participation guarantee contracts were first used in very large cases where the competition for the business was extreme. T h e issuance of such contracts, however, has led to a demand for similar coverage by smaller employers. Many employers, and some pension consultants, are of the opinion that if a firm does not use the deposit administration contract, it does not have the most up-to-date coverage. There are, of course, many arguments in favor of the use of these contracts; but it appears to the writer that the assumption of safety which the life insurance industry has diligently developed over the years could be undermined in the event some of these plans turn out to be underfunded or are entirely discontinued. While it is true that a deposit administration or immediate participation guarantee contract can be kept as fully funded as a deferred group annuity contract, it seems likely that they will be more susceptible to underfunding and discontinuance during a period of economic stress—the acid test of financing mediums. T h e insurance company is writing group annuities in a real world and the impact of collective bargaining on private pension plans as well as the intense competitive situation both within and without the insurance industry cannot be avoided. Still, developments in this field have come at a rapid pace, and the fact that some companies have refused to follow all attempts to meet the demands of the employer indicates at least that these plans should be underwritten very carefully. Trend Toward "Annuity

Companies"

In recent years, there has been a tendency for life insurance companies, particularly companies active in the group annuity business, to become more typically "annuity companies." Combined annuity reserves for all companies amounted to 8.0 per

216

Evaluation of Group Annuities 12

cent of total reserves in 1930, 12.7 per cent 13 in 1947 and 18.1 per cent in 1951. T h i s trend has been even more striking in the case of those companies which are active in the group annuity business. Table 22 presents a comparison of annuity reserves and total reserves of the fifteen leading group annuity companies 14 covering the period from 1940 to 1953. TABLE 22 C O M P A R I S O N OF A N N U I T Y RESERVES W I T H T O T A L RESERVES FOR F I F T E E N LEADING G R O U P A N N U I T Y C O M P A N I E S FOR P E R I O D 1 9 4 0 - 1 9 5 3 ( 0 0 0 OMITTED)

ι

v

Annuity Reserves December 31 L/CCC/'(CCi / i

Year

Total Reserves

Group

1940 1945 1947 1949 1950 1951 1952 1953

$13,903,885 20,080,490 25,901,582 29,746,417 31,840,799 33,923,828 36,446,284 38,952.549

$ 722,771 1,880,400 2,656,553 3,685,798 4,357,417 5.067,658 5,908,963 6,783,933

Total· $2,118,052 3,864,003 4,892,271 7,681,228 8,734,137 9,618,427 10,590,595 11,638,671

„ ,· . . Ratio of Annuity η j Reserves to Total Reserves 15.2% 19.2 18.9 25.8 27.4 28.4 29.1 30.0

• Includes Individual and Supplementary Contracts Involving Life Contingencies.

As indicated in Table 22, annuity reserves represented 30 per cent of the total reserves held at the end of 1953. T h r e e of these companies held annuity reserves which were close to 50 per cent of total reserves. There can be little question that a company with half its reserves held for annuities is as much an annuity company as a life insurance company. These figures do not include reserves on insurance policies taken out primarily to provide retirement incomes nor do they include reserves on other insurance policies which look to the day when they will be applied on an annuity basis. Certainly, this branch of the business is now an important factor in the solvency of the entire company. A company actively writing group annuities soon finds that a 12 Estimated by author from material obtained from several sources. 13 A. N. Guertin, "Annuitant Mortality Trends," Discussion, Transactions of the Society of Actuaries, IX (1952), p. 345. n These companies represent well over 95 per cent of the group annuity business, measured by premium income for the year 1953.

217

Other Issues

substantial proportion of its reserves is held for annuities, and it becomes incumbent on management to employ a realistic rate basis including a provision for mortality improvement. It should be remembered that the secular trend toward mortality improvement has produced a steadily decreasing margin in annuity rates, in contrast to the increasing margin in life insurance rates. T h e usual provision for adjustment of rates in group annuity contracts will no doubt provide a measure of safety in this regard, but the rapid growth of the annuity portion of the life insurance business only emphasizes the problem of mortality improvement discussed earlier. T h e important point is that the current experience and observable trends in mortality should be taken into account realistically in all phases of group annuity operations. This is particularly important at a time when the annuity portion of the life insurance business may be expected to increase in magnitude and when severe competition prevails in the pension field. OTHER

ISSUES

T h e private retirement program is only a part of the over-all pension structure in the United States. Pension arrangements in the United States include Federal Old-Age and Survivors Insurance as well as other public programs such as those for civilian employees of the Federal Government and employees of the states and municipalities. Combining these public programs with all private plans, coverage figures available indicate that nine out of ten persons in the United States who work in civilian jobs are now active or potential recipients of retirement benefits. 15 More than eight out of ten have old-age and survivors insurance; and almost half of the remainder, or about 10 per cent, are protected by other public programs. 16 T h e only major employed groups not now under a retirement plan are certain self-employed professional persons, 17 and those domestic and agricultural workers who do not meet the qualifying tests imposed by the Social Security Act. is National Planning Association, Pensions in the United States, p. 9. ie Ibid. 17 T h e 1954 Amendments extended the Social Security Act to all professional persons except doctors, dentists, lawyers and other medical categories. They also provided coverage for farm operators for the first time.

218

Evaluation of Group Annuities

Since this nearly universal coverage of current workers under retirement systems is a very recent development, the present arrangements are less effective in supplying active benefits to those persons already over 65 and not employed than they are for current workers. These retired workers number approximately nine million; about two-thirds of these workers and their wives or husbands are receiving some kind of a retirement benefit. 18 Nearly all of these benefits are being paid from the public programs. Less than 10 per cent of the retired persons referred to above are now receiving benefits from private retirement plans. 19 Most supplementary private plans are of even more recent origin than the public programs. T h e great majority of existing private retirement plans have been established since 1940 and most collective bargaining plans even more recently. T h e high proportion of coverage of the currently employed workers presents a rather favorable picture for the future. But is this coverage more apparent than real? Historically, American labor turnover has been quite high. T o the extent that plans do not provide vesting, a covered employee may lose any earned retirement credits in the event he changes jobs. There is a need for research regarding the mobility of labor and the extent to which long service requirements limit the protection offered by private plans. There are other questions of importance which warrant further study. For example, the economic and social implications of the accumulation of vast reserves is a major area deserving investigation. Full employment coupled with inflation continues to pile u p funds. But what will be the impact of these funds in a deflationary period? What will the impact be on the capital market? T h e r e is very little information available regarding the investments of trusteed plans. Will a large proportion of their funds find their way into equities? Will regular investment of substantial sums tend to stabilize the stock market? Or will unusual demands on established reserves unsettle the market? T h e question of compulsory retirement at a fixed retirement age is an area where there is much disagreement. Research may well indicate that compulsory retirement of management at a IB Ibid., p. 11. i» Ibid., p. 12.

Other Issues

219

fixed r e t i r e m e n t age is essential whereas such r e t i r e m e n t is n o t n e a r l y as i m p o r t a n t a t the lower p a i d levels, p a r t i c u l a r l y in t h e mass p r o d u c t i o n i n d u s t r i e s . A s s u m i n g c o m p u l s o r y r e t i r e m e n t is i n d i c a t e d , t h e q u e s t i o n of w h a t r e t i r e m e n t age s h o u l d be used is a n o t h e r q u e s t i o n w o r t h y of investigation. C a n we a f f o r d to r e t i r e m e n a t 65 if life e x p e c t a n c y c o n t i n u e s to i m p r o v e ? A r e l a t e d q u e s t i o n , of course, is w h e t h e r this i m p r o v e m e n t in life expectancy is a result of e x t e n d i n g t h e lifetime of t h e disabled, o r a c t u a l l y r e p r e s e n t s a n ability to w o r k l o n g e r . In these a n d o t h e r areas, t h e r e a r e m a n y issues a n d p r o b l e m s w h i c h n e e d c a r e f u l research as well as clear a n d critical t h i n k i n g . P e r h a p s t h e m a t t e r r e q u i r i n g clearest t h i n k i n g is j u s t w h a t s h o u l d be t h e objectives of p r i v a t e p e n s i o n plans. T h e objective of a p l a n inter alia m a y b e to s u p p l e m e n t t h e old-age benefit of t h e F e d e r a l O.A.S.I. p r o g r a m , to r e d u c e t h e t u r n o v e r a m o n g y o u n g e r employees, or to a t t r a c t a n d h o l d executives. E a c h o b j e c t i v e r e q u i r e s its o w n set of provisions a n d p r o c e d u r e s . In t h e first case t h e p r o b l e m of old age security p r e d o m i n a t e s . H e r e , a m o n g o t h e r things, t h e p r o b l e m of taxes enters. T h e t a x i n c e n t i v e p r o v i d e d by t h e G o v e r n m e n t s h o u l d n o t p e r m i t t h e h i g h e r - p a i d e m p l o y e e s to benefit p r o p o r t i o n a t e l y m o r e t h a n lower-paid workers. T h e R e v e n u e Act of 1942 insists t h a t e a c h p l a n b e b r o a d in scope; s t a n d a r d s have b e e n imposed r e q u i r i n g t h a t t h e p l a n n o t d i s c r i m i n a t e in f a v o r of officers o r o t h e r h i g h l y p a i d w o r k e r s in r e g a r d to e i t h e r benefits o r c o n t r i b u t i o n s . Similarly, if t h e i n t e n t i o n is to p r o v i d e security f o r t h e aged, s t a n d a r d s of a c t u a r i a l solvency b e c o m e e x t r e m e l y i m p o r t a n t if a t a x p a y e r is to be g r a n t e d f a v o r a b l e t r e a t m e n t on t h e a s s u m p t i o n t h a t h e is h e l p i n g to p r o v i d e such security f o r his employees. O n t h e o t h e r h a n d , if t h e m o t i v a t i o n f o r a p l a n is to increase efficiency a n d p r o d u c t i o n , t h e fact t h a t an officer or h i g h e r p a i d e m p l o y e e s t a n d s t o b e n e f i t p r o p o r t i o n a t e l y m o r e by t h e existence of a progressive system of t a x a t i o n is relatively u n i m p o r t a n t , since t h e objective of t h e p l a n is to h o l d such employees. A g a i n , if a p e n s i o n p l a n is a d e f e r r e d wage e a r n e d by c u r r e n t l a b o r services, f u l l i m m e d i a t e vesting is i m p l i e d . B u t if it is a d i f f e r e n t i a l wage p a i d as a r e w a r d f o r l o n g a n d f a i t h f u l service, o t h e r i m p l i c a t i o n s arise. T h e p o i n t here is s i m p l y t h a t t h e g r o w t h of t h e p r i v a t e p e n s i o n m o v e m e n t has b e e n r a p i d , a n d t h a t m a n y

220

Evaluation of Group Annuities

developments have taken place which appear to be inconsistent, from one or several points of view. There is a need, then, for further examination of current developments, for a restatement of motives and objectives, and—following such a restatement— for an adjustment in policy and practice to implement the objectives adopted.

Appendix A FIFTY-SIX U N I T E D STATES LIFE I N S U R A N C E COMPANIES H A V I N G G R O U P A N N U I T Y C O N T R A C T S I N FORCE DECEMBER 31, 1953 T h e r e is presented below a schedule of fifty-six U n i t e d States companies with one or more g r o u p a n n u i t y contracts in force as of December 31, 1953. A n u m b e r of the companies have only one contract in force, presumably covering their own employees. Number of Contracts

Company Equitable Life Assurance Society of the U. S. 860 Prudential Insurance Company of America 289 Metropolitan Life Insurance Co. 344 John Hancock Mutual Life Insurance Co. 299 Aetna Life Insurance Company 533 Connecticut General Life Insurance Co. 363 Travelers Insurance Co. 153 Total for Seven Cos. 2,841 Bankers Life Company Massachusetts Mutual Life Insurance Co. Pacific Mutual Life Insurance Company New York Life Insurance Company State Mutual Life Assurance Company Continental Assurance Co. Occidental Life Insurance Company Life Insurance Company of Virginia Southwestern Life Insurance Company Farm Bureau Life Insurance Company Union Central Life Insurance Company Lincoln National Life Insurance Company American United Life Insurance Co. Minnesota Mutual Life Insurance Co.

Number of Certificates

Premium Income for Year 1953 (000 Omitted)

898,531

J268.854

490,553 476,538

164,603 151,211

284,241 298,344

109,559 101,052

137,221 94,830 2,680,258

54,322 31,300 $880,901

157

72,058

J 12,065

109

23,668

8,156

19

18,418

4,762

9

4,559

3,511

88 128

5,138 13,340

3,482 3,139

50

9,741

3,033

61

10,717

2,462

46

15,062

1,870

4

3,293

1,843

5

4,161

1,010

13

3,037

928

19

3,952

870

18

1,841

810

221

Appendix A

222 Company Mutual Service Life Insurance Co. Northwestern National Life Insurance Co. National Life and Accident Insurance Co. New England Mutual Life Insurance Co. Paul Revere Life Insurance Company Great Southern Life Insurance Co. Country Life Insurance Company Hoosier Farm Bureau Life Insurance Co. Mutual Life Insurance Company of New York Provident Life and Accident Insurance Co. H o m e Beneficial Life Insurance Co. American National Life Insurance Co. Independent Life and Accident Insurance Co. Commonwealth Life and Accident Insurance Co. Standard Insurance Co. Pan American Life Insurance Company Standard Life Insurance Co. of Indiana Protective Life Insurance Company H o m e Security Life Insurance Company United States Life Insurance Company Iowa Life Insurance Co. Atlas Life Insurance Co. Woodmen Central Assurance Co. Loyal Protective Life Insurance Co. Manhattan Life Insurance Co. D u r h a m Life Insurance Co. Wisconsin National Life Insurance Co. Michigan Life Insurance Co. Western and Southern Life Insurance Co. Bankers National Life Insurance Co.

Number of Contracts

Number of Certificates

Premium Income for Year 1953 (OOP Omitted)

5

2,876

718

11

3,077

666

3

8,609

657

9

1,880

646

2

1,100

505

16

2,526

354

1

661

344

1

2,401

320

49

3,764

307

58

3,888

258

1

2,086

181

2

1,918

180

1

794

177

2 1

119 89

163 146

1

209

135

6

252

124

7

698

108

3

435

83

2 1 4

147 150 245

62 59 58

1

179

52

2 2 1

86 133 34

35 28 23

1 1

74 29

22 18

1

4,488

15

3

2,097

9

Appendix A

223

Company Number of Contracts State Capital Life Insurance Company Government Employees Life Insurance Co. Commonwealth Life Insurance Company Amicable Life Insurance Company Church Life Insurance Co. T o t a l for Fifty-six

Number of Certificates

Premium Income for Year 195} (000 Omitted)

57

9

74

8

36

5

72 9

4 1

Companies 3,77 2,914,535 $935,322 SOURCE: Annual Statements of Indiv dual Companies. NOTE: T h e n u m b e r of certificates o u t s t a n d i n g has been adjusted to exclude duplications resulting from coinsured contracts.

Appendix Β SCHEDULE

OF

FIRST

WRITTEN UNITED Company Metropolitan Life Insurance Co. E q u i t a b l e Life Assurance Society of the U. S. P r u d e n t i a l Insurance Co. of America T r a v e l e r s Insurance Co. A e t n a L i f e Insurance Co. C o n n e c t i c u t General L i f e Insurance Co. J o h n Hancock M u t u a l L i f e Insurance Co. SOURCE:

GROUP

BY T H E STATES

ANNUITY

SEVEN

CONTRACTS

LEADING

COMPANIES Employer

Date

Type

12-25-21

W i l l i a m E. R u d g e , Inc.

Deferred

7- 4-27

Edward A. Woods Co.

Deferred

9-15-28

5- 1 -32

Cleveland Public Library Public Service Co. of Illinois Williams and Wilkins Co. and Waverly Press, I n c . Institute of Living

1- 1-37

Manila Electric Co.

4-25-29 7- 1-30

Operational Records of Individual Companies.

224

Deferred Deferred Deferred Deferred Deferred

Appendix C G R O U P A N N U I T Y FINANCIAL EXPERIENCE OF SEVEN LEADING LIFE COMPANIES T h e r e is presented below certain financial experience for a n n u i t y contracts underwritten by the Aetna Life Insurance Connecticut General Life Insurance Company, Equitable Life Society of the U. S., J o h n Hancock Mutual Life Insurance Metropolitan Life Insurance Company, Prudential Insurance of America, and Travelers Insurance Company for the period inclusive.

all g r o u p Company, Assurance Company, Company 1942-1953

1. I N C O M E AND E X P E N S E

Aetna Life Insurance Company (000 omitted) Income Year

Premium

1942 1943 1944 1945 1946 1947 1948 1949 1950 1951 1952 1953

$16,066 18,597 22,459 28,844 31,253 45,312 58,288 56,391 72,393 76,394 89,626 101,052

lnvestmerits

Other

$ 2,255 2,711 3,303 4,174 4,892 5,855 7,450 9,183 11,561 13,476 16,284 19,822

Total $18,321 21,308 25,762 33,018 36,145 51,167 65,738 65374 83,954 89,870 105,910 120,874

Aetna Life Insurance Company—(Continued) (000 omitted) Expenses Year

Com• mission

1942 1943 1944 1945 1946 1947 1948 1949 1950 1951 1952 1953

$169 221 221 252 271 328 433 407 461 553 556 579

Taxes

Other

Total

$

$ 167 194 228 261 304 468 536 508 613 722 954 1,170

$ 430 522 615 677 742 1,080 1,328 1,406 1,543 1,886 2,118 2,508

94 107 166 164 167 284 359 491 469 611 608 759

225

Appendix C

226

Connecticut General L i f e Insurance C o m p a n y (000 omitted) Income Year

Premium

1942 1943 1944 1945 1946 1947 1948 1949 1950 1951 1952 1953

% 8,467 11,481 16,860 14,633 14,971 20,283 28,876 23,393 28,959 41,401 49,367 54,322

Investments $

709 1,079 1342 2,031 2,435 2,927 3,813 4,809 5,752 6,565 8,322 10,519

Total

Other

$

3

$ 9,176 12,560 18,402 16,664 17,406 23,210 32,689 28,202 34,711 47,966 57,689 64,844

Connecticut General L i f e Insurance C o m p a n y — ( C o n t i n u e d ) (000 omitted) Expenses Year 1942 1943 1944 1945 1946 1947 1948 1949 1950 1951 1952 1953

Commission $114 80 127 142 114 189 97 127 172 212 252 237

Taxes

Other

Total

$

$

$ 381 405 649 667 716 956 930 1,117 1,092 1,316 1,543 1,578

88 152 240 200 160 207 278 496 311 318 402 337

179 173 282 325 442 560 555 494 609 786 889 1,004

227

Appendix C Equitable Life Assurance Society of the U. S. (000 omitted) Income Year 1942 1943 1944 1945 1946 1947 1948 1949 1950 1951 1952 1953

Fremium $51,010 59,038 96,929 98,617 120,332 153,055 173,910 187,664 197,787 230,330 252,137 268,854

Investments $ 5,899 7,306 9,175 10,995 13,255 17,946 23,765 30,437 35,715 41,474 50,283 59,506

Other

$

Total

1 5 1 2 3 249 1,949 978

$56,909 66,344 106,105 109,612 133,592 171,002 197,677 218,101 233,505 272,053 304,369 329,338

Equitable Life Assurance Society of the U. S.—(Continued) (000 omitted) Expenses Year

Commission

1942 1943 1944 1945 1946 1947 1948 1949 1950 1951 1952 1953

$237 358 577 591 628 711 751 725 808 814 836 863

Taxes

Other

Total

$

$

$1,202 1,531 2,035 2,699 3,207 3,944 4,265 4,357 4,968 5,848 6,091 6,909

368 476 603 800 960 1,275 1,401 1,418 1,478 1,981 2,045 2,241

597 697 855 1,308 1,619 1,958 2,113 2,214 2,682 3,053 3,210 3,805

Appendix C

228

John Hancock Mutual Life Insurance Company (000 omitted) Income Year 1942 1943 1944 1945 1946 1947 1948 1949 1950 1951 1952 1953

Premium $20,618 23,937 31,983 31,876 40,177 47,898 55,601 63,521 68,032 91,743 96,673 109359

Investments $ 1,581 2,247 2,659 3,740 4,645 5,731 7,176 8,930 10,897 13,530 16,846 19,382

Other $

Total 1 2

24 48 56 79 59 96 13 1,111 221

$22200 26,186 54,642 35,640 44,870 53,685 62,856 72,510 79,025 105,286 114,630 129,162

John Hancock Mutual Life Insurance Company—(Continued) (000 omitted) Expenses Year

Commission

1942 1943 1944 1945 1946 1947 1948 1949 1950 1951 1952 1953

$136 118 203 179 166 327 315 361 276 342 327 370

Taxes

Other

Total

$

$ 327 365 351 452 581 640 742 684 742 889 1,119 1,306

$

104 206 322 263 384 358 394 1,378 663 1,396 1,884 788

567 689 876 894 1,131 1,325 1,451 2,423 1,681 2,627 3,330 2,464

Appendix C

229

Metropolitan Life Insurance Company (000 omitted) Income Year

Premium

1942 1943 1944 1945 1946 1947 1948 1949 1950 1951 1952 1953

$41,446 45,917 59,273 63,782 88,128 87,040 102,297 116,584 169,671 132,055 155,561 151,211

Investments $15,245 16,123 18,249 19,909 20,549 22,669 26,259 29,944 34,118 36,942 42,988 49,090

Other $

3 1 1 4 2 6 7 6 16 8 —1 211

Total $56,694 62,041 77,523 83,695 108,679 109,715 128,563 146,534 203,805 169,005 198,548 200,512

Metropolitan Life Insurance Company—(Continued) (000 omitted) Expenses Year 1942 1943 1944 1945 1946 1947 1948 1949 1950 1951 1952 1953

Commission $125 123 122 109 134 115 92 74 53 63 96 86

Taxes

Other

Total

$ 555 486 579 -33 744 575 687 1,363 1,882 1,025 918 944

$ 850 951 1,080 1,157 1,496 1,778 2,076 1,999 2,113 2,359 2,743 3,107

$1,530 1,560 1,781 1,233 2,374 2,468 2,855 3,436 4,048 3,447 3,757 4,137

230

Appendix C Prudential Insurance Company of America (000 omitted) Income

Year 1942 1943 1944 1945 1946 1947 1948 1949 1950 1951 1952 1953

Premium $32,237 35,821 42,098 44,069 48,066 75,446 88,535 50,002 121,219 122,609 143,231 164,603

Investments $ 6,832 7,614 8,476 9,631 10,950 12,231 14,702 17,213 20,443 24,865 30,727 37,378

Other

$

7,322

38 214

Total $39,069 43,435 50,574 61,022 59,016 87,677 105,237 67,215 141,662 147,474 173,996 202,195

Prudential Insurance Company of America—(Continued) (000 omitted) Expenses Year

Commission

1942 1943 1944 1945 1946 1947 1948 1949 1950 1951 1952 1953

$122 80 65 67 122 165 230 281 266 331 385 412

Taxes

Other

Total

$

$

$ 561 600 679 954 1,051 1,798 2,379 1,750 2,459 2,839 3,505 4,327

237 293 382 610 409 739 920 59 829 1,008 1,958 1,350

202 227 232 277 520 894 1,229 1,410 1,364 1,500 1,162 2,565

231

Appendix C Travelers Insurance Company (000 omitted) Income Year

Premium

1942 1943 1944 1945 1946 1947 1948 1949 1950 1951 1952 1953

$ 3,850 4,265 5,593 5,350 5,510 7,075 8,003 11,728 16,560 26,656 25,129 31,300

Investments $

Other

527 627 746 998 1,062 1,221 1,469 1,778 2,175 2,764 3,698 4,648

Total t 4,377 4,892 6,339 6,348 6,572 8,296 9,472 13,506 18,735 29,420 28,827 35,948

Travelers Insurance C o m p a n y — { C o n t i n u e d ) (000 omitted) Expenses Year 1942 1943 1944 1945 1946 1947 1948 1949 1950 1951 1952 1953

Commission

Taxes

Other

Total

$ 18 13 41 43 28 36 25 61 112 99 115 147

$ 35 39 53 77 72 64 64 131 171 184 149 186

$ 47 47 72 62 72 85 103 155 219 247 266 368

$100 99 166 182 172 185 192 347 502 530 530 701

Appendix C

232 2 . ANNUITIES IN FORCE

Aetna Life Insurance Company Annual

Year

1942 1943 1944 1945 1946 1947 1948 1949 1950 1951 1952 1953

Contracts Dec. 31

245 265 300 319 335 361 376 403 439 476 507 553

Certificates Dec. 31

81,000 84,000 108,000 113,000 133,000 166,000 185,000 197,000 223,000 241.000 271,000 298,000

Now Payable

»1,265 1,421 1,730 2,108 2,576 3,249 4,032 4,955 5,877 7,172 8,596 10,384

Income

Deferred But Fully Paid

$11,297 14,288 17,152 19305 22,785 27,458 33,648 39,929 47,550 55,829 65,199 75,765

(000

Omitted)

Deferred But Not Fully Paid

$ 59 72 35 34 31 35 35 35 35 34 35 33

Total

$12,621 15,781 18,917 21,647 25,392 30,742 37,715 44,919 53,462 63,035 73,830 86,182

Connecticut General Life Insurance Company Annual

Year

1942 1943 1944 1945 194« 1947 1948 1949 1950 1951 1952 1953

Contracts Dec. 31

89 112 131 151 166 190 199 206 236 285 322 363

Certificates Dec. 31

34,000 60,000 85,000 97,000 98,000 107,000 113,000 119,000 128,000 122,000* 128,000* 137,000*

Now Payable

$ 218 236 269 364 563 734 1,039 1,409 1,717 2,142 2,656 3,359

Incom e (000

Deferred But Fully Paid

$ 3,312 4,845 6,967 8,626 9,828 12,269 15,619 18,078 21,022 24,698 28,744 33,135

Omitted)

Deferred But Not Fully Paid

Total

$ 3,530 5,081 7,236 8,990 10,391 13,003 16,658 19,487 22,739 26,840* 31,400* 36,494'

Appendix C

233

E q u i t a b l e L i f e A s s u r a n c e Society o f t h e U . S. Annual Income

Year

Contracts Dec. 31

Certificates Dec. 31

1942 1943 1944 1945 1946 1947 1948 1949 1950 1951 1952 1953

268 327 409 473 531 578 627 660 732 765 809 860

200,000 255,000 330,000 380,000 448,000 522,000 555,000 611,000 725,000 792,000 840,000 899,000

Now Pa\ab!e

Deferred But Fully Paid

$3,521 3,938 4,916 6,037 7,392 10,251 11,751 13,964 17,556 21,049 24,908 29,317

$29,537 36,551 48,992 60,624 74,798 88,827 109,574 130,721 157,131 182,646 209,045 236,553

(000

Omitted)

Deferred But Not Fully Paid

Total $33,058 40,489 53,908 66,661 82,190 99,078 121,325 144,685 174,687 203,695 233,953 265,870

J o h n Hancock Mutual Life Insurance Company Annual Income

Year 1942 1943 1944 1945 1946 1947 1948 1949 1950 1951 1952 1953

Contracts Dec. 31 91 103 128 144 159 170 192 200 221 244 269 299

Certificates Dec. 31 65,000 73,000 91,000 107,000 124,000 150,000 173,000 189,000 209,000 251,000 262,000 284,000

Now Payable $

985 1,135 1,306 1,569 1,991 2,317 2,903 3,708 4,452 5,627 6,870 8,751

Deferred But Fully Paid $ 6,905 9,670 13,331 16,713 20,321 25,065 30,240 36,610 43,064 51,367 59,941 70,185

(000

Omitted)

Deferred But Not Fully Paid

$

270 945 1,467 1,617

Total $ 7,890 10,805 14,637 18,282 22,312 27,382 33,143 40,318 47,786 57,939 68,278 80,553

234

Appendix C Metropolitan Life Insurance Company Annual Income (000

Year 1942 1943 1944 1945 1946 1947 1948 1949 1950 1951 1952 1953

Contracts Dec. 31 274 279 282 286 290 297 303 307 311 321 339 344

Certificates Dec. 31 248,000 256,000 274,000 286,000 317,000 348,000 372,000 393,000 404,000 420,000 450,000 477,000

Omitted)

Now Payable

Deferred But Fully Paid

Deferred But Not Fully Paid

Total

$12,539 13,817 14,865 16,015 18,135 19,996 21,774 24,163 26,638 30,388 33,129 36,967

$ 62,626 65,943 71,954 78,175 85,580 93,522 103,338 114,326 132,150 144,091 159,045 172,086

$3,631 3,591 3,635 3,712 3,816 3,987 4,179 4,375 4,488 3,259 3,227 2,904

$ 78,796 83,351 90,454 97,902 107,531 117,505 129,291 142,864 163,276 177,738 195,401 211,957

Prudential Insurance Company of America Annual Income (000

Year 1942 1943 1944 1945 1946 1947 1948 1949 1950 1951 1952 1953

Contracts Dec. 31 102 103 103 103 107 126 156 167 196 216 254 289

Certificates Dec. 31 161,000 167,000 184,000 187,000 206,000 251,000 322,000 315,000 338,000 373,000 425,000 491,000

Now Payable $ 5,042 5,660 6,505 7,446 8,373 9,681 10,902 12,417 14,507 16,541 19,138 21,912

Deferred But Fully Paid $ 29,552 33,729 40,267 43,649 49,355 58,165 69,819 68,903 83,350 93,810 107,262 124,558

Omitted)

Deferred But Not Fully Paid $2,034 2,105 35 32 29 28 27 25 23 20 12 11

Total $ 36,628 41,494 46,807 51,127 57,757 67,874 80,748 81,345 97,880 110,371 126,412 146,481

Appendix C

235 Travelers Insurance Company Annual

Year 1942 1943 1944 1945 1946 1947 1948 1949 1950 1951 1952 1953

Contracts Dec. 31 40 43 57 61 66 70 74 85 102 118 139 153

Certificates Dec. 31 22,000 22,000 30,000 21,000 22,000 24,000 26,000 29,000 37,000 80,000 86,000 95,000

Now Payable $

538 569 618 691 788 919 1,027 1,156 1,455 1,753 2,160 2,740

Income

Deferred But Fully Paid $ 2,219 2,695 3,285 3,810 4,293 4,945 5,729 6,913 8,533 11,320 13,828 17,164

(000

Omitted)

Deferred But Not Fully Paid

$

377 447 510 578 574 974 1,215 1,237 1,429 1,742

Total J 2,757 3264 4,280 4,948 5,591 6,442 7,330 9,043 11,203 14,310 17,417 21,646

NOTE: T h e n u m b e r of certificates o u t s t a n d i n g has been a d j u s t e d to e x c l u d e d u p l i c a t i o n s r e s u l t i n g f r o m coinsured contracts. • Does not i n c l u d e a p o r t i o n of the lives a n d a n n u a l income r e l a t i n g to deposit a d m i n i s t r a t i o n contracts. SOURCE: A n n u a l S t a t e m e n t s of I n d i v i d u a l C o m p a n i e s .

Appendix D HISTORICAL SCHEDULE OF DEFERRED GROUP ANNUITY RATES The

f o l l o w i n g s c h e d u l e presents the various rate bases e m p l o y e d by

seven large c o m p a n i e s since their e n t r a n c e into the group a n n u i t y The

field.

s c h e d u l e r e f e r s o n l y to d e f e r r e d g r o u p a n n u i t y r a t e s a n d n o t

to

o t h e r types of g r o u p annuity rates. Illustrative Premium

Year Adopted

Number of CompaniesAdopting Mortality

1925

1

1930

5

1933

6

1934

6

1936

6

1938

7

1941

2

1941

2

1941

2

1945

1

1947

1

1949

1

1949

1

1949

1

1950

1

1950

1

1950

1

1951 1953 1953

1 1 1

Bases of

A M & McCi CA2 CA CA CA — 2 SA3 SA — 1 SA SA SA SA — 1 SA SA SA — 1 GAV4 SA GAV SA SA — 1 GA-1951-15

Rate

Interest 4

%

4

Loading

10% 10

3S/4

10

3'A

Single Rate

For $1 of Annual Annuity PerPayable centage Monthly at Change Age 65 for Relative Male Age 45 to 1925 $3.21

100

3.50

109

3.73

116

10

4.24

132

10

4.78

149

3

8

5.09

159

2 Ά 2 Ά

8

6.16

192

8

5.83

182

2

8

6.69

208

2>/4

8

6.16

192

214

8

6.51

203

2'A

8

6.16

192

2

5

6.40

199

2'A 2'A 2