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Section 4
GROUP ANNUITY PLANS

The group annuity market, which is linked to corporate defined benefit pension plans, was pioneered by the Metropolitan Life Insurance Company in the early 1920s (see James 1947). Life insurance companies began underwriting group life, health, and disability policies for large corporations in the years after World War I. Providing life annuities to retirees was a natural extension of this business.

Most early corporate pensions were financed on a pay-as-you-go basis, with the firm making payments to beneficiaries from current earnings. In 1921, Metropolitan began to write small contracts to manage corporate pension programs, collecting contributions while workers were employed and, in return, paying out benefits when they were retired. Metropolitan introduced its own retirement pension program in 1925 and began actively marketing "group annuities," the name for structured pension programs, in 1927. In the first year of operation, Metropolitan sold only 30 contracts for group annuities, covering fewer than 40,000 individuals.

The group annuity market suffered from the same difficulties as the individual annuity market in the early 1930s, with low investment returns leading to losses on group annuity contracts. This experience, coupled with the passage of the Social Security Act of 1935 (which promised workers a minimal retirement benefit) led to slow growth of group annuities. By 1941, James (1947) reports, only 269,101 individuals were covered by group annuity policies with Metropolitan Life Insurance Company.

The typical policy at this time (described, for example, by Dublin [1943]), required employer and employee contributions during the employee's active service. The employee was eligible to receive an annuity beginning at age 65, with some provisions for retirement at other ages. At retirement, the employee could typically choose between a lump-sum payout of his total contributions, and the "paid-up option" in which these contributions were used to purchase a life or joint life annuity. Employer contributions were usually applied to purchase an annuity. The goal of most group annuity plans was to provide, in conjunction with individual benefits from Social Security, a retirement income that replaced roughly 40-60 percent of the retiree's earnings from employment (see Dublin 1943, 185).

The group annuity business grew rapidly in the late 1940s and throughout the 1950s. Table 4 charts the growth of group annuities since the late-1950s. In 1958, 3.9 million workers were covered in various types of group annuity plans. This number grew to 38 million by 1988 and to nearly 45 million by 1993, the last year for which data are available. At one time essentially all group annuities were associated with defined benefit pension plans, though not all defined benefit plans were administered through group annuities. In more recent years, group annuities have also been used in conjunction with defined contribution plans. Hoffman and Mondejar (1992) provide data on the assets of insured and noninsured private pension funds. In 1950, insured pension fund assets were 40 percent of the total assets of private pension funds; this fraction declined gradually to 31 percent by the end of the 1980s. The broad trends in this ratio are sensitive to the mix of defined benefit and defined contribution pension plans.

TYPOLOGY OF GROUP ANNUITY PRODUCTS

Group annuity contracts take several forms. The first type to achieve popularity was the deferred group annuity contract. An employer purchasing such a contract makes periodic payments to an insurance company, which applies these payments to the purchase of deferred annuities for covered workers. The purchase price of these annuities is specified by the employer's contract with the insurance company, so the insurer indemnifies the employer against changes in rates of return, mortality risk, or other factors that could alter the pricing of deferred annuities. Maclean (1962) reports that such policies are often structured so that the employer receives a dividend from the insurance company if mortality experience or investment returns prove to be more favorable than the initial contract anticipated. The employer does not pay more, however, if supplying deferred annuities turns out to be more expensive than the insurance company had originally anticipated. This type of contract covered 71 percent of the individuals with group annuity contracts in 1950 but declined to only 48 percent a decade later.

A key attraction of deferred group annuity contracts is that employees know they have a certain pension income, which is guaranteed by the insurance company writing the annuity contract. Managers in turn know that they have met their future pension obligations in full. Because some workers will not remain with the firm long enough to collect pension benefits, however, fully-funded deferred group annuity contracts require the employer to set aside funds for future pension liabilities that may not materialize. These contracts also give employers little flexibility in choosing the funding level for their pension.

A second type of group annuity contract, the deposit administration contract, grew in popularity during the 1950s. This type of contract offers more flexibility in the timing of employer contributions and a more direct link between employer cost and the mortality or turnover experience of employees than does the deferred group annuity contract. Contributions to the deposit administration plan are held by the insurer in an unallocated fund. The insurer promises a minimum return on this fund. When an employee retires, the insurer withdraws an amount sufficient to purchase an immediate fixed annuity for the amount of the retiree's assured retirement benefit from the fund account. The insurer does not indemnify the employer against changes in the price of fixed annuities. Although the insurance company bears all of the risks of mortality and rate-of-return fluctuations for retired employees, the employer bears these risks for employees who have not yet reached retirement.

The employer may be able to contribute less to the reserve fund than the required contributions under a deferred group annuity contract. Deposit administration plans expanded very rapidly in the 1950s, from covering only 10 percent of all individuals in insured pension plans in 1950 to covering 31 percent by 1959. Deposit administration plans and deferred group annuities are aggregated under the single entry "group annuities" in Table 4.

A third type of group annuity contract, first offered in 1950 and one of the most popular in subsequent years, is the immediate participation guarantee (IPG) contract. This is a variant of the deposit administration contract, with a fund account maintained by the insurer but with even more direct links between the mortality experience of covered employees, returns on investment, and the pension costs of the employer. With an IPG plan, if the employer maintains a fund account balance large enough to fund the guaranteed annuities for all retirees, then the employer's account is credited with the actual investment experience of the insurer, and the actual payments to retirees are withdrawn from this account. In this way the employer is essentially self-insuring the mortality experience of retirees and receiving actual rather than projected investment returns. If the employer's fund balance drops below the amount needed to fund the required guaranteed annuities, however, then the plan becomes a standard deferred annuity contract, and the insurer uses the account balance to purchase guaranteed individual annuities for all participants in the pension plan. Provided the account balance is high enough, the employer bears the investment and mortality risks associated with the plan. These risks are assumed by the insurer if the account balance falls below the threshold.

The rules governing an employee's participation in defined benefit private pension plans vary from employer to employer, with corresponding effects on participation in associated group annuity programs. Several common features nevertheless deserve comment. First, when firms introduce these plans, they typically purchase deferred annuities for the pension liabilities associated with prior service of current employees. Second, if employees vested in a pension plan die before the plan's retirement age, their contributions will be returned, in most cases with interest; the employer's contributions to the pension plan will not be returned. Third, an employee who leaves the firm before reaching retirement age may choose to withdraw the current value of his or her pension benefit as a lump sum or to receive the benefits due at retirement age. With the advent of individual retirement accounts and other self-directed retirement income accounts in the early 1980s, workers who were leaving the firm were able to roll over their accumulated pension wealth into another retirement saving account.

GROUP ANNUITIES AND PENSION POLICY IN THE UNITED STATES

Group annuity contracts grew rapidly during the 1950s and 1960s. They were originally linked to defined benefit pension plans, which promise workers a retirement benefit specified by a formula typically depending on years of service and salary history. Their growth continued as employment at firms with defined benefit pension plans increased and as various legislative changes raised the fraction of the workforce at these firms that was covered by a pension. For a variety of reasons, however, the growth of defined benefit plans slowed and then reversed during the 1980s. Defined contribution plans, which permit employers to make contributions to an investment account maintained on behalf of the worker but which do not promise any particular stream of post-retirement benefits, have grown rapidly since the early 1980s. Currently, very few new defined benefit plans are being created, whereas the growth of defined contribution plans continues unabated. As was noted above, the use of group annuities has been changing, and these annuities are increasingly used in conjunction with defined contribution plans.

Table 5 shows substantial changes in the relative flows of contributions to defined benefit and defined contribution pension plans during the 1980s. The table shows the number of defined contribution and defined benefit pension plans, participants in these plans, and contributions to these plans, during the period 1975-91. The number of defined contribution plans more than doubled between 1975 and 1982 and then rose another 50 percent between 1982 and 1989. The number of defined benefit plans increased during the 1975-82 period, but the increase was slower than that for defined contribution plans. Between 1982 and 1991, however, the number of defined benefit plans actually declined, with the 1991 number more than 40 percent below the peak. The number of participants peaked in 1984. In contrast, the number of defined contribution plan participants increased during the 1980s, although more slowly than the number of plans.

The last column in Table 5 tracks contributions to defined contribution and defined benefit pension plans. The disparity between the contribution series is even more dramatic than that between the number of participants or the number of plans. In constant 1989 dollars, defined contribution plan contributions increased from $35.4 billion in 1980 to $73.7 billion in 1991. Contributions to defined benefit plans, however, peaked at $64.1 billion in 1980 and 1981 and then declined to only $27.4 billion by 1991. Defined benefit plan contributions were even lower in 1989 and 1990.

The shift from defined benefit to defined contribution pension plans was the result of several coincident developments, including regulatory changes and a shift in employment growth from industries that historically offered such plans (such as manufacturing) to industries that did not (services and trade). The changing regulatory treatment of defined benefit and defined contribution pension plans began with the Employee Retirement and Income Security Act of 1974 (ERISA). ERISA imposed minimum plan standards for participation, vesting, and retirement, as well as requirements for funding past service liability. It also established the Pension Benefit Guaranty Corporation (PBGC) to insure pension benefits to employees in defined benefit plans and financed this insurance program with taxes on existing plans. ERISA placed a lower regulatory burden on defined contribution plans, which were subject only to the same minimum plan standards that affected defined benefit plans. Post-ERISA legislation has raised PBGC premiums, required faster funding of liabilities, and penalized employers for claiming excess assets of terminated defined benefit plans.

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