COLAs Vanishing from Pension Plans

Much like rotary phones, snail mail and pension plans in general, cost-of-living allowances are increasingly becoming a thing of the past, new research finds. But, for those organizations considering a COLA, experts say they should implement one on an age-segmented basis to the workforce.

Wednesday, July 25, 2012
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Cost-of-living allowances, or COLAs, while never a prevalent feature of private-sector pension plans, have declined sharply since the 1990s, according to new research.

There are two types of COLAs: those that are a permanent feature of the plan and those that are made voluntarily by employers on an ad hoc basis. Declines in permanent COLAs have been modest. Ad hoc COLAs have been nearly wiped out.

While public-sector plans commonly have COLAs as a permanent feature, only 10 percent of private-sector plans, "a significant minority," have a permanent COLA feature, says Alan Glickstein, senior retirement consultant at Towers Watson in Dallas.

Towers Watson does an annual benefits study that asks plan sponsors questions about the permanent features of their pension plans. The survey has found that plans have consistently reported a 10-percent prevalence rate for permanent COLAs written into defined-benefit-plan documents.

Even some plans that have permanent COLAs have, in practice, ceased providing them when the plans were frozen. According to a company source at Aetna Inc. in Hartford, Conn., the permanent COLAs in Aetna's pension plan have not been given since the company froze the plan more than 18 months ago.

"[W]e elected to freeze the plan as of December 31, 2010, while enhancing the employer contribution to our 401(k) plan to make our retirement benefits more appealing to a broader employee base," said Joseph Zubretsky, chief financial officer and executive vice president at Aetna in a investor conference call on Nov. 3, 2010, "This change lowered our pretax expenses by approximately $21 million in the third quarter," he added.

Utility companies and manufacturers, and other businesses where seniority is valued, are more likely to have pension plans and also more likely to have permanent COLAS, according to Glickstein. High tech and retail companies, on the other hand, are least likely to have them.

One also occasionally sees permanent COLAs at companies that have collectively-bargained plans. "You would see it in a segment that traditionally tended to have richer retirement benefits, to attract and retain workers," says Arthur Noonan, senior retirement consultant for Mercer in Pittsburgh.

Often, the companies with permanent COLAs were highly regulated, where the retirement benefits could be "part of the cost of doing business," Noonan says.

With deregulation of the energy markets, however, even utilities are less able to offer COLAS. And, when they do, "it may be for legacy retirees only and not necessarily for current retirees," says Noonan.

In contrast to the slow erosion of permanent COLAs, the ad hoc COLA -- which originally covered a much larger share of private-sector employers -- has been devastated.

Just how rare is the ad hoc COLA? "I would consider it very rare. And I would be looking for a really good explanation as to why [companies] are doing it," says Noonan, who estimates "less than 1 percent" of plan sponsors currently are offering a voluntary ad hoc COLA.

Back in the 1990s, when many plans were well-funded and sometimes in surplus, a number of companies with defined benefit plans provided ad hoc adjustments to retiree annuitants every 5 or 10 years, according to Noonan. "I won't say that more than half were doing it," he says. "But, most companies thought about it and a significant number did grant them," he adds.

There are some plans that have variable annuities to share risk with the annuitant and "make the plan more manageable," says Noonan. In many ways, those variable annuities perform like a COLA, he adds.

Inflation has remained fairly low for a long time, in contrast with the 1990s, and that means the retirees have not fallen as far behind as was the case if there were no COLAs two decades ago, says Glickstein. For this reason "the already rare occurrences [of ad hoc COLAs] have become more rare."

Glickstein also points to another trend that has reduced annuities, even when they are a permanent part of the plan -- and that is the move by more and more plans to offer a lump sum instead of an annuity.

Among the 500 companies in the Towers Watson annual benefits survey, the number of sponsors who now offer lump sums in defined-benefit plans has risen to 60 percent.

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"All that contributes to less of a focus on what had been a more prevalent feature of pensions," Noonan says.

Some employers with permanent COLAs have put in place both a ceiling to deal with the potential of very high inflation and a floor, to deal with potential deflation. For example, if prices were to fall and a plan did not have a COLA floor, benefits could actually fall, he says.

For those plans that might be considering a COLA, it is likely that they would implement one on an age-segmented basis to the workforce, he says. "My recommendation is to treat them differently," he says to the various age cohorts of retirees covered by a plan.

For employers considering an ad hoc COLA, Noonan recommends a higher COLA for retirees who have been retired 15 or more years, with a slightly smaller COLA for those between 10 and 15 years and a smaller one yet for those retired between 5 and 10 years, and possibly with no COLA for those who have retired in the last 5 years.

As more and more of retirement saving is directed to 401(k) plans, the prevalence of COLAs will shrink even further. Even as companies begin to offer retiring workers who have accumulated 401(k) balances the option of taking installments over 10 years instead of a lump sum, "the type of annuity products available in defined-benefit plans don't exist in 401(k) plans," says Glickstein.

Plan sponsors have "an increasing interest" in the range of benefits offered employees invested in the defined contribution plans when they retire, Glickstein says. "We will see more annuities in those plans, plus annuity options with a built-in escalator," to provide retirees some protection against the rising cost of living over their retirement years.

Since retirees are likely to pay for COLA protection in defined contribution plans with annuity options, "it seems less likely that any annuity from an employer-provided plan would adjust to inflation at a cost to the company."

One of the possible options emerging in discussions at plan sponsors, Glickstein says, is one to purchase an annuity that begins at age 85 to protect the retiree's income against longevity risks. Such protection would be significantly less expensive that an annuity beginning at 65, and can leave the retiree with the bulk of the accumulated benefit.

"Retirements are going to last [a lot] longer than you think" because of improving life spans, he says. "It's in everyone's interest to see that people do not run out of money."

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