Over the past few years, many defined benefit (DB) plan sponsors considered lump sum payouts to their terminated vested participants as a way of “right-sizing” their plan. The ultimate goal is to reduce plan costs and risk.

The IRS recently released the November 2014 417(e) rates, which will be the 2015 reference rates for many DB plans. This post shares a brief update of the impact these rates could have on 2015 lump sum payout strategies.

Low Interest Rates Will Increase Cost of 2015 Lump Sums

So, what’s the potential impact on 2015 lump sums? The table and chart below show the possible difference between comparable 2014 and 2015  lump sums at sample ages assuming payment of a $1,000 deferred-to-65 monthly benefit. Note that the 2014 lump sum estimates are based on November 2013 interest rates, while 2015 values are based on November 2014 rates.

November 2014 lump sum chartNovember 2014 lump sum tableNote: If we adjust for the fact that participants will be one year older in 2015 (and thus one fewer years of discounting), then this increases the costs above by roughly another 5% at most ages.

What’s Causing Lump Sum Costs to Increase?

DB plans generally must pay lump sum benefits using the larger of two plan factors:

(1) The plan’s actuarial equivalence; or

(2) The 417(e) minimum lump sum rates.

Since interest rates have been so low over the past few years, the 417(e) rates are usually the lump sum basis. In particular, 2013 lump sums were abnormally expensive due to historically low interest rates at the end of 2012 (the reference rates for 2013 lump sum calculations), while higher rates towards the end of 2013 made 2014 lump sums more affordable. This is because lump sum values increase as interest rates decrease, and vice versa.

For calendar year plans, the lookback month for the 417(e) rates is often a couple of months before the start of the plan year. Here’s a brief comparison of the November 2013 rates (for 2014 payouts) versus the November 2014 rates (for 2015 payouts).November 2014 segment rate tableAs we can see, the first segment rate increased slightly while the second and third segment rates decreased substantially since last November. The overall large decrease in interest rates is why lump sums will be more expensive in 2015.

What Else Should Plan Sponsors Consider?

  1. If you’re still considering a lump sum payout window, you’ll want to carefully weigh the additional costs of the 2015 lump sum rates compared to 2014.
  1. Even with lower interest rates pushing up lump sum costs, there are still incentives to “right-size” a plan now. These include (a) large ongoing PBGC premium increases and (b) the potential for new mortality tables to further increase lump sum costs significantly in a couple of years.
  1. In addition to lump sum payout programs, plan sponsors should consider annuity purchases and additional plan funding as ways to reduce long-term plan costs/risks

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