What’s the Impact of 2018 IRS Retirement Plan Limits?

The IRS Notice 2017-64 just announced the 2018 retirement plan benefit limits, and there are many changes since 2017. What does it all mean for employer-sponsored retirement plans? Below is a table summarizing the primary benefit limits, followed by our analysis of the practical effects for both defined contribution (DC) and defined benefit (DB) plans.

Qualified Plan Limit 2016 2017 2018
415 maximum DC plan annual addition $53,000 $54,000 $55,000
Maximum 401(k) annual deferral $18,000 $18,000 $18,500
Maximum 50+ catch-up contribution $6,000 $6,000 $6,000
415 maximum DB “dollar” limit $210,000 $215,000 $220,000
Highly compensated employee (HCE) threshold $120,000 $120,000 $120,000
401(a)(17) compensation limit $265,000 $270,000 $275,000
Social Security Taxable Wage Base $118,500 $127,200 $128,700

 Changes affecting both DB and DC plans

  • Qualified compensation limit increases to $275,000. Highly-paid participants will now have more of their compensation “counted” towards qualified plan benefits and less towards non-qualified plans. This could also help plans’ nondiscrimination testing if the ratio of benefits to compensation decreases.
  • HCE compensation threshold remains at $120,000. This is the fourth year in a row that the HCE compensation limit has been stuck at $120,000. When this threshold doesn’t increase to keep pace with employee salary increases, employers may find that more of their employees become classified as HCEs. This could have two direct outcomes:
  • Plans may see marginally worse nondiscrimination testing results (including ADP results) if more employees with large deferrals or benefits become HCEs. It could make a big difference for plans that were previously close to failing the tests.
  • More HCEs means that there are more participants who must receive 401(k) deferral refunds if the plan fails the ADP test.

Note that there is a “lookback” procedure when determining HCE status. This means that the 2019 HCEs are determined based on whether their 2018 compensation is above the $120,000 threshold.

DC-specific increases and their significance

  • The annual DC 415 limit increases from $54,000 to $55,000 and the 401(k) deferral increases to $18,500. Savers will be glad to have more 401(k) deferral opportunity, albeit a modest $500 increase. Even though these deferrals count towards the total DC limit, employers can also increase their maximum profit sharing allocations. Individuals could potentially get up to $36,500 from employer matching and profit sharing contributions ($55K – $18.5K) if they maximize their DC plan deductions.
  • 401(k) “catch-up” limit remains at $6,000. Participants age 50 or older still get a $6,000 catch-up opportunity in the 401(k) plan, which means they can effectively get a maximum DC deduction of $61,000 ($55K + $6K).

 
DB-specific increases and their significance

  • DB 415 maximum benefit limit (the “dollar” limit) increases to $220,000. This is the second straight year we’ve seen an increase in the DB 415 limit, after three years of static amounts. The primary impact is that individuals who have very large DB benefits (say, shareholders in a professional firm cash balance plan) could see a deduction increase if their benefits were previously constrained by the 415 dollar limit.
  • Social Security Taxable Wage Base increases to $128,700. This is a modest $1,500 increase from the prior limit. With regards to qualified retirement benefits, a higher wage base can slightly reduce the rate of pension accruals for highly-paid participants in integrated pension plans that provide higher accrual rates above the wage base.

2017 Pension Lump Sums Are Looking More Affordable

How quickly things change! A month ago we were anticipating very expensive 2017 lump sum costs for defined benefit (DB) pension plans due to continually low interest rates. However, rates have been on a strong rebound since the election and now 2017 lump sums are looking much more affordable.

The IRS recently released the November 2016 417(e) interest rates which are used by many DB plans as the reference rates for lump sum payments. These three segment rates are 20 to 35 basis points higher than the October 2016 rates, though overall they are still lower than the November 2015 rates.

This post shares a brief update of the impact these rates could have on 2017 lump sum payout strategies.

Glass Half Full: 2017 Lump Sum Costs Are Going Up, But Less Than Expected

The table and chart below show the possible difference in lump sum values at sample ages assuming payment of a $1,000 deferred-to-65 monthly benefit. The calculations compare the November 2015 rate basis to the November 2016 basis.

Although the projected 2017 lump sum costs are still higher than 2016, the increases are only half of what we were expecting a month ago. It remains to be seen if rates continue their upward trend, but the reduction in anticipated lump sum cost increases may encourage more plan sponsors to embrace pension risk transfer (PRT) strategies like lump sum windows for terminated vested participants.

The November lump sum rates aren’t the end of the story for 2017 PRT opportunities either. If rates continue to increase, then plan sponsors will want to consider using a different reference period for the temporary lump sum window to reflect the higher rates. Even if rates don’t rise anymore, 2017 will likely be the last year to pay lump sums without reflecting new mortality assumptions in 2018.

2016 Pension Accounting Preview: a Positive Outlook

Many defined benefit (DB) plan sponsors are aware that interest rates dropped significantly in the first half of 2016 but staged a remarkable rise since the November election. Combined with relatively strong equity returns, 2016 year-end pension disclosures may not be as bad as expected 6 to 8 weeks ago.

Discount Rate Analysis

Using the November 2016 Citi Pension Liability Index (CPLI) and Citi Pension Discount Curve (CPDC) as proxies, pension accounting discount rates are down by about 20 basis year-to-date. Although they’re not quite up to 2015 year-end levels, the rebound (from almost 90 bps lower than last year) is welcome relief to pension plans.

In the chart below, we compare the CPDC at three different measurement dates (12/31/2014, 12/31/2015, and 11/30/2016). We also highlight the CPLI at each measurement date. The CPLI can be thought of as the average discount rate produced by the curve for an “average” pension plan.

nov-2016-citigroup-curve

Net Effect on Balance Sheet Liability

The other half of the pension funded status equation is the plan asset return. Like discount rates, it’s been a bumpy year but it appears to be ending in the right direction. Domestic stock indices are doing well and a balanced portfolio is likely at or above its expected return.

Depending on the starting funded status, the change in pension liabilities and assets can have a leveraging effect on the reported net balance sheet asset/liability.

Below is a simplified illustration for a plan that was 80% funded on 12/31/2015. We assume a 5% increase in pension liability during 2016 and then compare the funded status results under two asset scenarios: (1) Assets 5% higher than 12/31/2015 and (2) Assets 8% higher than 12/31/2015.

illustration-of-change-nov-16

In the first scenario, the plan’s funded percent remains constant at 80% even though the dollar amount of pension debt increases by about 5%. In the second scenario, the funded status actually improves slightly both on a percent and dollar basis.

Conclusions

So, what should plan sponsors be considering over the next month as we approach year-end? Here are a few ideas.

  • The 2016 Society of Actuaries mortality table updates will likely be recommended for use at year-end. Those tables should decrease pension liabilities slightly for most plans.
  • Don’t forget to measure settlement accounting if you completed a lump sum window in 2016! Some small and mid-sized plans may not be familiar with this requirement, and it can significantly increase your 2016 pension accounting expense.
  • Using the Citi above-median yield curve could increase discount rates by roughly 12 basis points.
  • Now may be a good time to consider strategies that lock in some of this year’s investment gains. These could include exploring an LDI strategy to more closely align plan assets and liabilities, or offering a lump sum payout window for terminated vested participants in 2017.

Pension Lump Sums Likely More Expensive in 2017

Lump sum windows and other pension risk transfer strategies continue to be popular among many defined benefit (DB) pension plan sponsors. Paying lump sums to terminated vested participants can reduce long-term plan costs and risks by permanently eliminating these liabilities. However, the cost of the lump sum payments is heavily influenced by the underlying interest rate and mortality assumptions.

The IRS recently released the October 2016 417(e) interest rates. Although many DB plans will likely use the November or December rates as their 2017 lump sum payment basis, the October rates are good indicators of what 2017 lump sum costs might look like. This post shares a brief update of the impact these rates could have on 2017 lump sum payout strategies.

Lower Interest Rates Will Increase Cost of Lump Sums

So, what’s the story for 2017? The table and chart below show the possible difference in lump sum values at sample ages assuming payment of a $1,000 deferred-to-65 monthly benefit. The calculations compare the November 2015 rate basis (used by most plans for 2016 lump sums) to the October 2016 basis.

lump-sums

november-2017-ls-rate-update-table

The dollar increase in lump sum value is relatively consistent around $10K to $12K. This translates to a 5% cost increase at the very late ages, versus a nearly 30% cost increase at younger ages. Note that if we adjust for the fact that participants will be one year older in 2017 (and thus one fewer years of discounting) then this increases the costs by an additional 5% at most ages.

 

Interest rates dropped significantly in the first half of 2016 and have only recently begun to rebound. This increases lump sum costs because lump sum calculations increase as interest rates decrease, and vice versa. Below is a comparison of the November 2015 and October 2016 417(e) lump sum interest rates. Note that the second and third segment rates are 70+ basis points lower than last year.

415e-interest-rates

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 2017 lump sum rates compared to 2016. However, there’s still the chance that rates could rise substantially before year-end.
  2. Even with lower interest rates pushing up lump sum costs, there are still incentives to “de-risk” 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 (likely in 2018).
  3. 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. Some plan sponsors are also pursuing a “borrow to fund and terminate” strategy.

What’s the Impact of 2017 IRS Retirement Plan Limits?

The IRS just announced the 2017 retirement plan benefit limits, and there are some notable changes from 2016. What does it all mean for employer-sponsored retirement plans? Here is a table summarizing the primary benefit limits, followed by our analysis of the practical effects for both defined contribution (DC) and defined benefit (DB) plans.

Qualified Plan Limit 2015 2016 2017
415 maximum DC plan annual addition $53,000 $53,000 $54,000
Maximum 401(k) annual deferral $18,000 $18,000 $18,000
Maximum 50+ catch-up contribution $6,000 $6,000 $6,000
415 maximum DB “dollar” limit $210,000 $210,000 $215,000
Highly compensated employee (HCE) threshold $120,000 $120,000 $120,000
401(a)(17) compensation limit $265,000 $265,000 $270,000
Social Security Taxable Wage Base $118,500 $118,500 $127,200

 

Changes affecting both DB and DC plans

  • Qualified compensation limit increases to $270,000. High-paid participants will now have more of their compensation “counted” towards qualified plan benefits and less towards non-qualified plans. This could also help plans’ nondiscrimination testing if the ratio of benefits to compensation decreases.
  • HCE compensation threshold remains at $120,000. For calendar year plans, this will first affect 2018 HCE designations because $120,000 will be the threshold for the 2017 “lookback” year. When the HCE compensation threshold doesn’t increase to keep pace with employee salary increases, employers may find that more of their employees become classified as HCEs. This could have two direct outcomes:
    • Plans may see marginally worse nondiscrimination testing results (including ADP results) if more employees with large deferrals or benefits become HCEs. It could make a big difference for plans that were previously close to failing the tests.
    • More HCEs means that there are more participants who must receive 401(k) deferral refunds if the plan fails the ADP test.

DC-specific increases and their significance

  • The annual DC 415 limit increases from $53,000 to $54,000 and the 401(k) deferral limit remains at $18,000. A $1,000 increase in the overall DC 415 limit may not seem like much, but it will allow participants to get a little more “bang” out of their DC plan. Since the deferral limit didn’t increase, this means that any additional DC benefits will have to come from higher employer contributions. Individuals can now receive up to $36,000 from match and profit sharing contributions ($54K – $18K).
  • 401(k) “catch-up” limit remains at $6,000. Participants age 50 or older still get a $6,000 catch-up opportunity in the 401(k) plan, which means they can effectively get a maximum DC deduction of $60,000 ($54K + $6K).

DB-specific increases and their significance

  • DB 415 maximum benefit limit (the “dollar” limit) increases to $215,000. This limit finally increased after being static for three straight years. The primary impact is that individuals who have very large DB benefits (say, shareholders in a professional firm cash balance plan) could see a deduction increase if their benefits were previously constrained by the 415 dollar limit.
  • Social Security Taxable Wage Base increases to $127,200. This is a big jump from the prior $118K limit and effectively reflects two years of indexing (the limit couldn’t increase last year because the Social Security COLA was 0% and caps the wage base increase rate). With regards to qualified retirement benefits, a higher wage base can slightly reduce the rate of pension accruals for highly-paid participants in integrated pension plans that provide higher accrual rates above the wage base.

Closed DB plan nondiscrimination testing relief extended for 2017

 arms-in-air

Employers with “closed” DB pension plans (i.e., closed to new entrants, but benefits continue to accrue for existing participants) received another extension of nondiscrimination testing relief in IRS Notice 2016-57. This will help these employers demonstrate compliance with existing nondiscrimination testing rules while waiting for final regulations likely to be effective starting in 2018.

 

Background

Closed DB pension plans often run into unintended nondiscrimination testing problems. Why? Generally there is higher turnover among non-highly compensated employees (NHCEs) vs. highly compensated employees (HCEs). The NHCEs positions are filled with new employees who are not eligible for the closed DB plan, so the DB plan gradually becomes “concentrated” with HCEs. This will eventually cause the plan to fail the nondiscrimination testing requirement that pension plans not cover a disproportionate share of HCEs.

 

The IRS acknowledged this unintended consequence with Notice 2014-5 which provided temporary relief for DB plans with a soft-freeze date prior to December 31, 2013. The relief applied to the 2014 and 2015 plan years and allowed aggregated nondiscrimination testing of DC plans and closed DB plans without having to pass the usual “gateway” requirements, as long as the DB plan passed testing on a standalone basis in 2013. This was a significant development because gateway allocations can be very expensive and require per-participant allocations of up to 7.5% of pay. The alternative was to freeze all DB plan accruals so that the coverage requirements no longer applied to the DB plan.

 

Relief Extended

The relief in Notice 2014-5 was extended to the 2016 plan year in Notice 2015-28, and proposed regulations were issued on January 29, 2016. Since those regulations likely won’t be finalized and effective until the 2018 plan year, the IRS is now extending the temporary nondiscrimination testing relief for the 2017 plan year as well.

 

Although this relief is welcome news to plan sponsors, they should not lose sight of the fact the closed DB plan still needs to pass nondiscrimination testing when aggregated with the employer’s DC plan(s). This shouldn’t be a problem in most cases, unless the DB plan provides such large benefits to HCEs that the aggregated plans fail the 401(a)(4) benefits testing.

 

Sponsors of small and mid-sized closed DB plans should also keep in mind that eventually 401(a)(26) minimum participation requirements could become a problem. These rules require that the smaller of (a) 40% of active employees or (b) 50 active employees participate in the DB plan. In high turnover industries, those thresholds may not be far on the horizon.

 

What’s the Impact of 2016 IRS Retirement Plan Limits?

The IRS just announced the 2016 retirement plan benefit limits, and there are virtually no changes from 2015. What does it all mean for employer-sponsored retirement plans? Below is a table summarizing the primary benefit limits, followed by our analysis of the practical effects for both defined contribution (DC) and defined benefit (DB) plans.

Qualified Plan Limit 2015 2016
415 maximum DC plan annual addition $53,000 $53,000
Maximum 401(k) annual deferral $18,000 $18,000
Maximum 50+ catch-up contribution $6,000 $6,000
415 maximum DB “dollar” limit $210,000 $210,000
Highly compensated employee (HCE) threshold $120,000 $120,000
401(a)(17) compensation limit $265,000 $265,000
Social Security Taxable Wage Base $118,500 $118,500

 

Changes affecting both DB and DC plans

  • Qualified compensation limit remains at $265,000. A flat qualified compensation limit could have several consequences. These include:
    • More compensation counted towards SERP excess benefits if a participant’s total compensation (above the threshold) increases in 2016.
    • Lower-than-expected qualified pension plan accruals for participants whose pay is capped at the 401(a)(17) limit and were hoping for an increase.
  • HCE compensation threshold remains at $120,000. For calendar year plans, this will first affect 2017 HCE designations because $120,000 will be the threshold for the 2016 “lookback” year. When the HCE compensation threshold doesn’t increase to keep pace with employee salary increases, employers may find that more of their employees become classified as HCEs. This could have two direct outcomes:
    • Plans may see marginally worse nondiscrimination testing results (including ADP results) if more employees with large deferrals or benefits become HCEs. It could make a big difference for plans that were previously close to failing the tests.
    • More HCEs means that there are more participants who must receive 401(k) deferral refunds if the plan fails the ADP test.

DC-specific increases and their significance

  • The annual DC 415 limit remains at $53,000 and the 401(k) deferral limit remains at $18,000. Although neither of these limits has increased to allow higher contributions, it should make administering the plan a little easier in 2016 since there are no adjustments to communicate or deal with. Since the 401(k) deferral limit counts towards the total DC limit, this means that an individual could potentially get up to $35,000 from profit sharing ($53K – $18K) if they maximize their DC plan deductions.
  • 401(k) “catch-up” limit remains at $6,000. Participants age 50 or older still get a $6,000 catch-up opportunity in the 401(k) plan, which means they can effectively get a maximum DC deduction of $59,000 ($53K + $6K).

DB-specific increases and their significance

  • DB 415 maximum benefit limit (the “dollar” limit) remains at $210,000. This limit remained unchanged for a third straight year, which may constrain individuals with very large DB benefits (e.g., shareholders in a professional firm cash balance plan) who were looking forward to increasing their DB plan contributions/deductions.
  • Social Security Taxable Wage Base remains at $118,500. When this limit increases, it can have the effect of reducing benefit accruals for highly-paid participants in integrated pension plans that provide higher accrual rates above the wage base. When the wage based remains unchanged (like this year), it means that these individuals’ accruals may be higher-than-expected if their total compensation (above the wage base) continues to increase.

 

OPEB Funding Policy Opportunities

New Governmental Accounting Standards Board (GASB) statements 74 and 75 are intended to make accounting for OPEB (Other Postemployment Benefits, usually retiree medical) more transparent by moving the entire unfunded liability to the face of the financial statements. This post discusses some of the OPEB funding policy opportunities that employers should consider as they prepare to implement GASB 74/75 over the next two years.

Opportunity #1: The potential for funded status improvement. Unlike pension plans which are generally pre-funded, most public sector OPEB liabilities are unfunded and benefits are pay-as-you-go. But employers should consider that ANY funding policy is better than nothing – and even a modest level of pre-funding will improve the plan’s funded status and balance sheet impact.

Opportunity #2: A funding policy can help lower the calculated liability. The ultimate cost of retiree medical benefits can never be known exactly until benefits are actually paid in the future. However, the best estimate of those costs in today’s dollars is impacted by how (and if) funds are invested. To the extent that investment returns can help fund future benefit costs, an OPEB trust with higher expected returns can help reduce your calculated OPEB liability.

Opportunity #3: Attention can drive action. OPEB liabilities are becoming front-page headlines – particularly because of their unfunded nature. Employers should harness this increased scrutiny to compel stakeholders (e.g., employers, employees, and taxpayers) to collaboratively review OPEB terms and create a strategy to prudently prefund these promises.

There will be pitfalls along the way. It may be difficult to secure additional funding sources when employers and employees are already trying to eliminate existing pension debt. Plus, OPEB costs are usually more volatile than pensions, so an OPEB funding policy will need to consider strategies to deal with this “moving target”.

There may also be situations where an employer does not want to prefund OPEB. Perhaps they fear that “committing” money towards OPEB will reduce their ability to reduce benefit levels in the future. However, this rationale just skirts the larger issue of knowingly promising benefit levels which are unaffordable.

GASB 74/75 is a catalyst for public employers to revisit their OPEB funding policies. There is a limited timeframe for stakeholders to develop a meaningful funding strategy before the entire unfunded liability goes “on the books”.

First pensions, now OPEB – New GASB 74 & 75 will transform OPEB reporting

Public sector employers, get ready! The Governmental Accounting Standards Board (GASB) has officially approved new accounting statements for Other Post-Employment Benefit plans (OPEB; retiree medical). Here’s what the recent GASB announcement confirms:

  • Final provisions will closely mirror GASB 67/68 pension accounting. The official statements won’t be released until late June, but last summer’s OPEB exposure draft included similar provisions such as:
    • The unfunded liability will now go on the balance sheet.
    • The liability discount rate will be based on a projection of how long dedicated assets (plus future contributions) will cover current plan members’ future benefit payments.
    • OPEB expense will recognize asset and liability changes over a shorter time period.
    • Goodbye ARC! Funding and accounting are officially separated, so plans and employers should consider developing a new OPEB funding policy.
  • Expanded note disclosures and RSI are required, including sensitivity of results to a +/-1% change in the discount rate and medical trend assumptions.
  • Effective dates:
    • GASB 74 Plan accounting is first effective for reporting periods beginning after June 15, 2016 (e.g., fiscal years beginning July 1, 2016 or January 1, 2017).
    • GASB 75 Employer accounting is first effective for reporting periods beginning after June 15, 2017 (e.g., fiscal years beginning July 1, 2017 or January 1, 2018).

Although the implementation dates are almost 3 years away, employers should take action now to prepare. Some questions to ask include:

  1. How can I develop and implement an OPEB funding policy over the next few years? Prefunding OPEB can help reduce the unfunded balance sheet liability.
  2. What plan benefit adjustments and investment policy changes are available to lower my long-term OPEB liability? Now is the time to review your OPEB management strategies.
  3. What is my strategy to educate stakeholders about OPEB promises and their potential financial impact under the new GASB 74/75 requirements? OPEB is a complex topic that may be unfamiliar to plan members, government decision-makers, and taxpayers.

The new GASB 74/75 statements should help make OPEB promises more understandable and transparent. While there’s still sufficient lead-up time, employers should view this as an opportunity to proactively address an employee benefit which is often unfunded but must be managed prudently.

Pension Lump Sums Much More Expensive in 2015

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