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.

False alarm! IRS withdraws controversial proposed cross-testing regulation provisions

A couple of months ago, the IRS proposed some changes to the §1.401(a)(4) nondiscrimination testing regulations.  On Thursday, they withdrew the part of those proposed regulations that was bad news for plan sponsors, as noted in our prior post.

We are pleased the IRS has reconsidered the unintended consequences benefit formula restrictions and “facts and circumstances” based determinations could have on employers’ willingness to sponsor qualified retirement plans.

Surprises in the proposed cross-testing regulations

surprised face

On January 29th, the IRS proposed revisions to the nondiscrimination testing regulations of §1.401(a)(4).  The title of proposed regulations (and most of the attention generated by them) is focused on the relief for closed defined benefit (DB) plans.  This post summarizes the proposed changes that would affect more than just closed DB plans.  Most of them are beneficial to plan sponsors, but one is not.

 

The bad news – benefit formula restrictions

The biggest surprise is a proposed restriction in setting different benefit levels for different participant groups.

Currently, plans can generally separate the participant population into groups with different benefit levels/formulas as desired, so long the plan is doesn’t disproportionately favor Highly Compensation Employees (HCEs) relative to non-HCES.  Plans can even go so far as to separate each plan participant into his or her own “group”.

The proposed regulations would require HCEs’ benefit formulas to apply to a “Reasonable Classification” of employees*.  This is a “facts and circumstances” determination.  §1.410(b)-4(b) states that “reasonable classifications generally include specified job categories, nature of compensation (i.e. salaried or hourly), geographic location, and similar business criteria”.  Picking participants by name (or in a way that effectively does that) is not considered a reasonable classification.

This is an important issue for plans that allow each participant to have a separate benefit level and rely of the Average Benefit Test to satisfy §1.401(a)(4).  Other plans may need to consider if their benefit groups are a reasonable classification.

*Unless the rate group satisfies the Ratio Percentage Test.

 

The good news – cross-testing gateways for aggregated DB/DC plans

The favorable part of the proposed regulations is more flexibility in combining DB and DC plans for nondiscrimination testing.  These proposed changes were suggested by the IRS in Notice 2014-5, so they aren’t a surprise to those that have kept up with the IRS’s previous relief efforts for closed DB plans.  However, those suggestions haven’t got much attention so they are good news for many.

Plans must pass through a “gateway” before aggregating DC and DB plans in a cross-test.  A cross-test is generally much more favorable than testing each plan separately.  The currently available gateways are:

  1. The DB/DC plan is “primarily defined benefit in character”
  2. The DB/DC plans consist of broadly available separate plans
  3. The DB/DC plan provides a minimum allocation to all benefitting non-HCEs

 

The proposed regulations would expand the DB/DC gateway options in three ways:

1.  New gateway: The proposed regulations would add another gateway – passing the cross-test test with a 6% interest rate (rather than the standard 7½% to 8½%). While the DB/DC would technically still need to pass the cross-test with a standard interest rate, this option could practically eliminate the gateway requirement for DB/DC plans that can pass with 6% interest.

2.  Matching contributions use: The proposed regulations would allow the average matching contribution for non-HCEs (up to 3% of pay) to count toward the DB/DC minimum allocation gateway. Matching contributions would still not be included in the cross-test.

3.  Option to average DC allocation rates: Current rules allow DB allocation rates for non-HCEs to be averaged for satisfying the minimum allocation gateway. The proposed regulations would allow the same treatment for DC allocation rates.  The purpose of this change is to allow plans to provide lower allocation rates for those with less service by providing higher rates to those with more service.

The IRS notes that they’re considering if restrictions on this option are needed to ensure it is used as intended, and not as another technique for minimizing non-HCE benefits.  The proposed regulations would also limit averaging of DB and DC rates to reduce the impact of outliers.

 

Many plans that satisfy the §1.401(a)(4) requirements with a general test will need or want to revisit their benefit formula design if these proposed regulations become final.  There is sure to be a lot of resistance to the benefit formula restrictions, so the regulations may not be finalized as proposed.  If you would like to send comments on the proposed regulations you can do so until April 28, 2016.

Plan sponsors may apply the proposed regulations specific to closed DB plans right away, but may not use the flexibility of the other proposed cross-testing rules until they are finalized.  We encourage you to contact your actuary if you have questions about how these proposed rules would affect your plan.

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.

 

DB Plan Sponsors Should Prepare Now for Higher Year-End Liabilities

The combination of lower discount rates and new mortality tables will dramatically increase pension plan liabilities and decrease DB plans’ funded status for December 31, 2014 financial reporting. Using the November 2014 Citigroup Pension Liability Index (CPLI) and Citigroup Pension Discount Curve (CPDC) as proxies, pension accounting discount rates are down by almost 90 basis points since December 31, 2013.

Fortunately, many plans have experienced solid investment returns so far during 2014. This will take some of the sting out of the liability increases, but it likely won’t be enough to entirely offset the effect of lower interest rates and the new mortality tables. The higher liabilities will affect both the year-end funded status of the plan and also the 2015 pension expense calculation.

Discount Rate Analysis

In the chart below we compare the CPDC at three different measurement dates (12/31/2012, 12/31/2013, and 11/30/2014). We also highlight the CPLI at each measurement date. The CPLI can be thought of as the average discount rate the CDPC produces for an “average” pension plan.

Citigroup comparison 11302014

The orange arrows in the chart highlight the trend in yield curve movement and show how rates are almost back to their 2012 lows at all points along the spectrum. This means that nearly all plans will feel the negative effect of lower discount rates.

Net Effect on Balance Sheet Liability

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 12/31/2013, where we assume a 10% increase in pension liability during 2014. We then compare the funded status results under two asset scenarios: (1) Assets 5% higher than 12/31/2013 and (2) Assets 8% higher than 12/31/2013.

11302014 bal sheet liability example

In both cases, the funded status of the plan decreases. There’s also a magnified increase in the unfunded balance sheet liability because it’s such a leveraged result. This amount increases by 30% and 18%, respectively, in the two sample scenarios.

Conclusions

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

  • Don’t forget that the new Society of Actuaries mortality tables will be recommended for use at year-end and will likely further increase plan liabilities.
  • Additional pension plan funding (above the IRS minimum requirements) may be appealing in 2014 and 2015. Not only will it increase the plan’s funded status, but it will also help lower your pension plan’s PBGC variable rate premiums.
  • Your plan’s specific cash flows could have an enormous impact on how much the drop in discount rates affects your pension liability. If you’ve just used the CPLI in the past, it’s worth looking at modeling your own projected cash flows with the CPDC or an alternative index or yield curve to see how it stacks up.
  • 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 early in 2015.

What’s the Impact of 2015 IRS Retirement Plan Limits?

The IRS just announced the 2015 retirement plan benefit limits and we’re seeing some modest increases from 2014. What does it all mean for employer-sponsored retirement plans? This post analyzes the practical effects for both defined contribution (DC) and defined benefit (DB) plans, followed by a table summarizing the limit changes.

Changes affecting both DB and DC plans

  • Qualified compensation limit increases from $260,000 to $265,000. Highly-paid participants will now have more of their compensation “counted” towards qualified plan benefits and less towards non-qualified plans. This helps for both nondiscrimination testing as well as for benefits.
  • HCE compensation threshold increases from $115,000 to $120,000. For calendar year plans, this will first affect 2016 HCE designations because $120,000 will be the threshold for the 2015 “lookback” year. Slightly fewer participants will meet the new HCE compensation criteria, which will have two direct outcomes:
  • Plans may see better nondiscrimination testing results (including ADP results) if there are fewer participants at the low end of the HCE range, especially those with big deferrals. It could make a big difference for plans that were close to failing the tests.
  • Fewer HCEs means that there are fewer 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 $52,000 to $53,000 and the 401(k) deferral limit increases from $17,500 to $18,000. A $1,000 increase to the overall DC limit and $500 increase to the deferral limit may not seem like much, but it will allow participants to get a little more “bang” out of their DC plan. This means that individuals can get up to $35,000 from employer match and profit sharing ($53K – $18K) if they maximize their 401(k) deferrals. Previously, their profit sharing limit would have been $34,500 ($52K – $17.5K).

Higher Discount Rates Will Help 2013 Pension Disclosures and 2014 Expense

The final results are in and pension plan sponsors should be pleased with final year-end discount rates – at least compared to the FY2012 rates. Using the Citigroup Pension Liability Index (CPLI) and Citigroup Pension Discount Curve (CPDC) as proxies, pension accounting discount rates are up by about 90 basis points this year.

This is great news for pension plan sponsors. The higher discount rates will have a very beneficial effect on pension liabilities. This in turn will affect both the year-end funded status of the plan and also the 2014 pension expense calculation.

Analysis
In the chart below we compare the CPDC at four different measurement dates (12/31 2010 to 2013). 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.

Citigroup comparison 12312013

The orange arrows in the chart highlight the trend in yield curve movement and show how rates have increased at almost all points along the spectrum since 2012. This means that pretty much all plans, even closed/frozen plans with shorter durations, should experience the benefit of higher discount rates.

Net Effect on Balance Sheet Liability
Many plans also had strong investment returns during the year. 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 70% funded on 12/31/2012 and we assume a 10% decrease in pension liability during 2013. We then compare the funded status results under two asset scenarios: (1) Assets 5% higher than 12/31/2012 and (2) Assets 15% higher than 12/31/2012.

12312013 bal sheet liability example

In both cases, the funded status of the plan improves measurably. There’s also a magnified decrease in the unfunded balance sheet liability because it’s such a leveraged result. This amount decreases by 45% and 68%, respectively, in the two sample scenarios.

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

  • Now maybe 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 early in 2014.
  • Additional plan funding (above the IRS minimum requirements) may be appealing in 2014. Not only will it increase the plan’s funded status, but it will also help lower your pension plan’s PBGC variable rate premiums. These are scheduled to increase significantly starting in 2015 as a result of the Bipartisan Budget Act of 2013.
  • Your plan’s specific cash flows could have an enormous impact on how much the drop in discount rates affects your pension liability. If you’ve just used the CPLI in the past, it’s worth looking at modeling your own projected cash flows with the CPDC or an alternative index or yield curve to see how it stacks up.
  • Even though increased discount rates tend to lower the present value of pension liabilities, your plan may still have an overall liability increase. This could result from active participants continuing to accrue new benefits in the plan, or from the fact that benefits will have one fewer year of interest discount at 12/31/2013 compared to 12/31/2012.