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.
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.
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.
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.
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.
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.
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.
What else should plan sponsors consider?
- 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.
- 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).
- 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.