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.

 

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.

 

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”.

Developing a thoughtful public pension funding policy

A thoughtful pension funding policy provides the best way for public sector employers to keep their pension promises. The funding policy provides discipline to address unfunded pension liabilities, while respecting the many current demands for budget dollars.

The League of Arizona Cities and Towns recently sponsored a study by a special Task Force to identify areas for improvement and develop reform recommendations. The final recommendation is “Create a pension funding policy.” The Task Force emphasized that Arizona cities and counties “have a fiduciary responsibility to ensure (the) plan has sufficient financial resources to provide the benefits earned ….”

The pension funding policy is the best (and maybe the only) way for plan sponsors to meet their fiduciary duty to keep the pension promise. But developing a pension funding policy is not easy. It requires projecting unfunded pension liabilities beyond what is usually shown in existing actuarial reports. It also requires a delicate balancing of all of the various constituent interests over a variety of time frames.

The easy way out has always been to ignore the problem and leave it to someone else in the future. But a prudent few will openly address the political and budget issues inherent in developing a funding policy that keeps the pension promise.

One city recently chose to invest the time and resources to develop a pension funding policy. After years of declining funded ratios and increasing contributions, the city Finance Officer championed a study that involved the City Commission, the pension fund members, the actuary and the investment advisor. The resulting pension funding policy provided for an increase in employer and employee payroll contributions – and also provided for a third stream of contributions unrelated to payroll: a pension sustainability contribution.

We encourage every public sector plan sponsor to develop a pension funding policy. And we applaud the prudent finance officers who actually begin the process to keep their pension promises.