Preview of 2014 Lump Sum Interest Rates

As mentioned in our July lump sum interest rate post, many defined benefit (DB) plan sponsors are considering 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 2013 417(e) rates, which will be the 2014 reference rates for many DB plans. This post shares a brief update of the impact these rates could have on 2014 lump sum payout strategies.

Background
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). This is because lump sum values increase as interest rates decrease and vice versa.

Effect of Interest Rate Changes
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 comparison of the November 2012 rates (for 2013 payouts) versus the November 2013 rates (for 2014 payouts).

November 2013 segment rate table

As we can see, all three segments have increased substantially since last November. So, what’s the potential impact on lump sum payments? The table and chart below show the difference in lump sum value at sample ages assuming payment of deferred-to-65 benefits using the November 2012 and November 2013 417(e) interest rates.

November 2013 lump sum chart

November 2013 lump sum table

Note: If we adjust for the fact that participants will be one year older in 2014 (and thus one fewer years of discounting), then this decreases the savings by about 5% at most ages.

Lump Sum Strategies
So, what else should plan sponsors consider?

1. If you haven’t already considered a lump sum payout window, the 2014 lump sum rates may make this option much more affordable than in 2013.

2. With the scheduled increase in PBGC flat-rate and variable-rate premiums due to MAP-21 (plus the proposed additional premium increases in the Bipartisan Budget Act of 2013) there’s an incentive to “right-size” a pension plan to reduce the long-term cost of PBGC premiums.

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

Evaluating PBGC Premium Options in Advance of Big Increases

Which door to choose?Each year, defined benefit (DB) pension plan sponsors must pay pension insurance premiums to the Pension Benefit Guaranty Corporation (PBGC). In light of large PBGC premium rate increases in 2013 and future years, plan sponsors should carefully evaluate their options before proceeding with their next premium payment.

Background

There are two components to annual PBGC premiums:

1. Flat rate premium based on the number of participants

2. Variable Rate Premium (VRP) based on the plan’s unfunded vested liabilities

As a result of last year’s Moving Ahead for Progress in the 21st Century Act (MAP-21), PBGC premium rates are scheduled to increase sharply over the upcoming years. Below is a table showing a summary of upcoming PBGC rate increases.

MPGC rate table 2013

Potential Strategies to Manage PBGC Premiums

Pension plan sponsors generally don’t like to pay PBGC premiums because it is money that could otherwise be spent on increased funding for the plan. With this in mind, here are some important issues to consider before proceeding with your next PBGC premium filing:

1. Unfunded liabilities for the VRP can be calculated using “standard” PBGC interest rates (snapshot rates) or “alternative” rates based on a 24 month average of the snapshot rates. Once you choose a method, you have to stick with it for at least 5 years. Since 2008 was the first year that plan sponsors could elect the “alternative” method, 2013 is the first year that they can make an election to switch back to the “standard” rates (though it likely won’t be advantageous to do so).

2. Over the long-term, both interest rate methods should produce similar VRP amounts even though the smoothed alternative interest rates will lag the standard rates. When interest rates are falling, VRPs based on the alternative interest rates should be lower than those using standard rates. The opposite will be true in a rising interest rate environment.

3. Sponsors of small pension plans (fewer than 100 participants) that haven’t completed their 2012 PBGC premium filing can actually lock-in beneficial VRPs for two years. Their 2012 premiums aren’t due until April 30, 2013 so they can estimate their 2012 and 2013 premiums under both the standard and alternative methods and see which one is the most economical.

4. Before switching interest rate methods just to get lower 2012 and/or 2013 VRPs, plan sponsors should be aware that it’s less expensive to be underfunded now than in 2014 or later years. That’s because the VRP premium rate is doubling in the next two years (see table above), which could wipe out any short-term VRP savings this year.

How could this strategy backfire? Consider a plan that switches to the alternative VRP method in 2013 in order to lower their unfunded liability by $1M. This would decrease their 2013 VRP by $9K (i.e., $9 per $1,000 in unfunded liability).

Now suppose that interest rates increase before 2014. The standard interest rate method would immediately use those higher interest rates to calculate 2014 VRPs. The alternative rates would lag and be lower than the standard rates, which would produce higher unfunded liabilities. Let’s suppose that the alternative method 2014 unfunded liability is now $1M higher than using the standard method. This means that the alternative method 2014 VRP would be $12K higher (i.e., $12 per $1,000 unfunded liability since the VRP rate increases in 2014) and you end up with a net loss of $3K on VRP for the two plan years.

Next Steps

What’s a plan sponsor to do? The 5-year commitment to the “standard” or “alternative” interest rate method means you can’t guarantee lower PBGC VRPs using one or the other. However, you should evaluate your options each year. If cash is tight and interest rates are on the move, it may be worth choosing one method or the other for some short-term PBGC premium savings with the knowledge that doing so could expose you to higher premium rates in upcoming years.

MAP-21: Good News & Bad News for Pension Plans

The “Moving Ahead for Progress in the 21st Century” (MAP-21) legislation signed into law last week included significant pension law changes.  These included good news and bad news for sponsors of defined benefit pension plans.

The good news is that MAP-21 provided some relief from the historical low interest rate environment.  The funding segment interest rates (which are based on 24 month average rates) will now be restricted to a range around the 25 year average rates.  That range is 10% for 2012, ramping up to 30% for 2016 and beyond.  This effectively increases the funding interest rates for 2012, which can significantly lower the liability and minimum contribution requirements from what they otherwise would be.

The bad news of MAP-21 is sharp increases in PBGC premium rates.  The fixed and variable rate premiums will increase as shown in the table below.  Rates will also be indexed for inflation.

Certain plans will also need to disclose the effect of the stabilized interest rates to participants on the Annual Funding Notice.  This applies to plans with 50 our more participants, a funding shortfall of $500,000 or more (based on rates without stabilization), and stabilized Funding Target less than 95% of the Funding Target without stabilization.

It’s important to note that the interest rate changes are optional for 2012.  Some plans, like professional firm cash balance plans, will not benefit from the interest rate changes and can avoid the expense of restating their 2012 valuation results.

Many plans will want to take advantage of the option to calculate the minimum contributions with the stabilized rates.  Those that do will have the option to measure funded status for benefit restriction purposes with or without stabilization.  MAP-21 does not allow the stabilized rates to be used for 2012 benefit restrictions without also using them for the minimum contribution calculation.

The interest rate stabilization of MAP-21 will not apply to the minimum lump sums under §417, maximum deductible contributions, PBGC variable rate premiums or PBGC §4010 reporting.  Pension accounting under FASB ASC 715 is also not affected.

Additional guidance from the IRS is needed to determine the exact impact of this law change and how to implement it for 2012.  Please contact Van Iwaarden Associates if you would like an estimate of the impact on your plan or to discuss the application of these rules in more detail.