Pension Discount Rates – September 2013 Preview

After several years of painfully-low pension discount rates, we’ve seen a modest rebound in 2013. Using the Citigroup Pension Liability Index (CPLI) and Citigroup Pension Discount Curve (CPDC) as proxies, pension accounting discount rates are up by about 80 basis points so far this year.

This is great news for pension plan sponsors, especially if rates continue their upward trend. Add in strong year-to-date equity returns, and we may finally see a reduction in unfunded pension balance sheet liability for fiscal year-end 2013.

Analysis
In the chart below we compare the CPDC at four different measurement dates (12/31 2010 to 2012, and 8/31/2013). 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 08312013

Rates have increased at all points along the spectrum since 12/31/2012. The orange arrows highlight the trend in yield curve movement. The increase in rates all along the yield curve means that all types of plans (e.g., frozen and open) should benefit if interest rates continue to increase through year-end.

Net Effect on Balance Sheet Liability
Many plans had strong investment returns during the first half of the year, with some fluctuations over the past couple of months. If those early investment gains can be preserved (or increased) until year-end, then this will further improve the pension funded status (assets minus liabilities). Depending on the starting funded status, the change in pension liabilities and assets can have a leveraging effect on the reported balance sheet liability.

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

  • Don’t count your chickens before they hatch. We’re still several months away from year-end for most plans and a lot can change between now and then. However, there’s reason to be cautiously optimistic.
  • 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.
  • 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.

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.

Deferred comp plans: when they’re a great choice, and when they’re not

Nonqualified deferred compensation plans are a common feature of executive pay packages.  They’re a great choice in the right conditions, i.e. when:Which door to choose?

  • The executive’s share of company profits is very small, and
  • The executive is willing to shoulder the employer’s credit risk, and
  • Providing the benefits through a qualified plan would be too expensive.

But they’re not so great when any of these conditions are missing.  Let’s examine each in turn.

Small share of company profits:  Nonqualified deferred compensation isn’t deductible for the company until it becomes taxable for the executive.  If the executive is a substantial owner in a profitable enterprise, e.g. a law firm or medical group partner, any deferred income boomerangs right back as taxable profit.  In contrast, qualified retirement plan contributions are deductible for the company when they’re made, and not taxable to the employee until they’re received in cash.

Willing to shoulder the employer’s credit risk:  Funding vehicles like rabbi trusts can protect the executive from the employer’s unwillingness to pay, but not against its inability to pay.  In today’s economic environment where even large companies are struggling, this risk may be unacceptable.  Protection from both of these risks – and even from the executive’s personal creditors – is provided by a qualified plan.

Qualified plan too expensive:  This is usually the main reason for setting up a deferred compensation plan.  Qualified plans have many requirements that don’t apply to most nonqualified plans:  coverage, nondiscrimination, government filings etc.  But they’re more flexible than most people realize.  In a cross-tested profit sharing/401(k) plan, top executives can often reach the annual $49,000 defined contribution limit with a 5% staff contribution.  And if that’s not enough, a cash balance or other defined benefit plan can allow much higher deductions:  up to an additional $100k-200k per year.

So, are we biased toward qualified plans?   Oh, absolutely.  Nonqualified plans can be a great choice, but make sure you’ve maximized your qualified plans first.