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.

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.

Déjà Vu All Over Again: PBGC Extends Reportable Event Relief for 2013 and Beyond

PBGC logoIn what has become an annual rite of winter, the PBGC recently released PBGC Technical Update 13-1 extending relief from the proposed amendments to the reportable events regulations for certain small pension plans. However, unlike previous years’ relief, the new technical update provides guidance for all plan years after 2012 (or until new proposed or final rules are released) and not just a one-year extension.

Summary of Important Guidance

Similar to the prior pronouncements, the new Technical Update:

– Extends the waiver of the requirement to report a missed quarterly contribution for small pension plans under ERISA §4043.25. This waiver is valid as long as the plan (1) has fewer than 25 participants or (2) has between 25 and 100 participants and files a simplified notice with the PBGC. In both cases, the reason for the missed quarterly contribution cannot be due to financial inability.

– Affirms that the assets and liabilities used to calculate the PBGC variable rate premium should be used to determine reporting requirements for events occurring during the following plan year. This includes determining whether the plan is eligible for reporting waivers, reporting extensions, or is subject to advance reporting requirements.

Of course, the relief in Technical Update 13-1 will be superseded once the PBGC issues  final rules.

After four years of temporary reportable event relief, it seems likely that the new proposed regulations will eventually incorporate some of this relief on a permanent basis. At the very least, Technical Update 13-1 provides the stability of knowing that reportable event relief will continue until new rules are released and that we won’t have to wait for the PBGC to reaffirm the relief annually.

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.

Déjà vu: PBGC Extends Reportable Event Relief for 2012

Almost a year to the day after providing relief for the 2011 plan year, the PBGC released PBGC Technical Update 11-1. This notice provides guidance for the 2012 plan year on how to comply with the proposed amendments to the reportable events regulations.

Summary of Important Guidance

Similar to the prior pronouncements, the new Technical Update:

– Extends the waiver of the requirement to report a missed quarterly contribution for small pension plans under ERISA §4043.25. This waiver is valid as long as the plan (1) has fewer than 25 participants or (2) has between 25 and 100 participants and files a simplified notice with the PBGC. In both cases, the reason for the missed quarterly contribution cannot be due to financial inability.

– Affirms that the assets and liabilities used to calculate the 2011 PBGC variable rate premium should be used to determine reporting requirements for events occurring during the 2012 plan year. This includes determining whether the plan is eligible for reporting waivers, reporting extensions, or is subject to advance reporting requirements.

Technical Update 11-1 also mentions two other small PBGC-related items:

  • It acknowledges that the reaction to the proposed 2009 reportable event regulations has been largely negative. So, the PBGC will issue new proposed regulations that “will more effectively target troubled plans and sponsors while reducing burden for those that are financially sound.”
  • If the PBGC issues a final rule before the end of 2012, then the guidance in Technical Update 11-1 will be superseded by the final rules.

After three years of temporary reportable event relief, it seems likely that the new proposed regulations will incorporate some of this relief on a permanent basis. We’ll just have to wait and see whether the rules are formalized in 2012 or whether we get another extension as an early Christmas present next year.

What’s New with PBGC Premium Relief

In this post we highlight three new PBGC premium relief items:

1. Seven Day Rule – for waiver of late premium penalties in 2011 and later.

2. “Alternative” premium method election relief – for 2010 and later years.

3. Waiver of certain “alternative” method penalties – for 2008 and 2009.

Below is a detailed summary of each relief item along with background information.

1. Seven Day Rule

Background: If a plan sponsor does not make their annual PBGC pension insurance payments on time, then there are late payment penalties and late payment interest.

Relief: For plan years beginning in 2011 and later, the PBGC will automatically waive penalties due solely to late payment as long as the payments are not more than 7 days late. Note that late payment interest is set by ERISA and cannot be waived by the PBGC. Read more…

When Small Pension Plans Move In and Out of PBGC Coverage

Many small pension plans are exempt from PBGC pension insurance coverage. These include “substantial owner” plans, where all participants in the plan own (directly or indirectly) more than 10% of the corporation’s stock. This post highlights what happens when the classification of a “substantial owner” plan changes, and what happens next.

We often see “substantial owner” plans when a pension plan covers only a business owner and their spouse. These plans are not covered by the PBGC and don’t have to pay PBGC pension insurance premiums. However, once there are any non-substantial owners in the plan (e.g., hiring one non-owner employee), things change.

Here’s the key points:

– A pension plan ceases to be a “substantial owner” plan (and is then covered by the PBGC) on the date when a non-substantial owner becomes a participant in the plan (PBGC Blue Book Q&A #2005-11).

– A plan returns to “substantial owner” classification when there are no longer any non-substantial owners participating in the plan. This interpretation is documented in PBGC Opinion Letter 90-6.

Example:

Suppose that Jones is the sole owner and participant in the Jones Pension Plan. After several years, Jones hires Smith (a non-owner) to work at the company. If Smith is hired in June 2010 and becomes a participant in the plan on July 1, 2011, then the plan is subject to PBGC coverage on that date as well. From that point on, PBGC premiums and filings must be completed annually.

Now, suppose that Smith terminates employment after a couple of years. Jones should notify the PBGC that the only remaining participant in the plan is a substantial owner. The PBGC will then confirm that the plan is no longer subject to PBGC coverage.

Proposed Changes to PBGC Premiums

The proposed 2012 federal budget contains an interesting provision which could dramatically change how PBGC premiums are determined. Here are the main aspects of the proposal:

– Gives the PBGC authority to set and adjust premium rates as it sees fit. Currently the PBGC does not have this power, so the change would give the PBGC more flexibility in responding to the need for premium rate adjustments.

– Directs the PBGC to consider individual plan sponsor risk (to their retirees and to the PBGC) when determining premium rates. Currently all plan sponsors pay a flat headcount-based premium along with a variable rate premium (VRP) based on their unfunded liabilities. One possibility is that consideration of a plan sponsor’s financial stability would involve a third premium component or an adjustment to the VRP.

– States that any changes to the PBGC rate structure would be subject to two years of study followed by a gradual phase-in of increases.

It’s unclear whether any of these changes will gain traction, but they are clearly being proposed to help close the PBGC’s current funding deficit. The proposed budget estimates that these premium adjustments could “save $16 billion over the next decade.” Another way to read this is that the premium changes are estimated to bring in an additional $16 billion in premium revenue to the PBGC over that time period.

Pension Plans May Face Higher 2011 PBGC Variable Premiums Due to Low Interest Rates

As we mentioned in our blog post yesterday, the segment interest rates used for PBGC purposes are historically low right now. The previous post provided details of how this could affect the liabilities reported in the 2010 Annual Funding Notice to participants. This post highlights the impact on plan sponsors’ PBGC variable rate premiums (VRPs) for 2011.

The PBGC VRP is equal to .009 multiplied by the unfunded vested liability for a plan year. So, if a plan has an unfunded vested liability of $1M, then their variable rate premium would be $9,000 = .009 x $1,000,000. A calendar year plan would usually calculate its vested benefit liability based on December 2010 PBGC interest rates, so those are the rates we want to focus on.

The December 2010 rates haven’t been published yet, but we expect them to be very low based on the rate experience in recent months. For example, the November 2010 PBGC segment rates were 1.65%, 4.91%, and 6.52%. In comparison, the December 2009 rates (used to determine 2010 VRPs) were 2.35%, 5.65%, and 6.45%. As these interest rates decrease, the calculated value of the plan liability increases. This could lead to potentially higher VRPs than plan sponsors are expecting.

Some issues to consider for the 2011 PBGC VRP: Read more…

2010 Annual Funding Notice Liabilities Could Surprise Plan Sponsors and Participants

For calendar year pension plans, the Annual Funding Notice (AFN) to participants is due no later than April 30, 2011. One potential issue with this year’s notice is the impact of low interest rates on the liabilities disclosed in the document. There are two interest rates that affect liabilities in the AFN:

–  PBGC segment interest rates: These are based on “spot” interest rates which are essentially a snapshot view of the current interest rate environment.

–  Funding segment interest rates: These are generally based on 24-month averages of the spot rates. Although the 24-month averaging helps smooth out interest rate spikes and valleys, it will also delay the recognition of future rate increases.

The AFN must show a three-year history of the plan’s funded status (calculated using the funding interest rates) as well as an estimate of year-end assets and liabilities (calculated using the PBGC interest rates). The potential problem with the 2010 AFN is that the estimated year-end liabilities could appear much larger than the funding liability history. Although this may not directly impact plan operations, it could cause confusion among participants who actually read their AFN. Read more…