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.

Pension Lump Sums Much More Expensive in 2015

Over the past few years, many defined benefit (DB) plan sponsors considered 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 2014 417(e) rates, which will be the 2015 reference rates for many DB plans. This post shares a brief update of the impact these rates could have on 2015 lump sum payout strategies.

Low Interest Rates Will Increase Cost of 2015 Lump Sums

So, what’s the potential impact on 2015 lump sums? The table and chart below show the possible difference between comparable 2014 and 2015  lump sums at sample ages assuming payment of a $1,000 deferred-to-65 monthly benefit. Note that the 2014 lump sum estimates are based on November 2013 interest rates, while 2015 values are based on November 2014 rates.

November 2014 lump sum chartNovember 2014 lump sum tableNote: If we adjust for the fact that participants will be one year older in 2015 (and thus one fewer years of discounting), then this increases the costs above by roughly another 5% at most ages.

What’s Causing Lump Sum Costs to Increase?

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), while higher rates towards the end of 2013 made 2014 lump sums more affordable. This is because lump sum values increase as interest rates decrease, and vice versa.

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 brief comparison of the November 2013 rates (for 2014 payouts) versus the November 2014 rates (for 2015 payouts).November 2014 segment rate tableAs we can see, the first segment rate increased slightly while the second and third segment rates decreased substantially since last November. The overall large decrease in interest rates is why lump sums will be more expensive in 2015.

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 2015 lump sum rates compared to 2014.
  1. Even with lower interest rates pushing up lump sum costs, there are still incentives to “right-size” 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 significantly in a couple of years.
  1. 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

DB Plan Sponsors Should Prepare Now for Higher Year-End Liabilities

The combination of lower discount rates and new mortality tables will dramatically increase pension plan liabilities and decrease DB plans’ funded status for December 31, 2014 financial reporting. Using the November 2014 Citigroup Pension Liability Index (CPLI) and Citigroup Pension Discount Curve (CPDC) as proxies, pension accounting discount rates are down by almost 90 basis points since December 31, 2013.

Fortunately, many plans have experienced solid investment returns so far during 2014. This will take some of the sting out of the liability increases, but it likely won’t be enough to entirely offset the effect of lower interest rates and the new mortality tables. The higher liabilities will affect both the year-end funded status of the plan and also the 2015 pension expense calculation.

Discount Rate Analysis

In the chart below we compare the CPDC at three different measurement dates (12/31/2012, 12/31/2013, and 11/30/2014). We also highlight the CPLI at each measurement date. The CPLI can be thought of as the average discount rate the CDPC produces for an “average” pension plan.

Citigroup comparison 11302014

The orange arrows in the chart highlight the trend in yield curve movement and show how rates are almost back to their 2012 lows at all points along the spectrum. This means that nearly all plans will feel the negative effect of lower discount rates.

Net Effect on Balance Sheet Liability

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 12/31/2013, where we assume a 10% increase in pension liability during 2014. We then compare the funded status results under two asset scenarios: (1) Assets 5% higher than 12/31/2013 and (2) Assets 8% higher than 12/31/2013.

11302014 bal sheet liability example

In both cases, the funded status of the plan decreases. There’s also a magnified increase in the unfunded balance sheet liability because it’s such a leveraged result. This amount increases by 30% and 18%, respectively, in the two sample scenarios.

Conclusions

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

  • Don’t forget that the new Society of Actuaries mortality tables will be recommended for use at year-end and will likely further increase plan liabilities.
  • Additional pension plan funding (above the IRS minimum requirements) may be appealing in 2014 and 2015. Not only will it increase the plan’s funded status, but it will also help lower your pension plan’s PBGC variable rate premiums.
  • 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.
  • 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 early in 2015.

Higher Discount Rates Will Help 2013 Pension Disclosures and 2014 Expense

The final results are in and pension plan sponsors should be pleased with final year-end discount rates – at least compared to the FY2012 rates. Using the Citigroup Pension Liability Index (CPLI) and Citigroup Pension Discount Curve (CPDC) as proxies, pension accounting discount rates are up by about 90 basis points this year.

This is great news for pension plan sponsors. The higher discount rates will have a very beneficial effect on pension liabilities. This in turn will affect both the year-end funded status of the plan and also the 2014 pension expense calculation.

Analysis
In the chart below we compare the CPDC at four different measurement dates (12/31 2010 to 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 12312013

The orange arrows in the chart highlight the trend in yield curve movement and show how rates have increased at almost all points along the spectrum since 2012. This means that pretty much all plans, even closed/frozen plans with shorter durations, should experience the benefit of higher discount rates.

Net Effect on Balance Sheet Liability
Many plans also had strong investment returns during the year. 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 70% funded on 12/31/2012 and we assume a 10% decrease in pension liability during 2013. We then compare the funded status results under two asset scenarios: (1) Assets 5% higher than 12/31/2012 and (2) Assets 15% higher than 12/31/2012.

12312013 bal sheet liability example

In both cases, the funded status of the plan improves measurably. There’s also a magnified decrease in the unfunded balance sheet liability because it’s such a leveraged result. This amount decreases by 45% and 68%, respectively, in the two sample scenarios.

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

  • 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.
  • Additional plan funding (above the IRS minimum requirements) may be appealing in 2014. Not only will it increase the plan’s funded status, but it will also help lower your pension plan’s PBGC variable rate premiums. These are scheduled to increase significantly starting in 2015 as a result of the Bipartisan Budget Act of 2013.
  • 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.
  • 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.

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

Lump Sum Interest Rate Update – June 2013

Many defined benefit (DB) plan sponsors are considering lump sum payouts to their terminated vested participants as a way of reducing plan costs and risk. This post shares a brief update of the interest rates used to calculate deferred vested lump sums and the impact it could have on potential 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. This means that lump sums are at historically high levels since lump sum values increase as interest rates decrease (and vice versa). Plan sponsors need to consider whether the recent increase in 417(e) interest rates will materially decrease lump sum values and make it worthwhile to postpone a lump sum program until 2014 if it means that lump sums will be “cheaper” then.

Effect of Preliminary 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 (e.g., the November rates). Here’s a brief comparison of the November 2012 rates (for 2013 payouts) versus the June 2013 rates (i.e., what rates might look like for 2014 payouts).

June 2013 segment rate table

As we can see, all three segments have increased 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 June 2013 417(e) interest rates.

June 2013 lump sum chart

June 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 should plan sponsors consider?

1. If you’re in the process of implementing a 2013 lump sum payout window for terminated vested participants, you may want to consider the potential savings of waiting until 2014 to pay benefits.

2. There’s no guarantee that interest rates will remain higher until your plan locks-in its lump sum rates later this year. Rates could go up or down, so you’ll need to consider whether you can handle the risk and cost if interest rates go back down and lump sum values increase.

3. Even if you’ve started the process of preparing for a 2013 lump sum window, it’s not a wasted effort if you decide to wait until 2014. Work spent tracking down missing participants, finalizing accrued benefit calculations, and drafting plan amendments needs to be done anyways. However, you’ll want to set a firm “go” or “wait” deadline so there’s enough time to complete the project in 2013 if you desire.