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.

Small Closed DB Plans Need to Monitor §401(a)(26) Status

Strategy blocksIn last week’s blog post covering nondiscrimination testing pitfalls for soft-frozen pension plans, we discussed how defined benefit (DB) plans that are closed to new participants can run afoul of the IRC §410(b) minimum coverage rules. Today’s post discusses how small DB plans closed to new entrants can also have difficulties passing the IRC §401(a)(26) minimum participation test.

Background
IRC §401(a)(26) requires that a minimum number of employees receive a “meaningful” benefit from a DB pension plan. Like §410(b), this is intended to prevent an employer from setting up a plan that only benefits a few highly compensated employees (HCEs) while the remaining staff receive minimal or no benefits.

Specifically, §401(a)(26) requires that the number of benefiting employees be equal to the smaller of:

1. 50 employees; or

2. The larger of (a) 40% of employees or (b) 2 employees

For most medium and large-sized pension plans, achieving the 50 employee threshold is easy and §401(a)(26) doesn’t pose an immediate concern. However, small employers can quickly run into §401(a)(26) difficulties because a small change in the number of DB plan members can have a large impact on whether 40% of employees are benefiting in the plan.

Example
Suppose Company A has 50 employees and sponsors a DB plan that was closed to new entrants in 2008. The number of employees covered under the DB plan has steadily shrunk due to natural turnover and there are currently only 22 employees earning benefits in the DB plan. This means that if 5 new employees are hired (55 x 40% = 22) or if 2 current DB participants retire (50 x 40% = 20), then the plan would be on the verge of failing the §401(a)(26) minimum participation test.

Strategies
So, what should sponsors of small pension plans do if faced with a §401(a)(26) failure? There are no alternative testing options, so the solutions are very similar to the plan changes that can solve a §410(b) failure.

1. Freeze DB accruals for HCEs

2. Freeze DB accruals for all employees

3. Add new participants to the DB plan

Note that Option #1 is only available if (A) the plan is not top-heavy and (B) the plan is not aggregated with any other retirement plans in order to pass other nondiscrimination tests. Most employers will likely choose option #1 or #2.

Since the demographics of small DB plans can change quickly, it’s imperative that plan sponsors monitor their §401(a)(26).status closely each year. Advance planning is the key to avoiding unpleasant corrective measures such as having to add new participants to the plan retroactively.

Beware Nondiscrimination Pitfalls for Frozen Pension Plans

pitfall-signMany defined benefit (DB) pension plans were closed to new entrants over the past several years. Oftentimes, these plan closures were done with a focus on short-term cost control without understanding some of the long-term compliance implications.

Then, one day, the plan sponsor gets an unwelcome surprise from their actuary – their DB plan is failing the IRS’ nondiscrimination tests! How can this happen – particularly if the DB plan is a “safe harbor” formula that has never needed nondiscrimination testing before?

This post explores how closed DB plans are increasingly faced with IRS nondiscrimination testing compliance issues and suggests some strategies for dealing with this situation.

Background
IRC §410(b) requires that a tax-qualified retirement plan “cover” a nondiscriminatory group of employees. In other words you can’t set up a retirement plan that benefits only highly compensated employees (HCEs) – that’s unfair and you need to include some non-highly compensated employees (NHCEs) too.

§410(b) coverage testing is generally a non-issue as long as a DB plan is open to all employees. However, once a DB plan is closed to new entrants, there will eventually be enough staff turnover so that only a fraction of an employer’s total employee group participates in the DB plan. If this grandfathered group is composed of proportionately more HCEs than NHCEs (which happens when there is higher turnover among the NHCEs), then the DB plan will run into §410(b) testing problems.

Technical Details
There are two ways to prove compliance with §410(b) minimum coverage requirements.

1. Ratio Percentage Test (RPT). This is the most straightforward §410(b) testing option. In this test, A divided by B must be at least 70% where:

A = # of NHCEs in the DB plan divided by the total number of NHCEs, and

B = # of HCEs in the DB plan divided by the total number of HCEs.

Note that “total” NHCEs and HCEs includes all employees who would otherwise meet the DB plan’s age and service eligibility requirements.

2. Average Benefits Test (ABT). When you can’t pass the RPT, you must tackle the Average Benefits Test. This is a multi-step process that focuses on the relative disparity of retirement benefits provided to NHCEs versus HCEs. I won’t go into all of the gory details here, but suffice to say that this is a numerically-intensive test and includes benefits provided by ALL of the employer’s retirement plans. If you can pass this test, then your frozen DB plan satisfies the IRS’ §410(b) minimum coverage requirements.

Example
Suppose Company A has 1,000 employees (900 NHCEs and 100 HCEs) and sponsors a DB plan that was closed to new entrants in 2008. The employer still has a total of 1,000 employees (900 NHCEs and 100 HCEs), but the number of employees covered under the DB plan has steadily shrunk due to natural turnover. There are now only 550 NHCEs and 90 HCEs in the DB plan. Their RPT result is: (550/900) / (90/100) = 67.9% which is below the 70% passing threshold.

In this case, the plan sponsor would need to complete an ABT in order to satisfy the §410(b) nondiscrimination rules.

Forewarned is Forearmed
So, what should plan sponsors do if faced with a potential §410(b) failure? Advance planning is the key to avoiding unpleasant corrective measures. Here are a few options:

1. Have your actuary complete a ratio percentage test, especially if you are in a high-turnover industry. This will help you see how close you are to the passing threshold and will suggest how long you have until the DB plan no longer passes the RPT.

2. If your DB plan is close to failing the RPT, have your actuary run an ABT to make sure that it provides passing results and is a viable back-up to the RPT.

3. If the DB plan’s ABT results are marginal as well, then you should consider some contingency plan design options. These include:

– Freezing DB accruals for HCEs
– Freezing DB accruals for all employees
– Adding new participants to the DB plan

Options #1 and #2 are likely the most agreeable. Very few sponsors who have closed their DB plan ever intend to open it up again like Option #3. Whatever your decision, it helps to be familiar with your options ahead of time so that you can address nondiscrimination testing issues quickly when they arise.

Closed DB plans face special challenges with respect to IRS nondiscrimination testing. Although these issues may emerge slowly over time, plan sponsors should be aware of the consequences and develop a strategy to maintain compliance with IRC §410(b) minimum coverage requirements.

Pension Plan Termination Investment Strategies

During the plan termination process, one issue often overlooked is the consequences of investment risk prior to paying out benefits. This can lead to disastrous results. Benefits may be fully-funded when the termination decision is made, but significant contributions will be required if assets are not invested conservatively and a market downturn occurs prior to paying benefits.

Here are a few investment issues to consider when working through the plan termination process.

  1. Plan terminations change the focus of pension plan investments to short-term risks. An investment strategy based on 30-year expectations is not compatible with a one- to two-year plan termination horizon.
  1. The plan termination process can take a while (over a year) and financial conditions may change dramatically between the termination decision and the date when benefits are actually paid out. Funded status volatility during this waiting period should be minimized.
  1. A change in investment policy doesn’t have to be abrupt, but it should adjust quickly to minimize investment risk as terminating plans get closer to being fully-funded.
  1. Minimizing investment risk helps lock-in the funding gains made over the past couple of years. It may also limit the chance of large investment returns, but for many plan sponsors this will be a satisfactory risk/return trade-off.
  1. A liability-driven investment (LDI) strategy works well for terminating pension plans because it focuses on keeping plan assets aligned with plan liabilities. Keep in mind, though, that the plan termination liability target will be different than the traditional funding or accounting liabilities.

Many sponsors of frozen DB plans are becoming more interested in terminating their plans, especially as their funding level improves. We’ll continue to add posts that address important issues related to plan terminations and how to make them go as smoothly as possible.

To Freeze or Not to Freeze (A Pension Plan)

Freezing a defined benefit (DB) pension plan has become common practice over the past decade. Plan sponsors give many reasons for freezing the DB plan, but one of the most common is that the funding requirements are too expensive and volatile. In a recent article, two actuaries from Milliman dissected a sample pension freeze and argue that this tactic is not always cheaper for the plan sponsor, and often provides a worse benefit for participants.

This post does a quick analysis of the article, but I’d encourage you to read the entire document (5 pages) for all of the details. The basic set-up of the case study is this:

  • A DB plan with fairly rich benefits is underfunded and subject to large IRS minimum required contributions. So, the plan sponsor decides to freeze benefit accruals in the DB plan in order to limit their exposure to future liability accruals.
  • In order to soften the effects of participants of the DB freeze, the 401(k) defined contribution (DC) plan benefit is increased from a 50% match on 6%-of-pay (i.e., maximum 3% company match) to a maximum 401(k) match of 4%-of-pay along with an additional non-matching contribution of 4%-of-pay (i.e., increase from maximum 3%-of-pay to maximum 8%-of-pay DC benefit).
  • Maintain current DB plan asset allocation

Read more…