What’s the Impact of 2017 IRS Retirement Plan Limits?

The IRS just announced the 2017 retirement plan benefit limits, and there are some notable changes from 2016. What does it all mean for employer-sponsored retirement plans? Here is a table summarizing the primary benefit limits, followed by our analysis of the practical effects for both defined contribution (DC) and defined benefit (DB) plans.

Qualified Plan Limit 2015 2016 2017
415 maximum DC plan annual addition $53,000 $53,000 $54,000
Maximum 401(k) annual deferral $18,000 $18,000 $18,000
Maximum 50+ catch-up contribution $6,000 $6,000 $6,000
415 maximum DB “dollar” limit $210,000 $210,000 $215,000
Highly compensated employee (HCE) threshold $120,000 $120,000 $120,000
401(a)(17) compensation limit $265,000 $265,000 $270,000
Social Security Taxable Wage Base $118,500 $118,500 $127,200

 

Changes affecting both DB and DC plans

  • Qualified compensation limit increases to $270,000. High-paid participants will now have more of their compensation “counted” towards qualified plan benefits and less towards non-qualified plans. This could also help plans’ nondiscrimination testing if the ratio of benefits to compensation decreases.
  • HCE compensation threshold remains at $120,000. For calendar year plans, this will first affect 2018 HCE designations because $120,000 will be the threshold for the 2017 “lookback” year. When the HCE compensation threshold doesn’t increase to keep pace with employee salary increases, employers may find that more of their employees become classified as HCEs. This could have two direct outcomes:
    • Plans may see marginally worse nondiscrimination testing results (including ADP results) if more employees with large deferrals or benefits become HCEs. It could make a big difference for plans that were previously close to failing the tests.
    • More HCEs means that there are more participants who must receive 401(k) deferral refunds if the plan fails the ADP test.

DC-specific increases and their significance

  • The annual DC 415 limit increases from $53,000 to $54,000 and the 401(k) deferral limit remains at $18,000. A $1,000 increase in the overall DC 415 limit may not seem like much, but it will allow participants to get a little more “bang” out of their DC plan. Since the deferral limit didn’t increase, this means that any additional DC benefits will have to come from higher employer contributions. Individuals can now receive up to $36,000 from match and profit sharing contributions ($54K – $18K).
  • 401(k) “catch-up” limit remains at $6,000. Participants age 50 or older still get a $6,000 catch-up opportunity in the 401(k) plan, which means they can effectively get a maximum DC deduction of $60,000 ($54K + $6K).

DB-specific increases and their significance

  • DB 415 maximum benefit limit (the “dollar” limit) increases to $215,000. This limit finally increased after being static for three straight years. The primary impact is that individuals who have very large DB benefits (say, shareholders in a professional firm cash balance plan) could see a deduction increase if their benefits were previously constrained by the 415 dollar limit.
  • Social Security Taxable Wage Base increases to $127,200. This is a big jump from the prior $118K limit and effectively reflects two years of indexing (the limit couldn’t increase last year because the Social Security COLA was 0% and caps the wage base increase rate). With regards to qualified retirement benefits, a higher wage base can slightly reduce the rate of pension accruals for highly-paid participants in integrated pension plans that provide higher accrual rates above the wage base.

What’s the Impact of 2016 IRS Retirement Plan Limits?

The IRS just announced the 2016 retirement plan benefit limits, and there are virtually no changes from 2015. What does it all mean for employer-sponsored retirement plans? Below is a table summarizing the primary benefit limits, followed by our analysis of the practical effects for both defined contribution (DC) and defined benefit (DB) plans.

Qualified Plan Limit 2015 2016
415 maximum DC plan annual addition $53,000 $53,000
Maximum 401(k) annual deferral $18,000 $18,000
Maximum 50+ catch-up contribution $6,000 $6,000
415 maximum DB “dollar” limit $210,000 $210,000
Highly compensated employee (HCE) threshold $120,000 $120,000
401(a)(17) compensation limit $265,000 $265,000
Social Security Taxable Wage Base $118,500 $118,500

 

Changes affecting both DB and DC plans

  • Qualified compensation limit remains at $265,000. A flat qualified compensation limit could have several consequences. These include:
    • More compensation counted towards SERP excess benefits if a participant’s total compensation (above the threshold) increases in 2016.
    • Lower-than-expected qualified pension plan accruals for participants whose pay is capped at the 401(a)(17) limit and were hoping for an increase.
  • HCE compensation threshold remains at $120,000. For calendar year plans, this will first affect 2017 HCE designations because $120,000 will be the threshold for the 2016 “lookback” year. When the HCE compensation threshold doesn’t increase to keep pace with employee salary increases, employers may find that more of their employees become classified as HCEs. This could have two direct outcomes:
    • Plans may see marginally worse nondiscrimination testing results (including ADP results) if more employees with large deferrals or benefits become HCEs. It could make a big difference for plans that were previously close to failing the tests.
    • More HCEs means that there are more participants who must receive 401(k) deferral refunds if the plan fails the ADP test.

DC-specific increases and their significance

  • The annual DC 415 limit remains at $53,000 and the 401(k) deferral limit remains at $18,000. Although neither of these limits has increased to allow higher contributions, it should make administering the plan a little easier in 2016 since there are no adjustments to communicate or deal with. Since the 401(k) deferral limit counts towards the total DC limit, this means that an individual could potentially get up to $35,000 from profit sharing ($53K – $18K) if they maximize their DC plan deductions.
  • 401(k) “catch-up” limit remains at $6,000. Participants age 50 or older still get a $6,000 catch-up opportunity in the 401(k) plan, which means they can effectively get a maximum DC deduction of $59,000 ($53K + $6K).

DB-specific increases and their significance

  • DB 415 maximum benefit limit (the “dollar” limit) remains at $210,000. This limit remained unchanged for a third straight year, which may constrain individuals with very large DB benefits (e.g., shareholders in a professional firm cash balance plan) who were looking forward to increasing their DB plan contributions/deductions.
  • Social Security Taxable Wage Base remains at $118,500. When this limit increases, it can have the effect of reducing benefit accruals for highly-paid participants in integrated pension plans that provide higher accrual rates above the wage base. When the wage based remains unchanged (like this year), it means that these individuals’ accruals may be higher-than-expected if their total compensation (above the wage base) continues to increase.

 

What’s the Impact of 2015 IRS Retirement Plan Limits?

The IRS just announced the 2015 retirement plan benefit limits and we’re seeing some modest increases from 2014. What does it all mean for employer-sponsored retirement plans? This post analyzes the practical effects for both defined contribution (DC) and defined benefit (DB) plans, followed by a table summarizing the limit changes.

Changes affecting both DB and DC plans

  • Qualified compensation limit increases from $260,000 to $265,000. Highly-paid participants will now have more of their compensation “counted” towards qualified plan benefits and less towards non-qualified plans. This helps for both nondiscrimination testing as well as for benefits.
  • HCE compensation threshold increases from $115,000 to $120,000. For calendar year plans, this will first affect 2016 HCE designations because $120,000 will be the threshold for the 2015 “lookback” year. Slightly fewer participants will meet the new HCE compensation criteria, which will have two direct outcomes:
  • Plans may see better nondiscrimination testing results (including ADP results) if there are fewer participants at the low end of the HCE range, especially those with big deferrals. It could make a big difference for plans that were close to failing the tests.
  • Fewer HCEs means that there are fewer participants who must receive 401(k) deferral refunds if the plan fails the ADP test.

DC-specific increases and their significance

  • The annual DC 415 limit increases from $52,000 to $53,000 and the 401(k) deferral limit increases from $17,500 to $18,000. A $1,000 increase to the overall DC limit and $500 increase to the deferral limit may not seem like much, but it will allow participants to get a little more “bang” out of their DC plan. This means that individuals can get up to $35,000 from employer match and profit sharing ($53K – $18K) if they maximize their 401(k) deferrals. Previously, their profit sharing limit would have been $34,500 ($52K – $17.5K).

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

What’s the Impact of 2014 IRS Retirement Plan Limits?

The IRS just announced the 2014 retirement plan benefit limits and we’re seeing some modest increases from 2013. What does it all mean for employer-sponsored retirement plans? This post analyzes the practical effects for both defined contribution (DC) and defined benefit (DB) plans, followed by a table summarizing the limit changes.

Changes affecting both DB and DC plans

  • Qualified compensation limit increases from $255,000 to $260,000. Highly-paid participants will now have more of their compensation “counted” towards qualified plan benefits and less towards non-qualified plans. This helps for both nondiscrimination testing as well as for benefits.
  • HCE compensation threshold remains at $115,000. For calendar year plans, this will first affect 2015 HCE designations because $115,000 will be the threshold for the 2014 “lookback” year. When the HCE compensation threshold doesn’t increase to keep pace with employee salary increases, employers may find that more of their well-paid employees become classified as HCEs. Eventually, this could have two direct outcomes:
  • Plans may see marginally worse nondiscrimination testing results (including ADP results) if more employees with large deferrals or benefits become HCEs. It could make a big difference for plans that were close to failing the tests.
  • More HCEs means that there are more participants who must receive 401(k) deferral refunds if the plan fails the ADP test.

DC-specific increases and their significance

  • The annual DC 415 limit increases from $51,000 to $52,000 but the individual 401(k) deferral limit remains unchanged at $17,500. A $1,000 increase to the overall DC limit will allow participants to potentially get a little more “bang” out of their DC plan – at least if their employer wants to give them more money.

Since the 401(k) deferral limit counts towards the total DC limit, this means that an individual could potentially get up to $34,500 from employer profit sharing ($52K – $17.5K). Previously, their profit sharing limit would have been $33,500 ($51K – $17.5K).

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.

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.

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.