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).

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.

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.