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.
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.
What else should plan sponsors consider?
- 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.
- 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).
- 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.