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.
Although there is some flexibility when selecting the interest rate basis for a lump sum window, this post estimates the potential 2019 lump sum effect using the November 2018 interest rates as a proxy.
Higher Interest Rates Will Decrease the Cost of Lump Sums
So, what’s the story for 2019? The table and chart below show the potential difference in lump sum values at sample ages assuming payment of a $1,000 per month deferred-to-65 benefit. The calculations compare the November 2017 rate basis (i.e., 2018 lump sums) to the November 2018 basis (i.e., 2019 lump sums).
The dollar decrease in lump sum value is relatively consistent around $11K to $15K. This translates to an 8% cost decrease at later ages, versus a 20% cost decrease at younger ages.
Interest rates increased steadily throughout 2018, except for a slight falter at year-end. Below is a comparison of the November 2017 and November 2018 417(e) lump sum interest rates. All the segment rates increased, with a notable jump in the first segment rate.
What else should plan sponsors consider?
- The lump sum mortality basis changed substantially in 2018, but there’s only a minor update in 2019. This shouldn’t be a major factor in 2019 lump sum cost comparisons.
- It’s unclear which direction interest rates will move during 2019. Likewise, investment returns have been volatile over the past few months. These unknown factors illustrate the appeal of lump sum payouts and other risk transfer activities: they eliminate significant pension risks in exchange for an upfront cost.
- 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 sponsors of frozen plans are also pursuing a “borrow to fund and terminate” strategy.