Market Commentary - 4th Quarter 2020
Markets continued their advance over the quarter as accomodative monetary policy and multiple COVID-19 vaccine approvals bolstered the economic recovery.
Many employers have experienced rapid and significant disruptions as a result of the COVID-19 pandemic. For many, these disruptions have resulted in a need to downsize workforces and/or implement pay cuts.
Defined benefit (DB) pension plans have historically been used as an effective human resource (HR) tool, enabling employers to attain desired objectives, such as attraction, retention, and orderly workflow patterns. However, pension plans can also be used as a strategic tool to help mitigate COVID-19 HR challenges. This Milliman Brief outlines several ideas for employers to consider in connection with their DB pension plans, as well as caveats to be aware of as you evaluate your organization’s staffing needs during this crisis. Note that plan sponsors of defined contribution (DC) pension plans also have additional considerations and opportunities, which are outside the scope of this article.
Many employers experiencing revenue disruption have either implemented or are considering implementing pay cuts. Some have addressed payroll reductions with corresponding reductions in hours, while others have not reduced hours. Regardless, pension plans can be an effective tool to bridge the income gap for certain employee groups. For example:
Employers exploring a reduction in force strategy may wish to consider offering a lump sum window. The window could be offered to employees who leave the organization shortly before the window or during the window’s period. The CARES Act can also be leveraged to facilitate the window, given the preferential tax treatment for eligible participants as mentioned earlier, on any portion of the lump sum that is not rolled over to a tax-qualified plan.
Another possibility is an early retirement window. Enhanced benefits can be offered to participants that retire within a given window period. However, either type of window is only possible if the funding level of the plan is sufficient.
Employers need to weigh the trade-offs of any strategy. Pension plans that provide early retirement subsidies may increase the cost of an in-service distribution strategy. Further, consideration should be given to the opportunity cost associated with lost future asset returns when lump sums are paid from the plan. However, the strategy may result in a net savings beyond the effects of a reduction in ongoing pay-related costs.
For example, private-sector defined benefit pension plans are subject to Pension Benefit Guaranty Corporation (PBGC) insurance premiums, which can be as high as $644 per participant per year (rates applicable for 2020). A portion of the premium is attributable to the pension plan’s funding shortfall. Recent market activity will move more employers towards the $644 per participant limit. Benefit obligations that are settled (e.g., a lump sum distribution) are no longer subject to a premium. This can lead to substantial savings when considering the average life expectancy of a participant. Further, there may be additional savings associated with a lump sum offering given that interest rates have continued to decrease; lump sum interest rates are generally based on rates from a lookback period.
The strategies described above focus on current employees. However, in light of the potential savings described earlier, as well as administrative synergy, employers may wish to consider expanding a lump sum offering to include former employees.
Regardless of the strategy considered, please be aware that any event resulting in a 20% reduction in a pension plan’s active participant population must, in general, be reported to the PBGC within 30 days (although an extension to July 15, 2020, is currently allowed). Further, a 20% reduction may trigger a “partial plan termination” resulting in immediate and full vesting.
We encourage you to contact your actuary to discuss the best way to use your organization’s pension plan as you navigate the COVID-19 crisis.
For complete and up-to-date thought leadership from Milliman on COVID-19, please visit milliman.com/coronavirus.
Using DB pension plans to smooth staff and payroll disruptions during COVID-19
This brief outlines several ideas for employers to consider in connection with their defined benefit pension plans as well as caveats to be aware of as you evaluate your organization’s staffing needs during the COVID-19 crisis.