Many corporate employers with defined benefit pension plans have been patiently waiting for the right opportunity to reduce the size of, or eliminate, their pension plans. With the recent rise in interest rates, many are asking whether now is the right time to move forward with de-risking strategies such as lump sum windows or plan terminations.
Due to the long-duration nature of pension liabilities, interest rate movement may have a significant impact on funded levels for pension plans. An increase of 100 basis points (bps) in interest rates reduces pension liabilities on average by 12% to 15%. Looking at year-to-date movements through July 31, 2022, corporate pension discount rates are up 145 bps (see Milliman’s Pension Funding Index August 2022), which means pension liabilities are down nearly 20%.
Many plan sponsors are eager to preserve these liability gains and want to take risk off their balance sheets by implementing de-risking strategies. Ideally this would be done when assets exceed liabilities, but assets have been volatile as well, and each plan is unique. Complicating the comparison is the timing of the lump sum payments or plan termination, as completion may be several months or more than a year from the time a decision is made to proceed. This article explores some strategies that plan sponsors should consider now, even if a plan’s funding situation is not ideal, to avoid missing out on what might be a “golden” opportunity.
Focusing on the “thorns”
There are two things about defined benefit plans that often annoy plan sponsors:
- Required annual premium payments to the Pension Benefit Guaranty Corporation (PBGC)
- Pension volatility on company financial statements
Both can be diminished if participants are removed from the plan, or eliminated entirely if the plan is terminated. However, plan sponsors who want to remove pension liabilities from their books can only do so by either settling the obligations directly with plan participants or by moving the obligations to an insurer. The latter approach leads to yet another “thorn”: the premium or surcharge that insurance companies charge to accept the pension liabilities.
Insurance companies particularly like to take on the liability of retirees (participants who have already commenced benefits). Their future cash flows are easier to predict, so the surcharge for these participants is generally less than 5%. Some insurance companies will only accept retirees while others want at least half of the liability to be for retirees.
Participants that have not yet commenced payment of their monthly pension benefits generally have some flexibility on when their benefits would start. This uncertainty makes future cash flows more difficult for insurers to predict. As a result, insurer premiums may reflect a surcharge in excess of 15% for such participants (surcharges between 15% and 25% are not uncommon based on our experience); for example, a plan sponsor may pay a surcharge of $7.5 million to $12.5 million to settle a $50 million non-retiree liability. It may be even higher if the plan provisions are complicated.
These high surcharges can be avoided when plan sponsors settle non-retiree liabilities directly with participants via a lump sum payment (i.e., a one-time payment equal to the entire value of the participant’s benefit). However, legal requirements can make settling obligations in a cost-effective manner challenging for this liability segment. Retires can also be offered lump sums, and we encourage plan sponsors to explore strategies to de-risk their retiree liabilities. However, given the additional complexities involved, the rest of this article focuses on non-retiree strategies.
Benefits of lump sum de-risking strategies
While many plan sponsors would like to terminate their plans, there could be reasons to keep them around. For example, the funding may not be sufficient for termination and the sponsor may not want to make up the difference all at once. Lump sum windows may be a great interim step to lessen the pain from thorns.
- Reduced ongoing plan costs: Pension plans are required to pay premiums to the PBGC, which can be as high as $686 (during 2022) per participant per year for the participant’s lifetime. Further, the premiums are indexed with inflation. There are also administrative costs such as sending required notices to participants and keeping track of their mailing addresses. Removing participants with modest benefits from the plan can disproportionately and materially reduce the plan’s ongoing costs.
- Reduced risk exposure: The size of the plan will decrease as participants elect lump sums, thus reducing the plan’s risk exposure.
- Avoid settlement accounting: A plan termination requires that all of the plan’s unrecognized amounts remaining on the employer’s books be recognized immediately. A lump sum window and/or plan amendment can be structured in such a way that this “settlement” accounting can be avoided.
Strategy to address the thorns and avoid a missed opportunity
Lump sum payments are regulated by the Internal Revenue Code. The interest rates used to determine lump sums are prescribed and are based on the plan’s “lookback month” and “stability period.” Specifically, lump sums that are paid within the plan’s stability period will be calculated based on interest rates from the plan’s lookback month.
The stability period for most plans coincides with the plan year. The lookback month must be before but no more than five months before the stability period begins. This means that, for calendar-year plans with an annual stability period, lump sums that are paid in 2022 are based on where interest rates were in the fall of 2021 (August to December). The impact of this time lag can be significant, because the interest rates that are required to be used to determine lump sum payments have increased significantly since November 2021. For example, plans that make lump sum payments based on June 2022 rates might pay 20% to 30% less than what they would have paid based on November 2021 interest rates!
Plan sponsors who want to take advantage of the rising interest rates and pay non-retirees directly might think that they need to wait until 2023 to implement a lump sum window, because lump sum payments that are made during 2022 will likely be based on lower interest rates dating back to late 2021. However, there is a way to take advantage of the higher interest rates in 2022 before reaching 2023.
Plan sponsors have the ability to change a plan’s lookback month and stability period, but legal requirements mandate that for a one-year “preservation” period lump sums must be determined under both the old and new provisions, with plans paying the higher lump sum amount to participants. However, if a plan sponsor offers a lump sum window to a group of participants who don’t currently have the ability to receive a lump sum (for instance, because the plan has a dollar cap on lump sum payments), then the lump sum benefit would represent a new plan feature for this group of participants. The plan sponsor can choose a different, potentially more favorable, lookback month and stability period, than is in place for participants whose lump sums are below the dollar cap. This eliminates the need for a one-year preservation of less favorable interest rates and can be a highly effective strategy during a volatile interest rate environment. For example, plan sponsors who want to offer lump sums that are higher than an existing dollar cap during the fall of 2022 based on June 2022 interest rates can amend their plans to permit a one-time lump sum window with a quarterly stability period beginning October 1 and a June lookback month.
Additional strategy to consider: Offering modest lump sums on an ongoing basis can reduce future thorns
Having a lump sum provision as a permanent feature in a plan increases the cash flow uncertainty. As mentioned previously, insurers increase their surcharge when asked to take on uncertain cash flows. As a result, most plan sponsors are reluctant to offer lump sums on an ongoing basis if their goal is to terminate the plan.
However, in our experience, plans that offer a modest lump sum provision on a permanent basis (e.g., up to $25,000) do not experience adverse pricing when they terminate their plans. One reason might be that lump sum election rates among those with smaller benefits tend to be high. As a result, the plan will likely have a limited number of participants who are eligible for this provision when the liabilities are moved to an insurer.
Additionally, a lump sum window offered for a “limited time” may have a greater ability to attract the attention of former employees than a permanent feature would. As a result, plan sponsors who are interested in this strategy may want to consider offering a one-time window first, before later making the lump sum provision permanent. Those who choose to include the lump sum window should consider the additional lookback month and stability period strategy described earlier.
As mentioned earlier, higher interest rates lead to smaller lump sums and savings to the plan sponsor. Future interest rates are difficult to predict and are not guaranteed but, because the Federal Reserve is indicating that additional interest rate increases may be necessary, the rates used to determine lump sums may also continue to increase. A plan sponsor may prefer waiting until 2023. This may be a simpler strategy and may turn out favorably. However, executing a lump sum strategy takes preparation, and we recommend taking the following steps now as future interest rate movements are monitored.
- Identify the target population
- Verify contact information
- Draft election forms
- Work with legal counsel to review window details and draft a plan amendment
With these steps taken, a plan sponsor could move forward more quickly once interest rates appear to plateau or reverse and can decide whether incorporating the lookback month and stability period strategy described earlier would be helpful.
Final thought: Contribution and funded status considerations
A lump sum window may decrease the funded status of a plan. Plan sponsors should work with their actuary to determine the impact the window may have on future required contributions. Also, if the plan’s adjusted funding target attainment percentage (AFTAP) is expected to fall below 80%, then a contribution(s) will be needed to increase and maintain the plan’s AFTAP to be at least 80%, both before and immediately after implementing any de-risking strategy.
Plan sponsors should take action now to review cost and risk reduction strategies in light of the current interest rate environment.
As with any strategy, there are many factors that need to be considered, each with their pros and cons. Furthermore, fiduciary requirements require the plan to be operated solely for the benefit of plan participants. We encourage plan sponsors to contact their consulting actuary and ERISA legal counsel to discuss the best approach.