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In this article we discuss a key election a sponsor may make as to how plan underfunding is measured – whether to use end-of-2018 spot rates or a 24-month average – that may have a material effect on how much PBGC variable-rate premiums the sponsor must pay in 2019. This is an issue for DB plan sponsors (only) and is highly technical, but for many sponsors there will be significant money at stake. The decision is made particularly acute by the recent and dramatic drop in interest rates.
This election generally must be made (for a calendar plan) by October 15, 2019.
Variable-rate premiums and valuing UVBs
Currently– in the context of interest rate relief that significantly limits the effect of ERISA minimum funding requirements – for many plan sponsors funding policy is framed with a view to reducing so far as possible PBGC variable-rate premiums.
The amount of variable-rate premiums a sponsor pays for 2019 is 4.3% of the plan’s 2018 unfunded vested benefits (UVBs), subject to a $541 per participant headcount cap. UVBs are determined as the present value of plan liabilities (for vested participants) minus the (year-end 2018) fair market value of plan assets.
In determining UVBs, sponsors have a choice. They can use (for a calendar year plan): (1) December 2018 spot segment rates (the “standard” method) or (2) the 24-month average segment rates used for plan funding (the “alternative” method) (disregarding 25-year average interest rate stabilization).
There are a lot of technicalities in that description – the easy way to think of this is as a choice between end-of-prior year spot rates or 24-month average rates.
A sponsor’s ability to elect the 24-month average method, or to elect out of the spot rate method, however, is limited. Once a particular method (standard or alternative) is elected, the sponsor can’t switch to the other method for five years. So this decision should generally be made with a view to (among other things) the expected behavior of interest rates over the medium-term.
Spot vs. 24-month average rates for 2019
As noted, the 2019 PBGC variable rate premium is determined based on 2018 UVBs, determined using spot or 24-month average interest rates as of December 2018 (assuming the plan uses a December 2018 lookback month for plan funding). Interest rates went up significantly during 2018, and as a result December 2018 spot rates are significantly higher than 24-month average rates.
Table 1 – 2019 variable-rate premium calculation: spot vs. 24-month average rates (December 2018 lookback month)
Because of the higher rates under the spot rate method, we estimate that a plan using it, with a typical duration, will have liabilities 2%-6% lower than it would have if it used the 24-month average method. To get a feel for the impact of that difference, consider a plan with $100 million in liabilities (using the 24-month average segment rates) and $80 million in assets. A 4% reduction in liabilities (resulting from a switch to end-of-2018 spot rates) would reduce UVBs from $20 million to $16 million, and would reduce PBGC variable-rate premiums by $172,000 (around 20%). For plans with different 24-month average periods (August-November), the strategy is progressively more attractive. For a plan with an August lookback month, switching to the spot rate method for 2019 reduces the premium by $220,000 for this plan.
Plans currently using the 24-month average method, with the ability to switch to the spot rate method, may want to (at least) consider that switch if the savings generated are significant enough.
But what about next year?
There is, however, a problem with such a strategy. As noted, a sponsor making a 24-month-average-to-spot-rate switch for 2019 variable-rate premiums is stuck with the spot rate method for five years. It looks like interest rates are likely to be significantly lower in 2019, and spot December 2019 rates, applicable to the 2020 variable-rate premium calculation, are likely to be significantly lower than 24-month average rates.
Below is a comparison of projected 24-month average and spot rates for 2020 and 2021 variable-rate premium calculations, reflecting changes in market interest rates through August 15, 2019.
Table 2 – 2020 and 2021 variable-rate premium calculation: spot vs. 24-month average rates (December lookback month)
If interest rates remain at current levels, savings from adopting the spot rate method for 2019 would be more than offset by significantly higher premiums in 2020 and 2021. That result obtains regardless of what lookback month is used.
If by the end of this year interest rates move up 100 basis points from current levels – basically where they were in April of this year – 2020 premiums will be similar under either method, and electing the spot rate method for 2019 premiums would be the better strategy. What we are saying is that the lower 2019 variable-rate premiums that result from the adoption of the spot rate method are “hard dollars” saved, while the higher premiums estimated for 2020 and especially for 2021 are more speculative and sensitive to the future path of interest rates.
A judgment call
Clearly, a sponsor’s decision as to whether to change to the spot rate method for the 2019 variable-rate premium calculation will depend on a number of variables, including plan demographics, the plan’s current financial position, investment results, the impact of the variable premium cap, and on-going de-risking activity. With respect to this decision, we would make the following observations:
1. If the current method (spot rate or 24-month average) was first elected for 2015 or later, you have no decision to make – you are stuck with the method you elected for 2019.
2. If you’re on the spot rate method, there’s no question for 2019 – stick with it.
3. If you are on the 24-month average method and have the ability to switch to the spot rate method for the 2019, consider the following:
The ability to preserve flexibility is an important factor – if you switch to the spot rate method you will generally be stuck with it for five years. You will probably want to delay the 2019 decision as long as possible, e.g., until early October 2019 (for a calendar year plan).
If you’re at the variable-rate premium headcount cap for 2019, it doesn’t matter which method you use, although which method you use may determine whether you’re subject to the cap.
Your view of interest rates over the next 18-30 months is most significant; beyond that period, even the 24-month average will be strictly a function of future rates.
Your decision will be affected by (and may affect) decisions you make with respect to funding, financial disclosure, and de-risking. These factors should all be considered before you make the spot rate vs. 24-month average decision.
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For our $100 million plan, hundreds of thousands of dollars are at stake in connection with this decision. Moreover, decisions based on current year impact only could be expensive mistakes that come home to roost over the next two years.
Plans with an opportunity here may want to pay close attention to interest rates up until October 15th before making a final decision for 2019.
We will continue to follow this issue.