Interest rates 2020: effect on retirement finance – introduction

The valuation interest rates for a typical DB plan have declined around 90 basis points since the beginning of the year, and – extraordinarily – almost 50 basis points since the beginning of March. This in the context of a 75-100 basis point decline for 2019. This decline, and the simultaneous decline in stock values – if they persist – will have significant consequences for DB plan sponsors. These declines will also have significant consequences for DC plan participants.

In the weeks that follow we are going to be posting a series of articles detailing the effect of these declines on retirement plan finance and the opportunities, challenges, and decision points for sponsors that they present.

In this brief introduction, we will simply identify the key issues for sponsors. Let’s begin, however, with the broader context of these considerations.

Perspective and context

First (and foremost) this is a public health crisis, and the lives and health of our fellow humans, very much including our fellow employees, and our families, are our primary concern. The financial issues it presents are necessarily secondary.

Nevertheless, for professionals with responsibility for managing retirement plans, understanding the financial consequences of the current, clearly extraordinary events is a primary responsibility.

Second, writing at a time when the entire federal securities yield curve has been under 1%, our assumption is that this is a temporary phenomenon, of sorts. That said, we don’t know how long this temporary phenomenon may last or what level rates may “bounce back” to. Even before covid-19 hit, rates were down around 30 basis points on the year, coming off of significant declines in 2019. And we don’t know the extent of any permanent effects the current crisis may have.

We offer this and the articles that will follow as a way for retirement plan professionals to begin thinking about the challenges that the current crisis presents and the significance of interest rate and asset performance as a critical moving parts in plan decision making.

The issues briefly

ERISA minimum funding: Declining market rates will (1) extend the period during which HATFA 25-year average rates apply and (2) marginally reduce those 25-year average rates, as new, much lower “interest rate years” are added to the front end of the 25-year average, and older, much higher interest rate years are subtracted from the back end. Overall, this will reduce minimum funding valuation interest rates and increase liability valuations.

These effects are happening at the same time as a nearly 20% decline in stock values.

These two developments – dramatically declining interest rates and dramatic losses in the equity markets – will stress plan funding requirements, for some plans triggering restrictions applicable where a plan is less than 80% funded.

De-risking calculation: As we noted in our recent article De-risking in 2020, notwithstanding that lump sum valuation rates for 2020 are much lower than they were for 2019, if current rate declines persist, then de-risking in 2020 may be considerably cheaper than in future years. 

PBGC variable-rate premium: Market rates are used to calculate unfunded vested benefits (UVBs) for purposes of determining the plan’s PBGC variable-rate premiums. Lower market interest rates, and lower asset values, will increase the amount of these premiums. There are a suite of strategies that can be used to reduce variable-rate premiums, summarized in our article Interest rates 2019 – managing funding and PBGC variable-rate premiums in a volatile interest rate environment.

Briefly, those strategies include: (1) borrowing (at current very low rates) and funding, to reduce UVBs; (2) certain contribution accelerations strategies; (3) and reducing headcount, by paying out lump sums or (in certain circumstance) annuities, where the plan is subject to the variable-premium headcount cap.

Which particular strategy should be adopted generally depends on the funded status and demographics of the plan. Current dramatically lower interest rates may, however, for some plans be a reason to change current strategies.

Measuring UVBs: Pursuant to a somewhat technical set of rules, sponsors may be able to choose between using end-of-prior-year spot rates or a 24-month average rates to value UVBs. This election may for 2020 have a significant effect on some plans’ UVBs and variable-rate premiums.

Impact on DC participants: Lower interest rates mean that retirement income (e.g., annuity purchase rates) is more expensive. Current declines come at the same time as dramatic declines in asset values – a double whammy. With the near-term implementation of SECURE’s mandatory lifetime income disclosure requirement, the negative consequences of these changes for participants’ retirement income goals will be made explicit.

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It’s our intention in the following weeks to review each of these issues in detail, focusing on how current changes in interest rates may change the sponsor’s calculations and strategies.