Lump Sum de-risking in 2017

In this article we discuss how changes in interest rates, Pension Benefit Guaranty Corporation premiums and mortality tables may affect sponsor decisions to de-risk (or not de-risk) defined benefit plan liabilities in 2017. For purposes of this article, by de-risking we mean paying out a participant’s benefit as a lump sum and thereby eliminating the related liability – the ‘low-hanging fruit’ for pension de-risking efforts.

This is a technical article, but for some sponsors there may be significant dollars at stake.

Example

We are going to illustrate the effect of these developments on the de-risking decision with an example: the de-risking gain with respect to a terminated vested 50 year-old participant who is scheduled to receive a monthly life annuity of $100 beginning at age 65.

Summary

We begin with the bottom line. For our example participant, declines in interest rates have increased lump sums in 2017 vs. 2016 by 4%-20%, depending on the ‘lookback month’ used by the plan to determine lump sums. The wide range is due to the fact that rates moved up sharply from all-time lows in the second half of 2016.

For plans with an August lookback month, the increase is $1,439 (from $7,092 to $8,531), but for plans with a December lookback month, the increase is only $281 (from $7,026 to $7,307).

The savings from de-risking comes from reduced PBGC premiums and the avoidance of increased costs from the adoption of new mortality tables. Total savings depend on whether or not the plan is affected by the PBGC variable premium cap, as summarized in the following table:

Plan savings (present value) from de-risking example participant

Thus, de-risking in 2017 still produces significant savings to plans, in the form of future premium and mortality savings worth 27%-72% of the total value of the example participant’s lump sum.

Interest rates

De-risking involves paying out the present value of a participant’s benefit as a lump sum. The interest rates used to calculate that present value are the Pension Protection Act (PPA) ‘spot’ first, second and third segment rates for a designated month. Sponsors typically set the lump sum rate at the beginning of the plan year, based on a lookback month defined in the plan (August through December for calendar-year plans), so they will know what rate will be used to calculate their lump sum for the entire year.

The following chart shows PPA spot second and third segment rates for the period 2012- 2016, with August and December lookback months highlighted:

As this data indicates, 2016 interest rates were generally lower than 2015 rates, particularly for plans with an August lookback month.

The following table shows the cost of a lump sum payment to our example participant for 2013-2017 for a sponsor using a prior year’s November rates.

Cost of lump sum payment – monthly $100 deferred vested benefit beginningat age 65/participant is 50

So the effect of the change in interest rates has been to increase the cost of de-risking our example participant by $672 ($7,550 – $6,878) relative to 2016 for a plan with a November lookback month.

PBGC premiums

Reducing participant headcount, e.g., by paying out lump sums to terminated vested participants, reduces the PBGC flat-rate premium and may, depending on plan funding and demographics, reduce the variable-rate premium. Premiums for the current year are based on headcount for the prior year. So de-risking in 2017 will reduce premiums beginning in 2018.

PBGC flat-rate premiums

The PBGC flat-rate premium is $74 per participant for 2018; it increases to $80 in 2019 and is increased for (wage) inflation thereafter. Discounting annual premiums for 35 years (assuming the participant lives to age 85) yields a present value of $2,070.

Variable-rate premiums

In our article Reducing pension plan headcount reduces risk and PBGC premiums we discussed how de-risking can, in some cases, dramatically reduce the variable-rate premium. The logic of that is not especially intuitive. The gains come from the headcount-based cap on variable-rate premiums. In 2018 the headcount cap will be about $530 per participant. Oversimplifying, depending on plan funding and demographics, de-risking (that is, lump summing-out) one participant in 2017 may save a sponsor $530 per year in PBGC variable premiums beginning in 2018 (on top of headcount premium savings.)

As plan funding improves, however, this savings will go away. For purposes of our example we’re going to assume the plan ‘funds its way out’ of the per participant variable-rate premium cap after 6 years. Discounting the annual variable premium cap for 6 years yields a present value of around $2,950.

For details on the effect of de-risking on the variable-rate premium, we refer you to our article.

Effect of new mortality tables

At the end of 2014 the Society of Actuaries finalized new mortality tables for private DB plans. While the SOA subsequently modified those tables in a way that will in most cases somewhat reduce their impact, they generally will increase liability valuations.

IRS is expected to update the mortality tables that plans must, under the Tax Code and ERISA, use in calculating lump sums in 2018. The effect of the adoption of the new tables on lump sum valuations will depend on a number of factors, but generally they will increase lump sum valuations by about 3%.

For purposes of our example, if our 50 year old is paid a lump sum before the new tables are adopted, we assume (somewhat arbitrarily) the plan will avoid a 3% mortality assumption-driven increase in cost of about $225.

Note: we are characterizing payment of a lump sum before new mortality tables go into effect as producing a ‘savings.’ That savings, however, is different from the PBGC premium savings discussed above. It’s possible to calculate the PBGC premium savings with some certainty. The gains from paying a lump sum before new mortality tables go into effect are more speculative and depend fundamentally on plan demographics and final IRS guidance.

Finally, sponsors may wish to consider whether, and how, to explain the effect of soon-to-be-adopted mortality tables on a participant’s decision to take a lump sum, either as part of a de-risking transaction or simply in the course of an ordinary retirement.

Regulatory environment

With the election of President Trump, it’s possible that concerns that some in the prior Administration expressed about de-risking may subside. For instance, because of Trump’s policy of reducing regulation generally, IRS may not (as in July 2015 it said it intended to) amend current regulations to “provide that qualified defined benefit plans generally are not permitted to replace any joint and survivor, single life, or other annuity currently being paid with a lump sum payment or other accelerated form of distribution.” (Notice 2015-49)

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Declines in lump sum valuation interest rates have made de-risking in 2017 more expensive than it was in 2016. However, because of increased PBGC premiums, de-risking continues to produce substantial savings.

We will continue to follow this issue.