In this article we discuss how changes in interest rates, Pension Benefit Guaranty Corporation premiums, and mortality assumptions may affect sponsor decisions to de-risk (or not de-risk) defined benefit plan liabilities in 2020. 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.
We begin with a brief summary of our conclusions, followed by a more detailed analysis.
Bottom line: the cost of de-risking will dramatically increase in 2020 (vs. 2019).
We illustrate our analysis of the effect of interest rates and PBGC premiums on the de-risking decision by using a (relatively simple) example: the cost-of-benefit and de-risking gain with respect to a terminated vested 50 year-old individual who is scheduled to receive an annual life annuity of $1,000 beginning at age 65.
For our example participant, decreases in interest rates (November 2018 vs. November 2019) have increased the 2020 base cost of paying this participant a lump sum benefit, vs. 2019, by around $2,277 (34%). On our assumptions, if a 50 year-old individual with a $1,000 benefit had been paid out in 2019, the cost would have been $6,671; in 2020 the cost would be $8,948.
Most of the savings from de-risking this participant come from reduced PBGC premiums – an (assumed) present value of $2,002 in PBGC flat-rate premiums and $2,676 in PBGC variable-rate premiums (only available to plans subject to the variable-rate premium cap).
In addition, for 2020 lump sum calculations there was an increase in the applicable mortality assumption, which will result in a (marginal) decrease in lump sum costs. For our example participant, that change would reduce the cost of paying out the participant in 2020 vs. 2019 by around $8.
The de-risking calculation is, of course, relative and dependent on the sponsor’s view of, e.g., future interest rate trends and the cost/savings of paying a participant all benefits this year vs. paying them next year vs. simply paying them when due (e.g., beginning at age 65).
What follows is a detailed discussion of these conclusions.
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. Many sponsors set the lump sum rate at the beginning of the calendar year, based on the spot rates in a prior year “lookback” month, so that participants will know what rate will be used to calculate their lump sum for the entire year. A plurality of plans use a November lookback month, which we use in our example. Under such an approach, for 2020 the lump sum rates would be the November 2019 PPA spot rates.
The following chart shows PPA spot second and third segment rates for the period 2018-2019 (with November rates highlighted).
As this data indicates, November 2019 interest rates were down significantly vs. November 2018 rates. (We note that the decrease in 2019 rates was significant across all lookback months; the November 2018-November 2019 decrease was, however, the greatest.)
As noted, based on these rates, the cost of de-risking our example participant increased 34%, from $6,671 in 2019 to $8,948 in 2020.
(For purposes of this calculation, rather than doing a strict Tax Code 417(e) calculation, we simply assume the participant has a 21-year life expectancy at age 65.)
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 2020 will reduce premiums beginning in 2021.
PBGC flat-rate premiums
We are estimating the 2021 PBGC flat-rate premium to be $85 (the 2020 rate of $83 adjusted for one year of wage inflation).
For purposes of our analysis we assume no inflation-related increases in PBGC premiums after 2021. We use a discount rate of 2.5%, which generally assumes low or no inflation.
Discounting annual premiums for 36 years (assuming our example 50-year old participant lives to age 86) yields a present value of the savings from the elimination of PBGC flat-rate premiums for our example participant of around $2,002.
In our article Reducing pension plan headcount reduces risk and PBGC premiums, we discuss 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. We estimate (again, based on one year wage inflation) the 2021 headcount cap to be $576. Oversimplifying (and again ignoring any future inflation adjustment to the cap), depending on plan funding and demographics, de-risking (that is, lump summing-out) one participant in 2020 may save a sponsor $576 per year in PBGC premiums beginning in 2021.
As plan funding improves, however, these savings will go away. For purposes of our example we assume the plan “funds its way out” of the per participant variable-rate premium cap after 5 years. Discounting annual premiums of $576 for 5 years yields a present value of around $2,676.
Effect of changing mortality improvement scales
In October 2019, the Society of Actuaries adopted a new mortality improvement scale (MP-2019), showing a further increase in mortality. Quoting the SOA: “most 2019 pension obligations calculated using Scale MP-2019 (with a discount rate of 4.0%) are anticipated to be 0.3% to 1.0% lower relative to their Scale MP-2018 counterparts.” In December 2019, IRS updated applicable mortality tables for years 2021 and following, to reflect the SOA’s new scale. As noted, based on the new mortality improvement scale, we estimate that the cost of de-risking our example participant decreased by around $8 in 2020.
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Decreases in lump sum valuation interest rates have made de-risking in 2020 significantly more expensive than it was in 2019. Changes in mortality assumptions will marginally reduce that increased cost.
As we discussed in our last article, however, the 2019 rate declines have continued into 2020 – medium- and long-term corporate bond rates are down another 30 basis points notwithstanding a relatively robust economy and neutral-to-ambiguous Fed policy. Thus, it is possible that de-risking in 2020 may be cheaper than in 2021.
Sponsors will want to consider these factors in making their 2020 de-risking decision.
We will continue to follow this issue.