Funding impact of changes in interest rate and mortality assumptions
In our prior article, we discussed the financial statement impact for defined benefit plans of changes in interest rate and mortality assumptions. In this article we consider the effect of those changes on ERISA minimum funding requirements.
For funding, we now have some certainty about what will be two major drivers of increases in minimum funding requirements for most plans: (1) the phase out of interest rate relief under the Highway and Transportation Funding Act of 2014 (HATFA) and (2) the new Society of Actuaries mortality table.
Against that background, changes in Federal Reserve interest rate policy and market interest rates – which we considered at length in our article on accounting changes – are likely to be less significant.
In this article, we discuss the changes in funding requirements that will result from the regulatory changes that we know are coming. We then consider, briefly, the effect of possible changes in market interest rates under the optimistic and pessimistic scenarios we used in our prior article.
Summary: baseline case
Let’s begin with a summary of the estimated effect on plan contributions for our shorter (duration 9) and longer (duration 15) duration plans. For the sake of simplicity, we consider a plan with a 2015 funding target of $100 million.
Those increases are spread out over around 12 years. That’s for two reasons: (1) HATFA doesn’t fully phase out until around 2020-2021 under our assumptions; and (2) the increases in liabilities resulting from these regulatory changes are paid off, under PPA rules, over 7 years.
The contribution increases will peak in 2022 at around 5-7% of 2015 liabilities. So, for instance, for our duration 15 plan with $100 million in liabilities, 2022 contributions will be $6.9 million more than they were in 2015.
Now let’s consider what’s behind these increases – the phase out of HATFA interest rate relief and the adoptions of new mortality assumptions.
Interest rates and funding – the effect of phasing out of HATFA
Unlike financial reporting – which reflects current interest rates – the interest rates used to calculate liabilities for funding purposes under ERISA minimum funding rules are subject to a couple of ‘fudges.’ Under the Pension Protection Act (PPA), a 24-month average of first, second and third segment rates is generally used. Under HATFA (oversimplifying somewhat) 90% of a 25-year average of these 24-month rates is used, as a floor on rates, until 2018; beginning in 2018, the 90% factor ‘phases down’ as follows:
|Reduction factor||Applicable year|
The decrease in the reduction factor results in a decrease in the floor. A floor based on a 70% factor will be effective only in the most extreme conditions.
As a practical matter, the HATFA rates are the liability valuation rates for plan funding purposes until around 2020. The following charts show valuation interest rates used for calculating liabilities for funding our shorter duration and longer duration example plans, assuming no change in interest rates after July 31, 2015. We call this the ‘baseline’ case.
The following table shows the effect on liability valuations for our two example plans of these changes compared to the 2015 liability.
Table 1. Increases in plan liabilities (compared to 2015) for funding resulting from phase out of HATFA interest rate relief
|Shorter duration plan||2%||3%||8%||12%||17%||21%||22%|
|Longer duration plan||2%||5%||12%||20%||28%||32%||32%|
A critical point to keep in mind here is that these are changes (decreases in valuation interest rates and corresponding increases in liabilities) that happen if nothing changes. For funding, liability valuations have, in effect, been insulated by HATFA from the effect of historically low market interest rates. As HATFA phases out, liability valuations (and contributions) are going to go up.
Mortality assumptions – effect of adoption of new tables reflecting longer life expectancies
As we mentioned in our recent article 2016 mortality tables published by IRS, the IRS has indicated that it will likely require use of a new mortality table in 2017, reflecting mortality improvements that are themselves reflected in the new Society of Actuaries mortality tables (RP-2014) and mortality improvement scale (MP-2014). IRS may make changes to the SOA assumptions, but no one doubts that the new IRS assumptions will result in increases participants’ assumed life expectancies across the board. To keep things simple, for purposes of this article we are going to assume that the IRS adopts the SOA tables/improvement scale ‘as is.’
As we noted in our article on the accounting effects, the effect of the new mortality assumptions on plan liability valuations will depend on plan demographics. There is, in effect, a ‘saddle’ – longevity increases are highest for the very young and the very old, and lowest for 45-65 year olds. Thus, the magnitude of the impact of the new mortality tables may often depend on how many 45-65 year olds vs. how many 25-35 and 75-85 year olds are in your employee demographic.
Assuming a relatively ‘even’ demographic distribution, the new mortality tables will have a greater effect on shorter duration plans, because of the significant life expectancy increases at older ages. Here is our estimate of the net increase in plan liabilities, for the 2017 year, for funding for our shorter duration and longer duration example plans.
|Shorter duration plan||9%|
|Longer duration plan||7%|
Again repeating what we said in our accounting article, this analysis holds for traditional DB plans. Mortality is less significant for, and will have less of on effect on, cash balance plans. The effect will also be less significant for ‘traditional’ DB plans that pay lump sums, because the plan is, in effect, not accumulating participants over age 65.
Combined effect of changes in interest rate and mortality assumptions on liability valuations for funding
Both the phasing out of HATFA and the new mortality assumption push liabilities in the same direction: higher.
|Shorter duration plan||2%||13%||18%||23%||27%||32%||33%|
|Longer duration plan||2%||12%||20%||29%||37%||42%||42%|
Effect on cash flow
Our chart at the beginning of this article (Chart 1) summarizes the effect on cash flow – the increase in required minimum contributions – of these increases in liabilities. We emphasize (again), that these increases assume that current interest rates do not change; the only things that do change are (1) the phase out of HATFA relief and (2) the adoption of new mortality assumptions. Contribution increases are spread over the period 2016-2027 because: (1) HATFA relief phases out around 2020; and (2) increases in liabilities are, under the PPA, paid off over 7 years.
The following table shows the contribution increase for a plan with $100 in liabilities in 2015 resulting from the phase out of HATFA and the adoption of new mortality assumptions (in 2017) – these are simply the numbers underlying Chart 1.
|Shorter duration plan||0.3||2.1||2.9||3.8||4.6||5.4||5.4||5.1||3.3||2.5||1.7||0.9|
|Longer duration plan||0.4||2.0||3.4||4.8||6.2||6.9||6.9||6.5||4.9||3.6||2.2||0.7|
Effect of changes in market interest rates
The foregoing has been an extended explanation of how we derived Chart 1 – the effect on funding requirements of the phase out of HATFA and the adoption of new mortality tables. Now let’s consider very briefly the effect on these numbers of changes in interest rates under our optimistic and pessimistic scenarios. As discussed in our prior article, our ‘optimistic’ assumption is that, through the end of the year, interest rates go up by 50 basis points across the entire yield curve. Our ‘pessimistic’ assumption is that short-term rates go up by 50 basis points, medium-term rates are unchanged, and long-term rates go down 50 basis points.
The following charts show the increases in required contributions by year resulting from the phase out of HATFA and the adoption of new mortality assumptions under our two interest rate scenarios for our shorter duration and longer duration plans.