At current interest rate levels, HATFA interest rate relief will be the interest rate used for minimum funding through 2027. While this will reduce valuation interest rates from what we were projecting at the beginning of 2019, generally HATFA interest rate stabilization (25-year averaging), together with 24-month “smoothing” of asset values, and seven-year amortization of funding shortfalls, considerably eases otherwise applicable ERISA minimum funding requirements.
In contrast, PBGC variable-rate premiums are determined based on a liabilities-minus-assets calculation of “unfunded vested benefits” that does reflect market interest rates (entirely or based on 24-month average rates at most) and the fair market value of assets. Thus, e.g., 2021 variable-rate premiums will reflect 2019-2020 interest rates and assets.
Variable-rate premiums and funding
In this context, many plan sponsors’ funding policy – and the response to current interest rate and asset declines – is likely to be framed with a view to reducing so far as possible PBGC variable-rate premiums.
The easy way to think about variable-rate premiums is as (for 2020) a 4.5% tax on underfunding. More technically, the amount of variable-rate premiums a sponsor pays with respect to a DB plan for 2020 is 4.5% of the plan’s unfunded vested benefits (UVBs), subject to a $561 per participant headcount cap. UVBs are determined as the present value of (beginning of year 2020) plan liabilities (for vested participants) minus the (beginning of year 2020) fair market value of plan assets.
The premium rate and headcount cap are both adjusted for wage inflation each year. As we have discussed, in calculating variable-rate premiums UVBs are determined based on either end-of-prior-year spot interest rates or (if the sponsor so elects and subject to certain limitations) a 24-month average.
Effect of interest rates and asset declines on variable-rate premium liability
While interest rate declines in 2019 were significant, and generally increased liability valuations for purposes of the 2020 variable-rate premium/UVB calculation, much (in some cases, all) of that increase was offset by increases in asset values – the S&P 500 was up over 25% for 2019.
The story thus far in 2020 is, obviously, different, and something of a moving target.
A week ago, interest rates were at historic lows. Extraordinarily, they have increased 100 basis point since then and are now up on the year. Nevertheless, declines in asset values (there has been a dramatic 30% decline in stock values) are likely to outweigh any interest rate-driven reduction in liability values. Thus, for many (perhaps most) plans, current conditions, if they persist, are going to trigger or increase payment of variable-rate premiums (often significantly) in 2021.
We estimate that a duration 12 plan, with a 60/40 equity/fixed income portfolio, that (on a fair market value basis) was 100% funded on January 1, 2020, is less than 88% funded as of March 20, 2020.For a $100 million dollar plan, this translates to $12 million in unfunded liabilities and a 2021 variable premium of $500,000.
Datapoint: For most plans, 2021 PBGC variable-rate premiums are going up significantly – for a $100 million plan, next year’s premium could jump around $500,000.
Reducing variable-rate premiums
In our 2019 article on the topic, we reviewed the strategies a sponsor may use to reduce variable-rate premiums, and we briefly repeat them below.
Strategies for reducing variable-rate premiums differs depending on what sort of plan you have and (critically) on the plan’s funded status.
- Plans that are fully funded on a non-HATFA basis. Sponsors of plans that are fully funded without regard to HATFA interest rate stabilization generally will not owe any PBGC variable-rate premium. 2020 interest rate declines will, however, if they persist, affect this “non-HATFA” calculation, and some sponsors who were in category 1 for 2020 may drop down to, e.g., category 2 for 2021.
- Plans that are fully funded on a HATFA basis but not on a non-HATFA basis. Sponsors of plans that are only fully funded if you apply the HATFA interest rate stabilization rules generally will owe PBGC variable-rate premiums. Sponsors of these plans may want to consider the borrow-and-fund strategy discussed in detail in our articles DB funding: pay now or pay later(2019) and Should I borrow money to fund up my pension plan?(2012).
- Plans that are not fully funded but are at least 80% funded on a HATFA basis. Sponsors of these plans generally can reduce PBGC variable-rate premiums by accelerating 2021 quarterly contributions, treating those accelerated contributions as for2020. Under this strategy, the sponsor, in effect, takes the amount of contributions required to be made for 2021 and contributes it for 2020. Doing that accomplishes two things: (1) it creates a credit balance that can be used to satisfy 2021 contribution obligations; and (2) it reduces the plan’s UVBs and thus the 2021 PBGC variable-rate premium obligation.
Indeed, a sponsor may want to consider this strategy with respect to anycontributions it intends to make in the relatively near future.
If interest rates and assets remain at current levels, funding requirements are in the long run likely to go up for many plan sponsors – see our article Markets 2020 – effect on ERISA minimum funding requirements. That possibility may provide an additional incentive for accelerating funding using this strategy.
We discuss this strategy in detail in our articles DB funding: pay now or pay later(2019) and Reducing PBGC variable-rate premiums: timing contributions(2015).
- Plans that are not 80% funded on a HATFA basis. The acceleration strategy described in category 3 is generally not available to these plans. That is because that strategy depends on using a credit balance to satisfy 2021 funding obligations, and a plan must be at least 80% funded in 2020 to do that. Plans in this group (as well as some plans in the previous group) are, however, often subject to the variable-rate premium cap, and sponsors of these plans may want to review our article De-risking in 2019, explaining how plans subject to the headcount cap can reduce variable-rate premiums by settling liabilities via lump sum windows and/or annuity purchases.
These headcount cap reductions can be very valuable. The combined premium (per participant premium + variable rate premium headcount cap) for a single participant is likely to be around $660 in 2021, increasing annually thereafter. Given the volatility in rates and drops in asset values this year, some plans may find their premiums limited by the cap for many years into the future, increasing the reward for reducing headcounts now. More details on the application of the headcount cap are discussed in our earlier article.
Some of these categories/strategies overlap– For instance, any plan subject to the headcount cap, including one that isat least 80% funded on a HATFA basis, will want to consider reducing headcounts by settling liabilities.
Importance of the spot vs. 24-month average election – Sponsors will want to keep in mind that the analysis here depends in many cases on the amount of the plan’s UVBs. As discussed in our prior article, for 2020, the amount of a plan’s UVBs may (significantly) depend on the spot rate vs. 24-month average election.
In general, the Alternative method will produce a lower premium liability for plans in 2020, but it’s not clear what such an election would mean for 2021. Sponsors with the ability to change their method in 2020 will want to wait until late September before pulling the trigger.
Other advantages of additional 2020 contributions
As noted, for some sponsors (e.g., those in category 3), an additional contribution this year (for calendar year plans, by September 15, 2020) may reduce 2020 variable rate premiums. This contribution will also improve the plan’s funded ratio (generally, for all purposes), which may (depending on the plan):
- Eliminate 2021 quarterly contribution requirements.
- Avoid restrictions on the payment of lump sum benefits.
- Ensure credit balances are available to meet funding requirements due beginning April 15, 2021.
- Avoid a PBGC 4010 filing due April 15, 2021.
There are actions that many sponsors can take to reduce the impact of recent interest rate declines on DB plan finance – critically, executing strategies that will minimize PBGC variable-rate premiums. Obviously, there are a number of moving parts to consider with respect to these strategies, and sponsors and their consultants will want to be familiar with critical issues including long-run contribution strategy, plan demographics, the plan’s current financial position, investment results, the impact of the variable premium cap, on-going de-risking activity, and financial statement impact.
We will continue to follow this issue.