Increases in interest rates, the increasing cost of PBGC premiums, and the idiosyncrasies of IRS minimum funding/benefit restriction rules may, for many sponsors, make 2023 a good year for defined benefit plan liability settlement – through the payment of lump sums or the purchase of annuities (AKA pension risk transfer). In what follows, we briefly review the issues with respect to 2023 settlements sponsors will want to consider.
Savings generated by a settlement
Generally, whether to settle liabilities will be a function of the savings generated by a settlement vs. its cost. Broadly, those savings consist of:
- Reduced administrative overhead – typically accounts for 20% of settlement related cost savings.
- Reduced PBGC per capita premiums – $96 (for 2023) per participant.
- For underfunded plans at the variable rate premium (VRP) headcount cap, reduced VRPs of $652 per participant (for 2023).
Sponsors may also benefit from the idiosyncrasies related to lump sum “lookback and stability period” rules. Lump sums paid in 2023 will (typically) be paid out based on interest rates for a 2022 “lookback month” (November is most common). October and November 2022 interest rates were significantly higher than current rates, and a sponsor may benefit by paying out lump sums at those higher lookback-month rates. (We discuss the math of lump settlement under IRS rules and the issue of current vs. “look back” interest rates in our article De-risking in 2022 – Part 1.)
The cost of settlement – market conditions
Interest rates drive both the cost of settlement (i.e., the cost of lump sums and annuities) and the calculation of plan liabilities (for purposes of financial statements and IRS minimum funding rules). The recent increase in interest rates (up 230 basis points in 2022) will translate into a reduced cost of settlement 2023.
For financial statement purposes, the 2022 increase in rates will generally result in a reduction in liabilities of 17%-27% (very much depending on duration).
For some plans, the ability to settle liabilities may “expire” on March 31
For purposes of the minimum funding rules, however, where a 25-year average of rates is used, most of that reduction in liabilities does not show up. For that purpose (minimum funding), the 2022 decline in asset values (which can only be “smoothed” over 24 months) is much more significant, and most plans will see a reduction in their minimum funding funded level, e.g., a reduction in their AFTAP (adjusted funding target attainment percentage), for 2023.
Thus, we are currently in a situation in which the market cost of settlement has gone down (as liabilities have gone down) while the plan’s “funded ratio” (under appliable IRS rules) has also gone down. Critically, many plans that were 80% or more funded (under the IRS rules) in 2022 may, in 2023, be less than 80% funded, triggering restrictions on the settlement of liabilities.
For purposes of the benefit restrictions calculation, however, a plan is permitted to assume, for the first three months of 2023, that its 2023 funded status is equal to its 2022 funded status. Thus, plans that were (under the minimum funding rules) 80%-or-above funded in 2022, but anticipate (because of 2022 asset losses), dropping below 80% in 2023, will still have three months in 2023 to settle liabilities before restrictions kick in. And plans that were 90% or more funded in 2022 but anticipate being below 80% in 2022 will have until September 30, 2023, to make unrestricted settlements.
SECURE 2.0 may change the ability to do lump sum windows and increase the cost of annuities
SECURE 2.0 includes an instruction to DOL to, within one year, “review the current interpretive bulletin governing pension risk transfers to determine whether amendments are warranted and to report to Congress its finding, including an assessment of any risk to participant review its safest available annuity guidance (Interpretive Bulletin 95-1).” Of particular concern is the involvement in risk transfer transactions of private equity-owned carriers. Without taking any position pro or con on this issue, it is possible that any restrictions on carriers coming out of this review process will result in a limitation on capacity and an (at least marginal) increase in cost.
SECURE 2.0 also includes an instruction to DOL to produce new rules for lump sum windows, including significant disclosure and reporting requirements. The timeline on implementation of these rules is somewhat unclear, but when they become effective they will increase the cost of and reduce the speed with which lump sum window transactions can be done.
Annuitization vs. lump sums
“Pro” lump sums. As discussed above, interest rates are down somewhat relative to the lookback month used to value lump sums under applicable IRS regulations. Thus, liabilities can be settled with lump sums at below (current) market rates.
“Pro” annuities. On the other hand, it is very unlikely that a sponsor can get a lump sum window done – terms communicated, elections solicited and received, and lump sums paid out – in three months. So, sponsors looking at the possibility of being less-than-80% funded for 2023 (see above) will probably not be able to do a 2023 lump sum window.
Finally, 2022 was arguably a positive year for lots of pension sponsors, despite double-digit asset losses, because liabilities fell by even more. This experience comes on top of 2021 experience that was very positive for most pension sponsors. In 2023, pension sponsors may be able to, so to speak, seize on a tide in the affairs of men which, taken at flood, can lead to fortune.
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We will continue to follow these issues.