As of the end of February 2021, market interest rates are up significantly since the beginning of the year. For many plans, this will mean that 2021 lump sums are valued at interest rates that are lower than current market rates.
In this article, we discuss how this situation, and certain other complicating factors that a sponsor may wish to consider, may affect the sponsor’s 2021 de-risking decision. We begin with some background on lump sum calculations.
Background – rules for calculating defined benefit plan lump sums
Generally, the interest rates used to value lump sums are the one-month first, second, and third segment rates applied under applicable ERISA plan funding rules. IRS regulations provide for a somewhat complicated system for deriving this rate the purpose of which is to make the discount rate more predictable and stable over time, so that participants will know in advance what discount rate will apply to them. To do this, the regulations provide for a “stability period” over which a pre-determined “lookback month” rate will apply.
The stability period is “the period for which the applicable interest rate remains constant.” There are five different stability period options: (1) one calendar month; (2) one plan quarter; (3) one calendar quarter; (4) one plan year; (5) or one calendar year. Simplifying, if the plan year is the calendar year, there are three options – a month, a quarter, or a year.
The lookback month is the first, second, third, fourth, or fifth full calendar month preceding the first day of the stability period. So, if the plan’s stability period is the calendar year, then the interest rate for, for instance, 2021, may be based on the rate for December, November, October, September, or August 2020.
A sponsor may change the stability period or lookback month, but there is a “grandfather” requirement: Generally, where there is such a change, the plan must provide that, for a period of one year beginning on the plan amendment’s effective date and ending one year after the later of its adoption date or effective date, a participant’s lump sum is determined using either the “old” interest/discount rate or the “new” interest/discount rate, whichever results in the larger distribution.
In our experience, a plurality of plans use a year-long stability period and a November lookback month.
Higher cost of 2021 lump sums relative to the (current) market
For plans using a year-long stability period and a November 2020 lookback month, the lump sum valuation interest rate for 2021 is around 35 basis points lower than current rates.
To state the really obvious: lump sums paid out by such a plan, and any other plan using 2020 lump sum valuation rates that are lower than current rates, will be greater than they would be if they were paid out at current rates.
To illustrate this effect, as in our last article, we use the cost-of-benefit with respect to a terminated vested 50 year-old participant who is scheduled to receive an annual life annuity of $1,000 beginning at age 65. The amount paid to this participant using a November 2020 lookback month valuation rate would be $10,428. If it were done at current rates, it would be around $9,600.
If this relationship between (older, lower) lump sum valuation rates and current rates continues for the rest of 2021, two issues are raised: First, paying out a lump sum in 2022 will generally be a “better deal” for the sponsor than paying it out in 2021. And second, if a lump sum is paid out in 2021, the additional cost (resulting from the use of the older, lower valuation rate) will show up as an increase in balance sheet net liabilities.
Annuity settlement as an alternative
In these conditions, one alternative a sponsor may consider is settling the liability by distributing an annuity rather than a lump sum. That is because annuities are priced at market rates rather than (as are lump sums) using 2020 lookback month rates.
This approach would generally not (at current rates) work with our example 50-year old participant – we estimate that an annuity carrier would charge a 30% premium-over-book to settle that liability.
As a participant approaches retirement age, however, this premium-over-book would go down. Depending on the cost-over-book of the lump sum, an annuity might begin to be competitive for terminated vested participants over, e.g., age 60.
One critical issue with respect to pre-retirement annuity settlements is whether the plan provides any early retirement (or other) subsidies – these will generally increase the cost of an annuity settlement.
Financial disclosure effects
We have discussed the financial disclosure effects in our articles on 2020 lump sum and annuity settlements and in our article Liability settlement, mark-to-market accounting, and PBGC premium reduction: effects on corporate earnings . We briefly note the following:
- With respect to 2021 lump sum settlements, if the lookback month interest rate used to value lump sums is lower than the 2021 valuation rate used for plan disclosure, there will be an increase in the 2021 balance sheet net liability with respect to the plan. The same principle applies to annuity settlements at an amount higher than (what would have been) the year end value of the associated liability.
- For sponsors with accumulated unrecognized experience losses (e.g., interest rate losses), settlement of a liability will trigger recognition of a (proportionate) share of those losses.
To a great extent, for many sponsors/plans, the critical issue is trend …
With respect to any settlement, there is, of course, always the risk of “settler’s remorse.” That is, e.g., if a liability is settled with an annuity at current rates, and rates then go up, there will be natural tendency to think “If we had just waited we could have gotten the annuity for less.” This risk is offset by the opposite one – “non-settler’s remorse” – triggered when rates go down.
The decision to de-risk is always colored by the sponsor’s view of interest rate trend. The historical trend in interest rates (arguably for the last 40 years) has been down. There is, of course, no way to predict (any better than the market is currently predicting) what rates will be a month from now, much less at year end.
This challenge is, for lump sums, somewhat mitigated by the lump sum calculation rules, especially for sponsors using a 12-month stability period. For these sponsors, one variable – the “cost” of the lump sum – will remain constant for all of 2021 (because the valuation interest rate is fixed as of the beginning of the year). For the moment, at least, those lower lump sum valuation rates (relative to market rates) will bias some sponsors towards delaying de-risking.
Wild card – funding relief
In our last article , we noted that when a plan is underfunded (on a market basis), settling a liability increases the plan’s underfunded percentage. That is because the liability is settled out at 100% but had been funded at less-than-100%. Depending on applicable funding relief/interest rate stabilization (with regard to which, see our article Retirement savings finance at the end of 2020 ), this effect may increase or trigger ERISA minimum funding, increasing the cash demands of the plan.
We note that (as of this writing), a significant increase in DB funding relief/interest rate stabilization is included in budget reconciliation legislation being considered by Congress. If that legislation passes (as proposed), this issue – a possible increase in funding requirements because of de-risking settlements – will, for the near term, for many sponsors, go away.
* * *
We will continue to follow this issue.