September 15, 2022 - Segal
By Michael Marks
Since the start of 2022, interest rates have risen significantly. High-quality corporate bond yields, the interest rates used to value lump-sum payments from a pension plan under ERISA, increased almost 200 basis points from the end of 2021 through July 2022. They have reached levels not seen in around 10 years.
With the Federal Reserve raising interest rates again in August, it seems likely that corporate bond yields will continue to rise through the end of the year.
Higher interest rates impact a pension plan in a variety of ways. One key area is the effect it has on lump-sum payments. In general, higher interest rates produce lower lump sums. That means a smaller payment amount is required to completely “cash out” a participant’s liability in the plan.
Consider the following example:
The IRS lump-sum rate at age 65 for January 2022 (which is based on corporate bond yields during December 2021) was approximately 2.75 percent. An accrued benefit of $200 per month would equate to a lump-sum value of approximately $37,600. The IRS lump-sum rate at age 65 for August 2022 (which is based on corporate bond yields during July 2022) was approximately 4.60 percent - an increase of 185 basis points. The same accrued benefit of $200 per month has a lump-sum value of $31,400 in August 2022 - a decrease of more than 16 percent.
The interest rates used for determining lump sums are typically set, and held constant, for each plan year. That means that the current high interest rate environment will result in lower lump-sum payments for the entire next plan year.
See the section at the end of the article for more information about other ways interest rates affect pension plans.
Cashing out participants from the plan has several cost and risk mitigation advantages, including reducing PBGC premiums and shrinking the risk profile of the plan. Lower lump-sum values may present plan sponsors with opportunities to cash out more participants than in a typical year.
Here are some opportunities to explore:
When considering whether to pursue any of the above opportunities, it is important for plan sponsors to be aware that paying many lump sums has potential ramifications. One is the possibility of settlement accounting. Another is a decline in the plan’s funded status, since the asset reduction (the cost of the lump sums) is typically greater than the liability reduction (measured on an IRS funding basis) due to the difference in the underlying interest rates. However, while that difference still exists, it is currently reduced due to the higher lump-sum interest rates.
Paying lump sums, whether through a window or similar activity, may be a key part of a plan’s risk-mitigation strategy, especially for a plan that is on the road to termination.
While lower lump sums are generally viewed as favorable for pension plans, since it is cheaper for the plan to settle liabilities and cash out participants, plan sponsors should be aware of how plan participants may perceive this significant drop in lump-sum values. Participant reaction will need to be managed, especially for participants who have been previously provided quotes with higher lump-sum amounts (e.g., via benefit statements, retirement estimates and self-service portals). Plan sponsors should be prepared to answer questions from participants who compare their 2022 (or estimated 2023) lump-sum amounts to actual 2023 lump-sum amounts.
Sponsors may even consider informing participants of the impact of the current interest-rate environment so participants who are considering retiring at the beginning of next year are not caught off guard. However, sponsors should be careful to do this in a manner that doesn’t cause an overwhelming amount of employee retirements at year-end, as this could negatively impact the plan (through drops in funded status and/or liquidity issues) or cause workforce concerns.
Beyond being aware of, and prepared for, the implications of lower lump-sum values, plan sponsors are advised to speak with their actuaries to assess the specific issues and opportunities for their plan. This includes consideration of both actuarial and participant communication issues. Sponsors may also want to proactively consider actions now that will take advantage of higher interest rates to help achieve their desired strategies and outcomes for the plan.
Changes in interest rates can affect these aspects of a pension plan in addition to lump-sum payouts:
While this article is focused on the impact on lump-sum values, if any of these other areas are of concern, speak with your plan’s actuary.