For thousands of defined benefit (DB) plan sponsors, sound pension management has become, in large part, management of Pension Benefit Guaranty Corporation (PBGC) premiums, October Three notes in its fourth annual PBGC Premium Burden report.
PBGC premiums for single-employer plans are calculated as the sum of a flat-rate premium ($83 per participant in 2020) plus a variable-rate premium (4.5% of unfunded PBGC liability in 2020, with a cap of $561 per participant). The flat-rate premium (FRP) more than doubled between 2010 and 2019 (from $35 to $80 per participant), and the median plan saw its FRP double as well (from $43,000 in 2010 to $86,000 in 2019).
For the variable rate premium (VRP), while there was a decrease in 2017 and 2018, premiums bounced back in 2019 due to poor 2018 asset performance. Other variables, such as employer contributions, benefit accruals and capital market fluctuations, also affect the VRP. Since 2010, the VRP rate has increased almost five-fold (from 0.9% in 2010 to 4.3% in 2019), while the median VRP paid has increased by more than seven times (from $22,000 to $167,000).
October Three notes that good asset performance in 2019 is expected to help offset 2020 premium increases, but it warns that premiums are likely to spike higher in 2021 based on adverse capital markets in the first half of 2020.
The report’s analysis focuses only on the roughly 5,000 plans that cover at least 250 participants.
A minority of plans (more than 30% in 2019) are overfunded and didn’t owe any VRP. At the other extreme, 30% of plans saw premiums limited by the VRP cap in 2019, a percentage that has grown steadily. October Three notes that it is the plans in the middle, about 40% of plans in 2019, for which adopting best practices regarding timing and recording of pension contributions translates to millions of dollars in lower PBGC premiums.
“Minimizing PBGC premiums depends on plans’ maximizing the use of ‘grace period’ contributions—amounts contributed to a plan after the end of the plan year but still attributable to that plan year. This is what we call best practices. Failure to adopt best practices around quarterly contribution requirements and applying funding balance has caused plan sponsors to pay higher PBGC premiums than necessary due to not maximizing and getting full credit for grace period contributions,” the report explains. “In many cases, all or part of contributions made to satisfy quarterly contribution requirements could have been characterized as grace period contributions but weren’t. So, plans often report lower asset values than they could have and, as a result, pay higher premiums than they need to.”
October Three notes that, sometimes, this strategy for minimizing PBGC premiums can’t be done. Plans that are less than 80% funded must make cash contributions to satisfy funding requirements, and other plans that don’t satisfy prior year requirements until the funding deadline can’t record grace period contributions optimally.
Another best practice the firm recommends involves modest acceleration of pension contributions. For a calendar year plan that was at least 80% funded in the prior year, it recommends:
- Accelerating quarterly contributions due on October 15 to September 15 and recording those contributions for the prior year;
- Accelerating residual minimum required contributions due on September 15 to April 15, which allows plans to record April 15 and July 15 contributions for the prior year;
- Accelerating quarterly contributions due on January 15 to September 15 and recording those contributions for the prior year; and
- Accelerating voluntary year-end contributions to September 15 and recording those contributions for the prior year.
“The accelerations above are modest—from as little as one month to five months at the most. And, other than voluntary year-end contributions, these contribution amounts are usually known months in advance,” the report says. “But the payoff to plan sponsors could be huge. Our analysis indicates that failure to adopt these best practices has caused plan sponsors to pay $1.2 billion more in premiums between 2011 and 2018 than they needed to.”
The election of the rate used to measure unfunded vested benefits (UVBs) may have a material effect on how much PBGC variable-rate premiums a DB plan sponsor must pay. October Three explains that the “standard” liability measurement for calculating PBGC premiums is based on the most recent monthly spot rates (December 2019 rates for 2020 premiums for calendar year plans), but PBGC allows an “alternative” liability measure based on 24-month average interest rates (with a 0- to 4-month lookback, depending on the plan’s minimum funding election). Plans may move from one method to the other but are “locked in” for five years after each move, so some plans may not have a chance to change their election for 2020.
According to October Three’s data, at least 120 plans with at least 250 participants changed to the standard method in 2019, reducing their premiums by an estimated $130 million compared with the alternative method. However, interest rates fell dramatically during 2019, so that for 2020, the PBGC alternative method produces a much lower liability than the standard method. Barring unusual situations—for example, plan merger or termination, 2020 contribution to fully fund plan, significant headcount reductions triggering the VRP cap—many DB plan sponsors that elected the standard method for 2019 will see 2020 premium increases more than offset the 2019 savings.
“Given that the 2019 election was not due until October 15 and interest rates had already fallen by then, this unfortunate election could have been avoided by looking just one year ahead. Making matters worse, rates have continued to fall during 2020, so the standard method will likely produce a higher PBGC premium for 2021 as well,” the report states.
October Three recommends that plans that are free to elect the alternative method for 2020 should do so. However, it advises revisiting the interest rate environment in early October before making a final election.
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