It’s that time again. The deadline for plan sponsors to determine how they plan to calculate Pension Benefit Guaranty Corporation insurance premiums is coming up, and this normally sleepy corner of plan operations is getting interesting. Market dynamics including rising interest rates and inflation could mean it makes sense for some plan sponsors to consider a change to their calculations in order to save money on premium payments. However, it’s not a straightforward process for everyone.
PBGC premium payments are a function of how many participants are in the plan, how underfunded the plan is and what the current interest rate is. The number of participants tends to remain relatively static in frozen plans. Funded status also doesn’t typically change drastically year to year. However, interest rates can change significantly and plan sponsors can lower their premiums by paying close attention to where rates are now and where they are likely to be in the future.
Premium minimums and caps are calculated by the PBGC annually. For this year, the variable rate premium is 4.8% of the plan’s 2022 unfunded vested benefits up to a cap of $598 per participant.
According to the PBGC, defined benefit plan sponsors that have underfunded plans can calculate their premium payments in one of two ways. They can use the spot rate, which uses interest rates from the month prior to the start of the plan year, or they can use the alternative method, which uses the average interest rate over the past 24 months. Once plan sponsors elect a calculation method, they have to keep the same method for five years. Plan sponsors that are able to, and that elect to change before October 15, will be able to start their five-year clock this year.
When interest rates were low for many years in a row, this choice didn’t have much of an impact on premiums. Now that rates are rising, when they rise and by how much can help or hurt the size of premium payments.
“What’s going on is that there’s a decline in assets because of market performance, but there is not a corresponding decline in liabilities,” explains Tonya Manning, chief actuary and wealth practice leader at pension consultancy Buck. “Usually the way the market works if assets go down and interest rates go up, you have a gap between assets and liabilities that holds relatively steady. But, when it comes to calculating premiums right now, the change in assets and interest rates are not moving in the same magnitude.”
Plan sponsors using the spot rate will realize the recent rise in interest rates. Plan sponsors using the alternative method may not fully capture the rise in interest rates because the 24-month average will be brought down by the lower interest rates of 2021. So, each calculation can come away with very different rates and resulting premiums. This difference may become especially acute in 2023, as the most current rate increases will be reflected in the spot rate, whereas the alternative method will only just start catching up. Plans that are locked in to using the alternative method may find themselves paying higher premiums until the 24-month average fully reflects all of the rate increases, or until their five-year window runs out, whichever comes first.
Pension consultant October Three recently issued an alert recommending that plan sponsors that can make a change before the October deadline do so and choose the spot method. The alert says making the change now can benefit plan sponsors for 2023.
“For 2023—which will be based on either a December 2022 spot rate or a 24-month average ending (depending on the elected look-back month) August-December 2022—if the current trend holds, using the standard method produces a significantly higher valuation rate/lower UVBs/lower variable-rate premiums. The movement in rates this year has been the sharpest since 2008, making the PBGC method elected for 2023 the most momentous decision sponsors have faced under current law,” the alert says.
The October Three alert also notes that making the change now means that the five-year lockup period will run from 2022 to 2027, which could have some specific benefits. Plan sponsors already have a pretty good indication that rates will continue to go up in 2022 and 2023. By making the election now, two of the five years are accounted for. If interest rate regimes change significantly in 2024 or beyond, October Three says, then plans will be in their countdown period, which could serve as a good hedge against uncertainty. By waiting until 2023 to make a change, plan sponsors lose one year of knowing what rates are likely to be.
Thinking through total premium cost and plan strategy can be essential for underfunded plans. Severely underfunded plans have to pay the highest PBGC premiums, because from the PBGC’s perspective, there is a greater risk that they may not make good on their plans and have to resort to payouts from the PBGC. Severely underfunded plans have to pay premiums of either 4.8% of unfunded vested benefits or a $598 per participant cap—whichever is lower. The cap will increase in 2023 to more than $600 per participant.
Dan Atkinson, consulting actuary at BCG Pension Risk Consultants, BCG Penbridge, explains it this way: Interest rate calculations have less of an impact for severely underfunded plans because plan sponsors are already paying at or near the cap. But plan sponsors may be further incentivized to consider risk transfer because it can make it more likely that the $598 fee per participant gets charged as a function of the risk transfer, which is often a cheaper outcome.
“Once you get to a point where you are paying almost $600 per person, it makes sense to redo the plan so there are fewer people,” he says.
Buck’s Manning agrees. “There are a lot of factors at play here, especially for underfunded plans,” she says. “Plan sponsors could, of course, make a large payment into a plan to improve the funded status, but there is a lot of uncertainty overall right now. In lieu of a big payment into the plan, plan sponsors should look closely at the various strategies available to them because it is a more meaningful exercise now than it has been in the past few years.”
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