Interest Rates a Factor for Crucial DB Valuation Decisions

Some defined benefit (DB) plan sponsors with a calendar-year plan year have until October 15 to make an election for what interest rate they will use to determine their unfunded vested benefits (UVBs) for the next five years.

They may choose between using end-of-2018 spot rates or a 24-month average. But, it is only time for an election for plan sponsors that have used their previous election for five years. In other words, as Michael Clark, director and consulting actuary at River and Mercantile in Denver, explains, if DB plan sponsors have made an election in the last five years, they cannot switch rates for 2019.

Clark says provisions that allow the switch of methodologies for calculating UVBs have been in place since passage of the Pension Protection Act (PPA). He adds that when interest rates move, the spot rate—or yield curve for the month prior to when the plan years starts—changes more quickly, while the 24-month average moves more slowly. “What we’ve seen, especially in 2019 as the yield curve moved down dramatically, is a wide disparity in the two methods for the upcoming year,” Clark says.

Dan Atkinson, River and Mercantile’s chief actuary, author of a blog post about the decision to be made for 2019, who is based in Waltham, Massachusetts, says plan sponsors were defaulted into the standard method—the spot rate—and a switch to the alternative method would require a five year period before the first year the plan would be eligible to switch back to the standard method.

Atkinson’s blog post and an October Three PerspectiveMatters, written by Brian Donohue, partner at October Three Consulting, based in Chicago, state that the election of the rate to use to measure UVBs may have a material effect on how much Pension Benefit Guaranty Corporation (PBGC) variable-rate premiums the plan sponsor must pay in 2019.

According to Donohue, some pension plans are overfunded and pay no variable-rate premiums, while on the other end of the universe of DB plans, there are those that are so underfunded they are limited by the variable-rate premium cap. There is no issue in making an election for these; “those in between is the only subset for which this is relevant,” he says.

“Sometimes near term decisions look obvious, but for every DB plan decision, sponsors have to consider the long-term view,” Donohue adds.

He says at end of 2013, interest rates moved higher, so as companies looked at valuating UVBs for their 2014 PBGC variable-rate premium, many using the alternative method saw that if they moved to the standard method for 2014, they would pay a lower premium. But, in 2014, interest rates came down, so those companies paid a higher premium in 2015.

According to Donohue, there is a similar scenario for this year. Those who already adopted the standard rate for 2019 reduced premiums, but because interest rates came down so much this year, premiums in 2020 will be quite a bit higher. “We can’t close the book on 2020 yet because we won’t know the standard rate until December,” he says. “But if plan sponsors adopted the standard, it is likely premiums will go up more in 2020 than what plan sponsors saved this year. Our stance is don’t go with the standard rate.”

“Any plan sponsor that has tentatively made its decision should revisit it,” Atkinson says.

Donohue says DB plan sponsors should take all the time they can to get all the information needed to make the right decision. He suggests sensitivity testing—assume interest rates don’t change, or see how much interest rates will have to go up to where it’s better to choose the standard rate.

There could be reasons a DB plan sponsor would select the standard rate in 2019, Donohue adds. For example, if it plans to make a big enough contribution next year to not have to pay a variable-rate premium, it may as well take the savings this year. Or, if the plan is so underfunded that the plan sponsor thinks the premium will be capped next year, it should choose the standard rate.

To use funding relief or not

Speaking of DB plan sponsor contributions, plan sponsors should weigh whether they should use the funding relief that was provided by the Highway and Transportation Funding Act (HATFA), as amended by the Bipartisan Budget Act of 2015 (BBA). For 2019 and 2020, HATFA rates are based on 90% of the average of rates for a (trailing) 25-year period, and they may generally be used for determining a DB plan sponsor’s minimum required contribution.

According to Clark, if a DB plan sponsor is using IRS segment rates in the calculation used to determine the minimum contribution, it doesn’t have a choice but to use funding relief. Plan sponsors can choose to use the full yield curve for this valuation, but the majority have not opted to use that approach, he says. The ones that have tend to be really well funded and have a liability-driven investing (LDI) strategy that utilizes interest rate hedging.

What funding relief did is effectively constrain one of major inputs for calculating liability for determining the minimum required contribution, Clark says. “For the last eight years or so, what that’s amounted to is the effective interest rate for determining unfunded, vested liabilities dropped approximately 20 basis points per year,” he adds.

Clark explains that the way relief works is by taking the 25-year average of yield curves, then the IRS divides it into three segments and puts a corridor around the 25-year average plus or minus 10%. If the effective interest rate falls outside the corridor, plan sponsors would be constrained by the corridor. That corridor will start to widen beginning in 2021. Atkinson says the corridor will be plus or minus 20% in 2022, and eventually it will be plus or minus 30%, at which point the rates will most likely be within the corridor range. At that point, according to Clark, it’s highly unlikely the relief will be providing any constraints.

Donohue says it this way: If the market interest rate shoots up, funding relief will go away sooner; if interest rates stay where they are, relief will go out to 2029.

For plan sponsors that have minimal cash on hand, the funding relief is a big help. But, Donohue points out that those who contribute less by using funding relief pay higher PBGC premiums. “Underfunding is an expensive type of borrowing. Plan sponsors could borrow to fund and do better,” he says.

Clark says that was a big criticism when funding relief was passed, even among the actuarial community and professional organizations: Plan sponsors would not be required to put in sufficient contributions to avoid being penalized by higher PBGC premiums.

“One thing we’ve been beating the drum on is 2019 has been a good year for implementing lump-sum cashout windows because of how far yields have fallen,” Atkinson says. “Most plans get to use interest rates from the fall of 2018 to calculate lump sums, when rates were at their peak level. Going into 2020, given interest rates today, lump sums will be more expensive comparatively.” Implementing a lump-sum window can reduce liabilities and potentially decrease unfunded vested benefits and the PBGC variable rate premium.

Atkinson adds that one benefit of funding relief, especially for frozen plans that are well-funded,  is that it allows some time for future investment returns to improve funding, rather than relying solely on contributions to erase any funding shortfall.  As an example, a plan that reasonably expects a return on assets of, say 7%, may never have to put money in the plan again, if this return is realized. But, without the funding relief, this plan sponsor is required to contribute money into their plans that they feel expected returns would solve.

Interest rates effect on DB plan sponsor balance sheet

Interest rates also affected DB plan sponsors’ valuation for company balance sheets. This valuation uses the yield curve as of point in time—the measurement date—with no averaging. Clark says corporate bond yields are down a full 1%, which has driven liabilities up 10% to 15%. Atkinson says it’s closer to 10% for older plans. According to Clark, this will result in a larger balance sheet liability for many corporations unless they use an LDI strategy that has kept pace with the change in liabilities.

“Plans that are underfunded and don’t have a lot allocated to an LDI strategy may see a significant increase on their balance sheet,” Clark says. “This will affect the net periodic pension cost going into next year.”

The bottom line is, as Donohue says, DB plan sponsors should not make decisions hastily, and conversations will differ among individual plans.