Pensions: Review & Preview

As we turn our clocks back, let’s take a minute to reflect. 2022 has been quite a year. Here are a few of the things we’ve seen:

• Aggressive interest-rate increases in an attempt to constrain and, ultimately, rein in inflation.
• Rising interest rates coupled with downturns in equity markets making cash the best place to be in the last 10 months or so.
• Significant improvements in funding positions for calendar-year plans resulting in lower, or no minimum required contribution for the 2022 plan year.
• Trending financial markets bringing lower PBGC variable-rate premiums for 2022.

Unless markets change significantly—or Congress provides relief—2023 is likely to be a difficult year for the unprepared. In looking at returns for some clients through mid-October, many are seeing losses on Trust assets of 20% – 25% or more. That drop is sure to have a major impact as we move into the next plan year. Let’s look at some of the major areas of concern.

Effect on Minimum Funding Requirements

While higher interest rates reduce pension liabilities, the recent rise in interest rates won’t likely have a significant effect on determining minimum funding requirements. Most qualified pension plans have already determined liabilities for minimum funding using elevated interest rates based on a 25-year average, not on current market rates.

For minimum funding purposes, your plan’s liabilities will not see a substantial decrease, but will likely see a small increase in 2023. The increase in liabilities coupled with assets that are expected to be 20 – 25% lower than the prior year’s funding determinations will likely cause 2023 funding levels to be far below 2022. As a result, plans that have not had required contributions in recent years may suddenly be faced with the need to contribute. Also, those that were restricted from contributing in the past may have an opportunity to make contributions in 2023.

The above notwithstanding, changing interest-rate selection methods from segment rates based on a 25-year average to the full yield curve (i.e., current market rates) may be a viable option depending on the continued movement in such rates. A change should only be pursued after fully understanding the issues associated with switching methods and only if the savings warrant the change.

For plans that use an actuarial value or smoothed value of assets to determine the funded status, 2/3 of current-year asset losses are typically deferred to the next two valuation dates. However, the law provides that such value can be no more than 110% of the market value of assets. If deferring 2/3 of the current year’s losses results in a smoothed value that exceeds 110% of the market value, then additional losses must be recognized, which will reduce the value of plan assets for minimum funding purposes.

Increase in PBGC Premiums

As most of you know, PBGC premium rates are indexed each year. The rates for 2023 have increased 8 – 9% from 2022, which is not unexpected based on the inflationary trends we have been experiencing. The rates for 2022 and 2023 are shown in the chart below for comparison purposes.

Sponsors of single-employer plans will be subject to a flat-rate premium of $96 per person and may be subject to a variable-rate premium due to the plan’s underfunded position, if any. The per-participant cap on the variable-rate premium ensures you will not pay more than $748 per participant in total PBGC premiums for 2023.

Mitigating head count may be a first thought to reducing 2023 PBGC premiums. However, it would require either the distribution of lump sums to eligible participants or the purchase of annuities for a portion of the retiree population. Of course, with interest rates trending upward from previous levels, the cost of paying lump sums from a traditional defined benefit plan in 2023, along with the associated PBGC premium, may be much less than paying out lump sums before the end of the year (unless those amounts are very small). With regard to purchasing annuities for a portion of the plan’s retirees, timing and insurer interest, or lack of it given current large caseloads, may make it impractical prior to year-end. Both options are good considerations for the future, as PBGC premiums are likely to rise again in 2024.

What Can be Done?

Certain plans may be able to switch the interest-rate method for determining PBGC variable-rate premium liabilities to take advantage of the drastic increase in rates. Under current regulations, the liabilities used for determining the amount of PBGC underfunding may be based on current spot rates at the time of the measurement (i.e., Standard Method) or on the non-relief funding rates, which are based on a 24-month average (i.e., Alternate Method). However, a plan may only change methodologies if the current method has been in use for five years. Also, plans that choose to switch methods will be required to continue to use the new method for an additional four years.

Below is a comparison of interest rates under both the Standard and Alternative Method. In a rising interest-rate environment, use of the Standard Method would result in lower PBGC liabilities and could result in a reduction in the PBGC variable-rate premium.

**The Standard Method rates for a given valuation date are the spot rates for the month preceding the valuation date (i.e., for January 1, 2023 valuation dates, the 12/1/2022 spot rates will be used under the Standard Method). In addition, the minimum funding look-back month will affect the actual 24-month rates that are applicable but the above is illustrative.

Year-end Liabilities and 2023 Expense

The combination of rising interest rates and declining financial markets make it difficult to assess the financial effect on pension accounting under ASC-715. The anticipated reduction in market values will result in a lower than expected return on plan assets, which is an offset to the next year’s net periodic pension expense. The rise in interest rates will likely result in lower year-end plan liabilities, but may increase the interest cost portion of the net periodic pension expense. The net effect of the loss on assets (less than expected returns) and gain on liabilities (reduction in liability due to rising interest rates) will determine whether the plan will experience an additional gain or loss at year-end that will need to be amortized in the upcoming expense.

We expect lump sum amounts to decrease significantly in 2023 due to rising interest rates. As a result, we have seen significant lump-sum payouts during 2022 for many of our clients as participants look to time their retirement and maximize lump-sum payments from the plan. If lump-sum payouts during a fiscal year exceed the service cost plus interest cost components of the net periodic pension expense for that fiscal year, settlement accounting will be triggered and an additional expense will need to be recognized during 2022.

Participant Benefits

As mentioned previously, changes in interest rates may affect participant benefits, particularly cash balance plans that convert account balances based on current interest rates or traditional plans that pay lump sums. Many plans lock interest rates once a year so it may be an important time for those contemplating retirement.

For participants in a traditional defined benefit pension plan considering a lump sum upon retirement, the value of the benefits earned under the plan may be substantially more if the distribution is taken before year-end. Of course, for cash balance plans, the equivalent annuity value will likely be much greater in 2023 if the interest rates used to annuitize the balance are higher.

The Bottom Line

Understanding the effect interest rates have on pension benefits is very important. BPAS is here to help you navigate these uncertain times and provide clarity to expectations. Let’s talk about how to help you prepare for what’s ahead.