Only Months Remain to Take Advantage of Less Expensive Pension Lump Sum Payouts in 2019
Defined benefit pension plan sponsors considering de-risking their pension plans may wish to implement a lump-sum window program in 2019 to take advantage of higher 2018 interest rates than those in 2019.
As interest rates decrease, pension plan liabilities increase. Paying pension plan benefits in a lump sum reduces long-term pension plan costs and risks by permanently eliminating the benefits liabilities as well as eliminating Pension Benefit Guaranty Corporation insurance premiums and other administrative expenses the plan sponsor would otherwise incur.
Interest rates and mortality assumptions influence the cost of lump-sum payments. Interest rates and mortality assumptions have an inverse relationship with the costs of lump sums—higher interest rates and mortality assumptions decrease the cost of lump sums and lower interest rates and mortality assumptions increase the cost of lump sums.
The applicable interest rate for determining the present value of a participant’s pension benefit payable as a lump sum is based on interest rates set under the Pension Protection Act as either the first, second and third segment rates for a designated month. Many plan sponsors set the interest rate as one of the segment rates in a prior year “lookback month.” For example, to calculate a lump sum payment in 2019 using a November lookback month, the applicable interest rate is based on November 2018 rates.
The applicable interest rate has decreased each month in 2019, so lump sums in 2020 will likely cost more than a lump sum paid in 2019 (which would be based on higher 2018 interest rates). The following chart illustrates the decreasing interest rates from 2018 to 2019.
November 2018 |
July 2018 |
July 2019 |
|
First Segment |
3.43 |
3.15 |
2.34 |
Second Segment |
4.46 |
4.2 |
3.38 |
Third Segment |
4.88 |
4.47 |
4.01 |
With volatile investment returns projected for the future, a lump sum window program—where eligible participants elect to receive the present value of their pension benefits in a lump sum payment—is an appealing alternative to eliminating potential pension costs and risks. As well, the increase in the applicable mortality assumption for 2019 should lower the cost of the lump sum payment. Compared to 2020, 2019 seems like a good year to de-risk.
Only well-funded pension plans may offer a lump sum window program (less than 80% funded plans are subject to restrictions on lump-sum payments). Plan sponsors generally have much flexibility in designing the window program. The program can be limited to certain eligible groups, so long as the eligible group does not discriminate in favor of highly compensated participants. Earlier this year, in Notice 2019-18, the Internal Revenue Service (“IRS”) signaled that a window program can offer retirees in pay status (as well as vested former employees who are not in pay status) the ability to elect a lump sum payment of their pension benefits. The IRS noted that it will continue to study the issue of retiree lump-sum windows, so it is possible that the IRS could change its position in the future, especially if there is a political change in 2020.
A plan amendment is required to implement a lump-sum window program. Multiple window program amendments could be considered a permanent lump sum option, so plan sponsors who have implemented window programs in the past should consult with counsel to assess this risk.
Plan sponsors wishing to implement a lump-sum window program should consult their legal counsel and actuaries to design the program, amend the plan, prepare participant communications and implement the program. For a 2019 window program, time is of the essence, as advanced planning, actuarial analysis, a plan amendment and participant communications are necessary to implement such program by the end of the year.