DB Plan Sponsors Should Prepare Now for Higher Year-End Liabilities

The combination of lower discount rates and new mortality tables will dramatically increase pension plan liabilities and decrease DB plans’ funded status for December 31, 2014 financial reporting. Using the November 2014 Citigroup Pension Liability Index (CPLI) and Citigroup Pension Discount Curve (CPDC) as proxies, pension accounting discount rates are down by almost 90 basis points since December 31, 2013.

Fortunately, many plans have experienced solid investment returns so far during 2014. This will take some of the sting out of the liability increases, but it likely won’t be enough to entirely offset the effect of lower interest rates and the new mortality tables. The higher liabilities will affect both the year-end funded status of the plan and also the 2015 pension expense calculation.

Discount Rate Analysis

In the chart below we compare the CPDC at three different measurement dates (12/31/2012, 12/31/2013, and 11/30/2014). We also highlight the CPLI at each measurement date. The CPLI can be thought of as the average discount rate the CDPC produces for an “average” pension plan.

Citigroup comparison 11302014

The orange arrows in the chart highlight the trend in yield curve movement and show how rates are almost back to their 2012 lows at all points along the spectrum. This means that nearly all plans will feel the negative effect of lower discount rates.

Net Effect on Balance Sheet Liability

Depending on the starting funded status, the change in pension liabilities and assets can have a leveraging effect on the reported net balance sheet asset/liability.

Below is a simplified illustration for a plan that was 80% funded on 12/31/2013, where we assume a 10% increase in pension liability during 2014. We then compare the funded status results under two asset scenarios: (1) Assets 5% higher than 12/31/2013 and (2) Assets 8% higher than 12/31/2013.

11302014 bal sheet liability example

In both cases, the funded status of the plan decreases. There’s also a magnified increase in the unfunded balance sheet liability because it’s such a leveraged result. This amount increases by 30% and 18%, respectively, in the two sample scenarios.

Conclusions

So, what should plan sponsors be considering over the next month as we approach year-end? Here are a few ideas.

  • Don’t forget that the new Society of Actuaries mortality tables will be recommended for use at year-end and will likely further increase plan liabilities.
  • Additional pension plan funding (above the IRS minimum requirements) may be appealing in 2014 and 2015. Not only will it increase the plan’s funded status, but it will also help lower your pension plan’s PBGC variable rate premiums.
  • Your plan’s specific cash flows could have an enormous impact on how much the drop in discount rates affects your pension liability. If you’ve just used the CPLI in the past, it’s worth looking at modeling your own projected cash flows with the CPDC or an alternative index or yield curve to see how it stacks up.
  • Now may be a good time to consider strategies that lock in some of this year’s investment gains. These could include exploring an LDI strategy to more closely align plan assets and liabilities, or offering a lump sum payout window for terminated vested participants early in 2015.

What’s the Impact of 2015 IRS Retirement Plan Limits?

The IRS just announced the 2015 retirement plan benefit limits and we’re seeing some modest increases from 2014. What does it all mean for employer-sponsored retirement plans? This post analyzes the practical effects for both defined contribution (DC) and defined benefit (DB) plans, followed by a table summarizing the limit changes.

Changes affecting both DB and DC plans

  • Qualified compensation limit increases from $260,000 to $265,000. Highly-paid participants will now have more of their compensation “counted” towards qualified plan benefits and less towards non-qualified plans. This helps for both nondiscrimination testing as well as for benefits.
  • HCE compensation threshold increases from $115,000 to $120,000. For calendar year plans, this will first affect 2016 HCE designations because $120,000 will be the threshold for the 2015 “lookback” year. Slightly fewer participants will meet the new HCE compensation criteria, which will have two direct outcomes:
  • Plans may see better nondiscrimination testing results (including ADP results) if there are fewer participants at the low end of the HCE range, especially those with big deferrals. It could make a big difference for plans that were close to failing the tests.
  • Fewer HCEs means that there are fewer participants who must receive 401(k) deferral refunds if the plan fails the ADP test.

DC-specific increases and their significance

  • The annual DC 415 limit increases from $52,000 to $53,000 and the 401(k) deferral limit increases from $17,500 to $18,000. A $1,000 increase to the overall DC limit and $500 increase to the deferral limit may not seem like much, but it will allow participants to get a little more “bang” out of their DC plan. This means that individuals can get up to $35,000 from employer match and profit sharing ($53K – $18K) if they maximize their 401(k) deferrals. Previously, their profit sharing limit would have been $34,500 ($52K – $17.5K).

Top 5 Take-Aways from the GASB OPEB Accounting Exposure Draft

Last week the Governmental Accounting Standards Board (GASB) released its long-awaited exposure draft of proposed Other Post-Employment Benefits (OPEB) accounting changes. Although there may be modifications before the rules are finalized, public employers should be aware of the potential consequences. Here’s our list of the top 5 items from the exposure draft:

1. Most of the proposed GASB 67/68 pension changes are carrying over to OPEB – which is not surprising. These include:

- The Net OPEB Liability (NOL; essentially the entire unfunded liability) goes on the face of the financial statements. This will be a major change from the incremental Net OPEB Obligation currently used as the balance sheet liability.

- The discount rate will be based on a projection of whether the employer’s current assets plus projected contributions are expected to cover current plan members’ future benefit payments.

- Enhanced disclosures of historical contributions, funded status, and the basis for selecting actuarial assumptions.

- Accelerated recognition of liability changes in OPEB expense; no more 30 year open amortizations.

- Funding and accounting are officially separated; this means no more ARC.

2. Goodbye community-rating exception to the implicit subsidy liability. Now everyone with blended premiums must calculate an implicit subsidy liability.

3. All plans will now use the Entry Age Normal (level percent of pay) actuarial method to allocate liabilities between past and future service periods. Although OPEB benefits are not usually pay-related, this new requirement is intended to make liabilities more comparable than the 6 different methods currently allowed under GASB 45.

4. Disclosure of the Net OPEB Liability’s sensitivity to changes in medical trend (+/- 1%), discount rate (+/- 1%), and combinations thereof. This means a total of 9 different NOL measurements.

5. Calculation of an Actuarially Determined Contribution (ADC) and development of a funding policy. Although not technically required, employers will need these two important items if they are prefunding their OPEB and not simply using pay-as-you-go funding.

And, as an added bonus, the exposure draft requires actuarial valuations at least biennially and has eliminated the triennial option for employers with fewer than 200 members. Given the volatility of OPEB liabilities, this is probably a better policy.

What do all of these changes mean for public employers? We’re still sorting through all of the details, but the primary outcome is that more effort will be required to prepare OPEB actuarial valuations and the results will have a greater impact on employers’ financial statements.

Although these changes aren’t scheduled to be effective until the fiscal year beginning after December 15, 2016, public employers will want to start thinking about the potential financial impact and whether they will prompt updated OPEB funding and investment policies. Comments regarding the exposure draft are due no later than August 29, 2014.

Public Pension Plan Funding Policy – The Time is Here

“Every state and local government that offers defined-benefit pensions [should] formally adopt a funding policy…,” according to the Government Finance Officers Association (GFOA) best practice recommendations. Guidelines for Funding Defined Benefit Pensions (2013) (CORBA)

SOA and GASB Provide Guidance

Blue Ribbon Panel. Last month, a blue ribbon panel formed by the Society of Actuaries went one step further to endorse risk measures, disclosures and actuarial assumptions as well as guidelines regarding plan governance and benefit changes. These recommendations come at a time when public pensions have come under mounting criticism since the “great recession” and it’s imperative that public plan sponsors be able to demonstrate that their plans are sustainable in the long-term.

GASB 67/68. Furthermore, it’s critical that public sector plan sponsors follow a written funding policy now that GASB 67 and 68 explicitly separate pension funding and pension accounting,. These accounting standards are effective for plan years beginning after June 15, 2013 and June 15, 2014, respectively. For many plan sponsors this means the fiscal years ending June 30, 2014 (!) and June 30, 2015.

Funding Policy Checklist

The place to begin is to gather the facts, actuarially and politically. Here is a checklist of items to assist in providing a basis for developing an effective funding policy:

  1. Assemble a history of plan benefit levels and changes.
  2. Develop a history of contribution levels by members and sponsors.
  3. Compare benefit levels, locally and nationally, to determine appropriateness.
  4. Consider the political history of plan changes.
  5. Identify the politically “hot” topics.
  6. Review legal constraints on plan changes.
  7. Analyze collective bargaining agreements and recent changes.
  8. Calculate the plan’s current funded status.
  9. Determine sustainable funding goals.
  10.  Evaluate options for achieving goals.

Example

We recently assisted a large Midwestern city in developing a comprehensive funding policy that linked future benefit changes to achieving a targeted funding level. In addition, the city Council adopted guidelines for amortization periods and for direct smoothing of actuarially-determined contributions. Indeed, funding policy, investment policy and pension benefit policy must be linked and reinforce one another.

The time is here for every plan sponsor to develop or review their pension plan funding policy to make sure that it is actuarially sound.

Higher Discount Rates Will Help 2013 Pension Disclosures and 2014 Expense

The final results are in and pension plan sponsors should be pleased with final year-end discount rates – at least compared to the FY2012 rates. Using the Citigroup Pension Liability Index (CPLI) and Citigroup Pension Discount Curve (CPDC) as proxies, pension accounting discount rates are up by about 90 basis points this year.

This is great news for pension plan sponsors. The higher discount rates will have a very beneficial effect on pension liabilities. This in turn will affect both the year-end funded status of the plan and also the 2014 pension expense calculation.

Analysis
In the chart below we compare the CPDC at four different measurement dates (12/31 2010 to 2013). We also highlight the CPLI at each measurement date. The CPLI can be thought of as the average discount rate produced by the curve for an average pension plan.

Citigroup comparison 12312013

The orange arrows in the chart highlight the trend in yield curve movement and show how rates have increased at almost all points along the spectrum since 2012. This means that pretty much all plans, even closed/frozen plans with shorter durations, should experience the benefit of higher discount rates.

Net Effect on Balance Sheet Liability
Many plans also had strong investment returns during the year. Depending on the starting funded status, the change in pension liabilities and assets can have a leveraging effect on the reported net balance sheet asset/liability.

Below is a simplified illustration for a plan that was 70% funded on 12/31/2012 and we assume a 10% decrease in pension liability during 2013. We then compare the funded status results under two asset scenarios: (1) Assets 5% higher than 12/31/2012 and (2) Assets 15% higher than 12/31/2012.

12312013 bal sheet liability example

In both cases, the funded status of the plan improves measurably. There’s also a magnified decrease in the unfunded balance sheet liability because it’s such a leveraged result. This amount decreases by 45% and 68%, respectively, in the two sample scenarios.

Conclusions
So, what should plan sponsors be considering over the next few months as we approach year-end? Here are a few ideas.

  • Now maybe a good time to consider strategies that lock-in some of this year’s investment gains. These could include exploring an LDI strategy to more closely align plan assets and liabilities. Or, offering a lump sum payout window for terminated vested participants early in 2014.
  • Additional plan funding (above the IRS minimum requirements) may be appealing in 2014. Not only will it increase the plan’s funded status, but it will also help lower your pension plan’s PBGC variable rate premiums. These are scheduled to increase significantly starting in 2015 as a result of the Bipartisan Budget Act of 2013.
  • Your plan’s specific cash flows could have an enormous impact on how much the drop in discount rates affects your pension liability. If you’ve just used the CPLI in the past, it’s worth looking at modeling your own projected cash flows with the CPDC or an alternative index or yield curve to see how it stacks up.
  • Even though increased discount rates tend to lower the present value of pension liabilities, your plan may still have an overall liability increase. This could result from active participants continuing to accrue new benefits in the plan, or from the fact that benefits will have one fewer year of interest discount at 12/31/2013 compared to 12/31/2012.

Preview of 2014 Lump Sum Interest Rates

As mentioned in our July lump sum interest rate post, many defined benefit (DB) plan sponsors are considering lump sum payouts to their terminated vested participants as a way of “right-sizing” their plan. The ultimate goal is to reduce plan costs and risk. The IRS recently released the November 2013 417(e) rates, which will be the 2014 reference rates for many DB plans. This post shares a brief update of the impact these rates could have on 2014 lump sum payout strategies.

Background
DB plans generally must pay lump sum benefits using the larger of two plan factors:

(1)  The plan’s actuarial equivalence; or
(2)  The 417(e) minimum lump sum rates.

Since interest rates have been so low over the past few years, the 417(e) rates are usually the lump sum basis. In particular, 2013 lump sums were abnormally expensive due to historically low interest rates at the end of 2012 (the reference rates for 2013 lump sum calculations). This is because lump sum values increase as interest rates decrease and vice versa.

Effect of Interest Rate Changes
For calendar year plans, the lookback month for the 417(e) rates is often a couple of months before the start of the plan year. Here’s a comparison of the November 2012 rates (for 2013 payouts) versus the November 2013 rates (for 2014 payouts).

November 2013 segment rate table

As we can see, all three segments have increased substantially since last November. So, what’s the potential impact on lump sum payments? The table and chart below show the difference in lump sum value at sample ages assuming payment of deferred-to-65 benefits using the November 2012 and November 2013 417(e) interest rates.

November 2013 lump sum chart

November 2013 lump sum table

Note: If we adjust for the fact that participants will be one year older in 2014 (and thus one fewer years of discounting), then this decreases the savings by about 5% at most ages.

Lump Sum Strategies
So, what else should plan sponsors consider?

1. If you haven’t already considered a lump sum payout window, the 2014 lump sum rates may make this option much more affordable than in 2013.

2. With the scheduled increase in PBGC flat-rate and variable-rate premiums due to MAP-21 (plus the proposed additional premium increases in the Bipartisan Budget Act of 2013) there’s an incentive to “right-size” a pension plan to reduce the long-term cost of PBGC premiums.

3. In addition to lump sum payout programs, plan sponsors should consider annuity purchases and additional plan funding as ways to reduce long-term plan costs/risks

What’s the Impact of 2014 IRS Retirement Plan Limits?

The IRS just announced the 2014 retirement plan benefit limits and we’re seeing some modest increases from 2013. What does it all mean for employer-sponsored retirement plans? This post analyzes the practical effects for both defined contribution (DC) and defined benefit (DB) plans, followed by a table summarizing the limit changes.

Changes affecting both DB and DC plans

  • Qualified compensation limit increases from $255,000 to $260,000. Highly-paid participants will now have more of their compensation “counted” towards qualified plan benefits and less towards non-qualified plans. This helps for both nondiscrimination testing as well as for benefits.
  • HCE compensation threshold remains at $115,000. For calendar year plans, this will first affect 2015 HCE designations because $115,000 will be the threshold for the 2014 “lookback” year. When the HCE compensation threshold doesn’t increase to keep pace with employee salary increases, employers may find that more of their well-paid employees become classified as HCEs. Eventually, this could have two direct outcomes:
  • Plans may see marginally worse nondiscrimination testing results (including ADP results) if more employees with large deferrals or benefits become HCEs. It could make a big difference for plans that were close to failing the tests.
  • More HCEs means that there are more participants who must receive 401(k) deferral refunds if the plan fails the ADP test.

DC-specific increases and their significance

  • The annual DC 415 limit increases from $51,000 to $52,000 but the individual 401(k) deferral limit remains unchanged at $17,500. A $1,000 increase to the overall DC limit will allow participants to potentially get a little more “bang” out of their DC plan – at least if their employer wants to give them more money.

Since the 401(k) deferral limit counts towards the total DC limit, this means that an individual could potentially get up to $34,500 from employer profit sharing ($52K – $17.5K). Previously, their profit sharing limit would have been $33,500 ($51K – $17.5K).

Pension Discount Rates – September 2013 Preview

After several years of painfully-low pension discount rates, we’ve seen a modest rebound in 2013. Using the Citigroup Pension Liability Index (CPLI) and Citigroup Pension Discount Curve (CPDC) as proxies, pension accounting discount rates are up by about 80 basis points so far this year.

This is great news for pension plan sponsors, especially if rates continue their upward trend. Add in strong year-to-date equity returns, and we may finally see a reduction in unfunded pension balance sheet liability for fiscal year-end 2013.

Analysis
In the chart below we compare the CPDC at four different measurement dates (12/31 2010 to 2012, and 8/31/2013). We also highlight the CPLI at each measurement date. The CPLI can be thought of as the average discount rate produced by the curve for an average pension plan.

Citigroup comparison 08312013

Rates have increased at all points along the spectrum since 12/31/2012. The orange arrows highlight the trend in yield curve movement. The increase in rates all along the yield curve means that all types of plans (e.g., frozen and open) should benefit if interest rates continue to increase through year-end.

Net Effect on Balance Sheet Liability
Many plans had strong investment returns during the first half of the year, with some fluctuations over the past couple of months. If those early investment gains can be preserved (or increased) until year-end, then this will further improve the pension funded status (assets minus liabilities). Depending on the starting funded status, the change in pension liabilities and assets can have a leveraging effect on the reported balance sheet liability.

Conclusions
So, what should plan sponsors be considering over the next few months as we approach year-end? Here are a few ideas.

  • Don’t count your chickens before they hatch. We’re still several months away from year-end for most plans and a lot can change between now and then. However, there’s reason to be cautiously optimistic.
  • Now maybe a good time to consider strategies that lock-in some of this year’s investment gains. These could include exploring an LDI strategy to more closely align plan assets and liabilities. Or, offering a lump sum payout window for terminated vested participants early in 2014.
  • Even though increased discount rates tend to lower the present value of pension liabilities, your plan may still have an overall liability increase. This could result from active participants continuing to accrue new benefits in the plan, or from the fact that benefits will have one fewer year of interest discount at 12/31/2013 compared to 12/31/2012.

Your plan’s specific cash flows could have an enormous impact on how much the drop in discount rates affects your pension liability. If you’ve just used the CPLI in the past, it’s worth looking at modeling your own projected cash flows with the CPDC or an alternative index or yield curve to see how it stacks up.

Lump Sum Interest Rate Update – June 2013

Many defined benefit (DB) plan sponsors are considering lump sum payouts to their terminated vested participants as a way of reducing plan costs and risk. This post shares a brief update of the interest rates used to calculate deferred vested lump sums and the impact it could have on potential lump sum payout strategies.

Background
DB plans generally must pay lump sum benefits using the larger of two plan factors:

(1)  the plan’s actuarial equivalence; or
(2)  the 417(e) minimum lump sum rates.

Since interest rates have been so low over the past few years, the 417(e) rates are usually the lump sum basis. This means that lump sums are at historically high levels since lump sum values increase as interest rates decrease (and vice versa). Plan sponsors need to consider whether the recent increase in 417(e) interest rates will materially decrease lump sum values and make it worthwhile to postpone a lump sum program until 2014 if it means that lump sums will be “cheaper” then.

Effect of Preliminary Interest Rate Changes
For calendar year plans, the lookback month for the 417(e) rates is often a couple of months before the start of the plan year (e.g., the November rates). Here’s a brief comparison of the November 2012 rates (for 2013 payouts) versus the June 2013 rates (i.e., what rates might look like for 2014 payouts).

June 2013 segment rate table

As we can see, all three segments have increased since last November. So, what’s the potential impact on lump sum payments? The table and chart below show the difference in lump sum value at sample ages assuming payment of deferred-to-65 benefits using the November 2012 and June 2013 417(e) interest rates.

June 2013 lump sum chart

June 2013 lump sum table

Note: If we adjust for the fact that participants will be one year older in 2014 (and thus one fewer years of discounting), then this decreases the savings by about 5% at most ages.

Lump Sum Strategies
So, what should plan sponsors consider?

1. If you’re in the process of implementing a 2013 lump sum payout window for terminated vested participants, you may want to consider the potential savings of waiting until 2014 to pay benefits.

2. There’s no guarantee that interest rates will remain higher until your plan locks-in its lump sum rates later this year. Rates could go up or down, so you’ll need to consider whether you can handle the risk and cost if interest rates go back down and lump sum values increase.

3. Even if you’ve started the process of preparing for a 2013 lump sum window, it’s not a wasted effort if you decide to wait until 2014. Work spent tracking down missing participants, finalizing accrued benefit calculations, and drafting plan amendments needs to be done anyways. However, you’ll want to set a firm “go” or “wait” deadline so there’s enough time to complete the project in 2013 if you desire.

Small Closed DB Plans Need to Monitor §401(a)(26) Status

Strategy blocksIn last week’s blog post covering nondiscrimination testing pitfalls for soft-frozen pension plans, we discussed how defined benefit (DB) plans that are closed to new participants can run afoul of the IRC §410(b) minimum coverage rules. Today’s post discusses how small DB plans closed to new entrants can also have difficulties passing the IRC §401(a)(26) minimum participation test.

Background
IRC §401(a)(26) requires that a minimum number of employees receive a “meaningful” benefit from a DB pension plan. Like §410(b), this is intended to prevent an employer from setting up a plan that only benefits a few highly compensated employees (HCEs) while the remaining staff receive minimal or no benefits.

Specifically, §401(a)(26) requires that the number of benefiting employees be equal to the smaller of:

1. 50 employees; or

2. The larger of (a) 40% of employees or (b) 2 employees

For most medium and large-sized pension plans, achieving the 50 employee threshold is easy and §401(a)(26) doesn’t pose an immediate concern. However, small employers can quickly run into §401(a)(26) difficulties because a small change in the number of DB plan members can have a large impact on whether 40% of employees are benefiting in the plan.

Example
Suppose Company A has 50 employees and sponsors a DB plan that was closed to new entrants in 2008. The number of employees covered under the DB plan has steadily shrunk due to natural turnover and there are currently only 22 employees earning benefits in the DB plan. This means that if 5 new employees are hired (55 x 40% = 22) or if 2 current DB participants retire (50 x 40% = 20), then the plan would be on the verge of failing the §401(a)(26) minimum participation test.

Strategies
So, what should sponsors of small pension plans do if faced with a §401(a)(26) failure? There are no alternative testing options, so the solutions are very similar to the plan changes that can solve a §410(b) failure.

1. Freeze DB accruals for HCEs

2. Freeze DB accruals for all employees

3. Add new participants to the DB plan

Note that Option #1 is only available if (A) the plan is not top-heavy and (B) the plan is not aggregated with any other retirement plans in order to pass other nondiscrimination tests. Most employers will likely choose option #1 or #2.

Since the demographics of small DB plans can change quickly, it’s imperative that plan sponsors monitor their §401(a)(26).status closely each year. Advance planning is the key to avoiding unpleasant corrective measures such as having to add new participants to the plan retroactively.

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