Single-employer defined benefit pension plans that have elected to use the “alternative method” for determining Pension Benefit Guaranty Corporation (PBGC) premiums have a window to take action that may significantly reduce their PBGC premiums for 2023. Action must be taken prior to the due date for PBGC premiums for the year, which for calendar year plans is October 16, 2023.
As background, PBGC premiums reflect two components. The first is a flat rate premium, which is currently $96 per participant. The second is the variable rate premium (VRP), which is assessed if the plan is not fully funded as determined under PBGC rules. The VRP is based on the amount of a plan’s unfunded vested benefits and is capped at an amount based on the number of participants (currently $652 per participant). The potential planning opportunity for reducing PBGC premiums focuses on the VRP and the manner in which liabilities are calculated.
Standard vs. Alternative Methods
The PBGC authorizes two methods for measuring plan funding, the standard method and the alternative method. Under the standard method, future benefit payments are discounted using three “spot segment rates” derived from a corporate bond curve, determined for the month preceding the month in which the premium payment year begins. Under the alternative method, the liability is calculated using the assumptions for determining the minimum required contribution for the year, which usually reflect interest rates averaged over a longer period.
An election to use the alternative method cannot be revoked for five years. In a period of falling interest rates, electing to use the alternative method can allow a plan to employ a higher interest rate to calculate the plan’s unfunded benefit liability and thereby reduce its VRP. Many defined benefit plans elected to use the alternative method in 2019 and 2020 when interest rates were falling.
Changing Methods
Fast-forward to 2023, and many plans that elected the alternative method are locked into lower interest rates for purposes of determining plan liabilities during a period of rising interest rates, as a result of interest-rate averaging over the longer period. Some plans that are nearly fully funded or completely fully funded for funding purposes under current interest rates are faced with a significant VRP because plan liabilities to calculate PBGC premiums are being valued using these lower interest rates.
A pension plan can make an election for funding purposes to shift from the segment rate approach to the full yield curve approach (described below), which considers only recent bond yields. This election will automatically apply to the liability used to determine the VRP. The Internal Revenue Service (IRS) grants automatic approval for this change, but any future change in that election to revert back to using the segment rate approach would require the approval of the IRS.
The plan would have to file an application, and the IRS may only approve the application if there is a valid business reason for the switch, with the plan having the burden of proving that the switch is not solely to take advantage of the interest rate environment.
Segment Rates
The funding target is calculated every year based on two sets of segment rates: (1) a 24-month average of the most recent segmented bond rates, and (2) a set of stabilized rates based on 25-year average bond rates (resulting in higher interest rates and lower plan liabilities than the first set of segment rates).
Under the alternative method, the PBGC liability used to determine the premium is based on the first set (without stabilization relief), but the calculations to determine annual minimum funding requirements are based on the stabilized rates, which produce a lower minimum contribution than what would have otherwise been required.
Full Yield Curve Election
If a plan makes the full yield curve election, in lieu of both sets of segment rates, all liabilities (both for minimum funding requirements and PBGC premiums) would be based on the full yield curve of bond rates as of the valuation date. In a rising-interest-rate market environment (as we are in currently), the full yield curve approach will result in a lower liability than the 24-month segment rates, as the yield curve rates are not weighed down by 23 preceding months of lower interest rates.
While the switch to the full yield curve approach may result in a significant saving in the VRP, in a decreasing-interest-rate market environment the plan would lose the interest rate smoothing of the segment rate average and, as a result, the plan’s future minimum required contributions and PBGC premiums may increase over what they would have been had the plan not made the election.
For this reason, a switch to the full yield curve approach may be most attractive to plans that are relatively well funded and which have hedged their liabilities as part of a de-risking strategy, as they are less likely to be affected by future drops in the interest rate.
Next Steps
Plans subject to an alternative method election prior to 2019 can elect to switch back to the standard method for 2023. If a plan elected to use the alternative method in 2019 or later, the plan would not be able to switch back to the standard method. However, such a plan may still benefit from electing the full yield curve approach. As noted above, elections must be made by October 16, 2023 for calendar year plans. We would be happy to work with plans and their actuaries to review the pros and cons of available options and next steps.