DB Plan Clients See Lump Sum Favorability Shift

A recent analysis published by Vanguard suggests 2017 might be the “last best chance” for defined benefit (DB) plan sponsors to pursue a lump sum strategy on favorable terms.

The pressure to move on lump sums today is largely due to changes driven by the Internal Revenue Service (IRS) and, “to a lesser but still meaningful extent,” by the Pension Benefit Guaranty Corporation (PBGC). Recent interest rate movements are also impacting the appeal of pursuing a lump sum, according to Vanguard.  

“It’s likely that most DB pension plan sponsors’ major objectives are to reduce the cost of maintaining their plan, increase its funded status, and mitigate its effect on the organization’s financial statements,” the firm explains. “Sponsors may be able to make progress toward these objectives in 2017 by offering a lump-sum window to terminated vested participants.”

The Vanguard analysis includes insight from Brett Dutton, Institutional Advisory Services, and Paul Bosse and Kim Stockton, of the Investment Strategy Group.

The trio explains that the IRS “indicated in September 2016 that it was postponing until 2018 the implementation of updated Society of Actuaries (SOA) mortality tables used to calculate lump-sum values, minimum funding requirements, and PBGC premiums.” Simply put, moving on lump sums now before the new SOA tables take effect may result in more favorable calculations from the plan sponsor’s perspective.

Vanguard warns that “sponsors should know that the IRS prohibits DB plans from paying lump sums to in-pay retirees and beneficiaries,” but many terminated vested participants will view lump sums as attractive. In the end it can be a win-win—the participants gain more control over their wealth while sponsors gain better control of their DB plan longevity exposure. 

NEXT: Getting ahead of PBGC premium hikes 

Concerning the PBGC, Vanguard suggest “premiums are going nowhere but up.”

“In addition, by reducing their plan's participant count by the number of terminated vested participants who accept a lump-sum window, a plan sponsor is reducing the amount it would pay in total PBGC premiums going forward after 2017,” Vanguard explains. “These savings can be substantial … In all cases, it would reduce the flat-rate premium paid on a per-participant basis; in some cases, the variable-rate premium might additionally decline due to a reduction in the cap, which is also calculated on a per-participant basis.”

The analysis steps through a variety of mitigating factors that can make offering a lump sum less attractive for plan sponsors, and these should be considered carefully, the experts warn. But on its face the consideration is fairly straightforward: “The two main factors that determine the value of lump sums paid to participants are mortality assumptions and interest rates … This is a good thing because the higher the long-term interest rate, the lower a plan's liabilities, the better its funding ratio, the lower its lump-sum values, and the lower the cost impact of the plan on the organization's financials. However, this lift might not help some plan sponsors thinking about a lump-sum window in 2017. The PPA [Pension Protection Act] requires a sponsor to define a look-back period of one to five months, generally before a plan year, as a measurement date for the interest rate used to determine lump sums. Thus, a plan might be required to pay 2017 lump sums based on interest rates that don't reflect the post-election boost.”

The experts urge plans to “carefully consider whether the impact of increasing longevity will be offset, or more than offset, by the impact of rising interest rates on lump-sum costs in future years … While the crystal ball to help plan sponsors know where interest rates will be in the future doesn't exist, it's worth noting that Vanguard doesn't expect rates to move much further in 2017.”