IRS Sees Mortality Shadow: 12 More Months of Lump Sum Windows?

In the hamlet of Punxsutawney, PA — a mere 90 minute drive northeast of my current blogging location — thousands of revelers gather each February 2 to see whether or not a groundhog will be frightened of its own shadow.

The climax of the proceedings occurs when the groundhog, Punxsutawney Phil, emerges from his burrow. (At least that’s what the eccentric older gentlemen in top hats tell us has happened.)  If Phil is determined to be frightened by his shadow there will be six more weeks of winter.  If he courageously… does nothing…it will be an early spring! groundhog

Mortality Anticipation

A similar anticipatory rite has occurred in the defined benefit (DB) world each year since 2014, the year the Society of Actuaries (SOA) released their latest suggested mortality assumptions for the valuation of pension liabilities. [“Fear of (Not) Dying”].  In October of that year, the SOA released their new base mortality tables (RP-2014) and improvement scales (MP-2014).

The construction of the new mortality assumptions is quite sophisticated, some might say complex. But the bottom line for non-actuaries (also called “people”) is that human beings are living longer, making the average cost of a lifetime pension promise 5 to 7 percent more expensive.

Auditors were quick to require use of the new SOA assumptions for accounting liabilities. (Let’s face it, they live for that stuff!)  The Internal Revenue Service, on the other hand, was much more deliberate.  IRS adoption of new assumptions would affect many elements of a DB plan including minimum funding, PBGC premiums, and lump sum conversions.  So the service considerately sought to provide ample lead time in announcing any mortality assumption changes.

Fence Sitting

Until spring of 2016, most policy watchers in the DB field had assumed, (at the suggestion of the IRS via Notice 2015-53), that new mortality assumptions would be adopted for the 2017 plan year. The belief that an imminent increase in lump sum values was fast approaching fed a rush by plan sponsors to execute lump sum windows this year to avoid the extra cost.  [“Pension Defenestration”]

As the months rolled by in 2016, however, it started to become clear that the IRS was remaining mugwumpishly silent of the mortality issue, likely with good cause.

Annual updates of mortality experience issued by the Social Security Administration have shown that the original improvement assumptions of MP-2014 may have been too aggressive. Longevity was not improving as quickly as the original SOA study had predicted. [“Mortality Meets Volatility”]  It’s not unreasonable to think the IRS may be waiting for more information before making their final decision.

Meanwhile, like revelers at Punxsutawney minus the bloody marys, the virtual crowd milling about waiting for a pronouncement began to get restless. When would the top-hatted official step onto the stage and declare the IRS mortality assumptions for 2017?

And the Answer Is…

On the afternoon of September 2, while most of the world had already set their out of office messages for the Labor Day weekend, the long awaited answer came in the form of Notice 2016-50.

The IRS had indeed seen its shadow. No mortality assumption changes are to be enacted for 2017. Twelve more months of lump sum windows without a mortality price increase!

Rates Rain on Party

Unfortunately, the interest rates paired up with the mortality assumptions to determine the lump sum value of a pension benefit have dropped precipitously this year. Corporate bond rates are down about 90 basis points from January 1.  A drop of this magnitude increases the average lump sum by 10 to 15 percent – two or three times the effect of the expected mortality change.

Without a significant rebound soon, increased cost may suppress lump sum activity in 2017 regardless of which mortality assumption is used. On the bright side, sponsors opening windows in 2016 can feel vindicated that their decision to do so now is likely to work out in their favor.

Looking Ahead

Notice 2016-50 appears to end further speculation on the mortality issue: “…the Treasury department and the IRS expect that the final regulations will apply beginning in 2018”. Although the language from Notice 2015-53 sounded almost this certain when declaring new mortality would come in 2017.

My opinion is that they mean it this time, and that sponsors and actuaries should prepare for higher liabilities and lump sums. The exact assumptions the IRS will adopt and their precise impact, however, still remain somewhat mysterious.

Maybe we can squeeze one more party out of that.

Mike Clark is a fellow of the Society of Actuaries (SOA) and a member of the American Academy of Actuaries (AAA), prestigious certifications presented to him by eccentric older gentlemen in top hats.

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