Everyone loves vacation. Some subset of everyone also loves the 1983 film National Lampoon’s Vacation starring Chevy Chase. In case you haven’t seen NLV (if such a thing is even possible) the plot features Chase’s character, Clark Griswold, loading up the family truckster, hitting the open road, and (theoretically) leaving his daily worries behind.
Many defined benefit (DB) plan sponsors have followed Griswold’s lead and have taken their own vacations as well…from minimum required pension contributions. But this pleasant respite is about to draw to a close.
MAP to a Funding Vacation
The Pension Protection Act of 2006 (PPA) originally defined the interest rate for minimum funding to be a 24-month average of high quality corporate bond rates. In response to persistent low rates, MAP-21 (short for “Moving Ahead for Progress in the 21st Century”) introduced a second funding rate equal to a 25-year average of high quality corporate bond rates multiplied by 90 percent. This is called the “stabilized rate” in pension actuarial jargon.
The higher of the PPA or stabilized rate is then used for the funding calculation, and higher rates = lower liabilities.
Since rates were much higher in the 1990s, the stabilized rate delivered an immediate, significant boost to the funding rate. Funding liabilities for a typical DB plan were initially reduced 15 to 20 percent in 2012. But the potency of this relief is gradually wearing off for a couple reasons.
Stabilized Rate Erosion
Like a conveyor belt, each year a high rate from the 1990s drops out of the average and is replaced by a much lower current rate, resulting in a predictable reduction of the stabilized rate of approximately 15 to 20 basis points annually.
The original hope was that bond rates would rebound relatively quickly, limiting the number of years the stabilized rate would exceed the 24-month average.
Now it appears that funding rates could drop as low as 5 percent or even less. What’s worse, this could happen sooner than many sponsors realize.
The 90 percent multiplier used in the stabilized rate calculation itself is scheduled to drop to 85 percent in 2021, and 5 percent per year thereafter to an ultimate level of 70 percent by 2024.
(The multiplier schedule has changed twice since MAP-21 due to stubbornly low interest rates and continual searches for tax revenue. Read more in “Third Defined Benefit ‘Relief” Law Less Charming to Plan Sponsors”.)
So in addition to the normal operation of the 25-year average “conveyor belt”, the multiplier reduction will cause the pace of decline for stabilized rates to roughly double beyond 2020, putting additional upward pressure on funding liabilities.
In 2017 the stabilized rate of a typical DB plan is around 6 percent compared to a 24-month average rate closer to 4.25 percent – providing significant funding holiday relief. But the following chart shows that this vacation is coming to an end, and the work of minimum pension funding will be starting again soon.
Even using a relatively optimistic assumption of corporate bond rates increasing 0.25 percent per year, the funding effective rate is projected to drop to 5 percent by 2021. (If rates don’t increase as assumed, the bottom of the projection occurs closer to 4.5 percent in 2022.)Barring a sudden spike in corporate bond rates, or yet another round of legislative relief, funding liabilities will soon be significantly higher than today. Without offsetting investment returns, funding ratios will decline and minimum contribution requirements will return from vacation: tan, rested and ready.
Required contributions are obviously a concern for plan sponsors, but declining plan funding ratios carry other consequences as well when minimum thresholds are crossed under PPA, including:
- Quarterly contributions: Sponsors of fully funded plans can make voluntary contributions on their own terms. Minimum contributions require adherence to an unintuitive quarterly schedule. Remembering deadlines is a nuisance and missing them triggers penalties.
- Lump sum restriction: Payment of participant benefits is restricted to half of their total value if the plan’s funding ratio falls below 80 percent, leading to potential participant discontent and administrative complexity.
- Credit balance forfeiture: Falling below 80 percent funded can trigger involuntary forfeiture of credit balances for certain plans, which can further accelerate cash funding requirements.
- At risk designation: Plans below 80 percent funded can be subject to additional funding requirements for “at risk” plans. Funding of nonqualified benefits for key employees of public companies can also be restricted.
- Annual funding notices: Reporting declining funding ratios to plan participants can trigger questions (and management discomfort!)
Sponsors approaching the end of funding vacation may want to start planning now. Contributing above minimum levels now can help stabilize annual contribution amounts in the long term, and also comes with additional benefits like potentially lower PBGC premiums and more favorable pension accounting results.
While these measures are useful for managing cash costs, they can’t stop the structural downward slide of funding interest rates. Minimum funding will almost certainly reemerge as an issue over the next few years. And those who haven’t already been making additional contributions may soon realize they are quickly approaching a dead end on the pension funding holiday road.
Mike Clark (Griswold) is a fellow of the Society of Actuaries (SOA) a member of the American Academy of Actuaries (AAA).
The subject matter in this communication is educational only and provided with the understanding that Principal® is not rendering legal, accounting, investment advice or tax advice. You should consult with appropriate counsel or other advisors on all matters pertaining to legal, tax, investment or accounting obligations and requirements.
Insurance products and plan administrative services are provided by Principal Life Insurance Company, a member of the Principal Financial Group® (Principal®), Des Moines, IA 50392.