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).
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.
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
