This year, we’ve seen a significant downward trend in interest rates. Although the Federal Reserve doesn’t anticipate another interest rate cut prior to year-end, the federal funds rate was reduced three times in 2019.
As a result, corporate bond rates have also been negatively affected. Corporate bond rates are extremely important to sponsors of defined benefit pension and postretirement healthcare plans because accounting and, where applicable, funding liabilities and employees’ lump sum present values are inextricably tied to these interest rates. Ultimately, the lower the interest rate, the higher the liability or lump-sum present value because there is less discounting of expected cash flows. As plan sponsors evaluate their 2020 budgets and cash flows it is important to understand the effect these lower interest rates will have on pension and postretirement healthcare plans.
The following is a brief summary of the 2019 rate changes and the respective impact on pension and postretirement healthcare plans.
Effect on Pension and Postretirement Healthcare Plans
Accounting Standard Codification (ASC) 715 requires year-end liabilities be based on applicable market rates at the time of the measurement. A pension or postretirement healthcare plan’s year-end obligations and balance sheet will be significantly affected by current market rates and, where applicable, the Trust’s actual market value. For plan sponsors with a 12/31 fiscal year, the following tables provide some perspective about how rates have changed since the last fiscal year-end.
As you can see from the above, rates are currently down over 100 basis points from the prior year. Even if plan sponsors use a custom discount rate approach, they can expect to see a similar or slightly greater drop in rates if rates remain at their current levels through the end of 2019. Similar to the change in lump sum rates discussed above, the drop in discount rates, if sustained through year-end, will have a significant impact on year-end obligations. Though these drops will have a negative effect on the company’s balance sheet at year-end, the company may actually see a reduction in the interest cost in 2020 due to the lower applicable rates.
The funded status of the pension plan and net periodic pension expense for the next fiscal year will also be impacted by the market value of assets in the Trust as of the measurement date. Since December 31, 2018, many sponsors have seen significant gains on their portfolios due to gains on equities in 2019. If such gains are sustained through year-end, they may offset some of the losses likely to be seen on the obligations. The same can be said for postretirement healthcare plans that are funded by a Trust. That being said, hopefully the market downturn that occurred in November and December of 2018 does not reoccur in December 2019.
Pension and postretirement healthcare plan liabilities under ASC 715 must be based on rates currently available as of the measurement date. Under the accounting rules, the plan sponsor must determine the assumptions and methods most appropriate for measuring their obligations. There are several methods available to value liabilities for accounting purposes. One such method is the use of a published yield curve such as the FTSE Pension Liability Index, the FTSE Above Median Double-A Index, or another such Index or curve. Alternatively, a pension or postretirement healthcare plan’s discount rate can be determined based on a hypothetical bond portfolio designed to replicate and, ultimately, defease a pension plan’s expected cash flows. The cost of the hypothetical bond portfolio is then used to generate a single equivalent discount rate that would produce the same present value based on the discounted cash flows. BPAS has the ability to create such custom bond portfolios. Under this approach, the plan sponsor has the ability to select individual bonds with higher yields which ultimately produces a lower cost portfolio and a higher applicable discount rate. Given the expected drop in discount rates, plan sponsors may want to discuss this option with BPAS and plan auditors to see if this option is worth pursuing.
In October, the Society of Actuaries (SOA) released updated mortality rates. Auditors will expect to see the updated mortality reflected in the pension and postretirement healthcare plan liabilities at year-end. Moving to the new tables is expected to cause a change in liabilities in the range of +/- 1% for pension plans and will vary based on the type of coverage provided for a postretirement healthcare plan.
Mortality assumptions for minimum funding and PBGC purposes are mandated by the IRS for pension plans. The 2020 tables reflect the MP-2018 mortality improvement scale and will result in a slight reduction in the plan’s liabilities compared to using the IRS tables for 2019.
Effect on Qualified Pension Plans
Lump Sum Interest Rates
For pension plans that pay lump sums, the IRS mandates that the minimum lump-sum present value be based on the applicable 417(e) mortality and interest rates. Those rates are based on the level of corporate bond spot rates at any given measurement date and are effective over the applicable stability period identified in the plan document. For some sponsors, the stability period is a single month, so the applicable rates change monthly. But, for many pension plans, the stability period is a year. The table below shows the rates applicable for 2019 based on the November 2018 rates, along with the most recently released rates as an example of those applicable in 2020.
For example, using the November 2018 rates, a participant at age 65 who has earned an annuity of $1,000 per month, would have a lump-sum present value of roughly $158,300 in 2020. That number would jump to nearly $179,600 in 2020 using the September 2019 rates— an increase of nearly 13.6%.
If your pension plan offers lump sums, and your actuary utilizes an assumption that some participants will elect lump sums, the ultimate 2019 rates under IRC 417(e) will affect a portion of the liability for accounting. In addition, it will have a profound effect on lump sums paid to participants during the 2020 calendar year.
Due to the interest rate relief provided for in the Bipartisan Budget Act of 2015, the immediate effect on pension plan liabilities for minimum funding purposes will not be as pronounced as the applicable rates based on the corridor around the 25-year average of such rates.
The drop in rates will have a more pronounced effect on PBGC liabilities, which are not constrained by the 25-year average utilized in calculating the funding target liability and are based on either a spot rate or on a 24-month average of such rates. A pension plan’s underfunding for PBGC purposes may be more highly impacted than the funding target liability used for minimum funding purposes. It is compounded by an increase in the PBGC variable rate premium from $43 to $45 and may result in larger than expected premiums in 2020.
Given the items above, plan sponsors may wish to have estimates prepared to identify the potential impact on their pension or postretirement healthcare plan’s accounting results, and their pension plan’s minimum funding and/or PBGC premiums for 2020. At BPAS, we’re here to help. To discuss in more detail, please contact your BPAS consultant at 1-866-401-5272.
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