After 2022’s roller-coaster of soaring interest rates and plunging investment returns, sponsors of single-employer defined benefit plans face a key choice as they calculate the 2023 variable rate premium they’ll pay to the Pension Benefit Guaranty Corporation (PBGC). Milliman pension actuaries Casey Baldwin and Ryan Cook spoke with Nina Lantz about using the full yield curve, not being afraid of the five-year lock-in, and how switching from the alternative to the standard calculation method can mean the difference between a $100,000 premium and a premium of $1.7 million.

Transcript

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Nina Lantz: Hello and welcome to Critical Point, brought to you by Milliman. My name is Nina Lantz. I'm a principal and the director of Milliman's Employee Benefits Research Group, and I'll be your host today.

In this episode of Critical Point, we're going to talk about how the rise in interest rates and market declines in 2022 may affect how plan sponsors of single-employer defined benefit plans choose to calculate their PBGC variable rate premiums for 2023. For many plans, PBGC premiums are due in October, so plan sponsors may want to have this conversation with their actuaries now.

Joining me today is Casey Baldwin, principal and consulting actuary in Milliman’s Portland, Oregon, office. Hi, Casey.

Casey Baldwin: Hey, Nina. Good to be with you today.

Nina Lantz: Also joining us is Ryan Cook, consulting actuary in our Boise, Idaho, office. Hi, Ryan.

Ryan Cook: Hi, Nina. Thanks for inviting me.

What is the PBGC variable rate premium?

Nina Lantz: As many of our listeners know, plan sponsors of single-employer and multi-employer defined benefit plans pay annual premiums to the Pension Benefit Guaranty Corporation, or PBGC, the federal agency that insures these plans. Today we'll focus on PBGC premiums for single-employer plans. There are two pieces to the annual premium calculation: a per participant premium, and a variable rate premium, based on a plan’s level of underfunding. Ryan, can you describe what the variable rate premium is?

Ryan Cook: Sure, Nina. So, as you mentioned, it depends on the underfunding level of the plan. So, if a plan’s fully funded, then there's no variable rate premium. But for those that have a funding shortfall on a PBGC premium liability basis, then the PBGC charges those plans 5.2% of that shortfall each year. And then there's a cap on that as well, so if a plan either offers richer benefits, or it's pretty far underfunded, then they'll hit this cap, which is $652 per participant.

How interest rates factor into the PBGC premium

Nina Lantz: Now, you recently wrote an article discussing a couple of different methods that plan sponsors can choose from for determining the variable rate premium. Can you take us through those?

Ryan Cook: Sure. So, as I mentioned, the variable rate premium’s based on the underfunded level, and that's based on a PBGC-specific measurement of the plan's liability. That PBGC measurement, it's very similar to what's used for funding purposes, but the main difference is the interest rates that are used.

The PBGC offers a couple different methods on what interest rates you can use to calculate the liability. The first, that a lot of plan sponsors may be using, is called the alternative method. Under that method, it follows the plan’s funding election, but it doesn't incorporate the interest rate relief that was first introduced with the Moving Ahead for Progress in the 21st Century Act back in 2012. It has been extended since then. So, for funding purposes, plan sponsors are going to take advantage of higher interest rates, which means lower liabilities. But the PBGC requires plan sponsors to use those original interest rates that were set up with the Pension Protection Act back in 2006. And so those interest rates follow a 24-month average of high-investment-grade corporate bond yields.

The other option the PBGC gives is the standard method, and that's much closer to a market rate, where it's just a one-month average of those high-investment-grade corporate bonds.

So the main difference here is if you're on the alternative method, you're looking at a 24-month average, a two-year average, of what the discount rates are. If you're on their standard method, you're looking at a one-month average. So it's just a matter of do you have this smooth interest rate, or do you have more of this market interest rate?

And plan sponsors are given the option to switch back and forth between these. However, whenever the plan sponsor switches, they're locked into that for five years. So, while they can switch, the PBGC doesn't want them to switch every single year.

“Unusual circumstances” affecting 2023 PBGC premiums

Nina Lantz: But there's nothing new about these methods. So, Casey, why is it so important to have this discussion now?

Casey Baldwin: Well, for 2023, we had some unusual circumstances leading up to our PBGC premiums. So most pension plans experienced some pretty significant investment losses during 2022. But at the same time, we saw some rapidly increasing interest rates, and that helped offset those investment losses. So for many plans on a mark-to-market basis, they had little to no change in their funded percentage. But as Ryan mentioned, the alternative method uses a 24-month averaging period to determine its liability, and so it's still capturing some of those historically low interest rates. So plans that are on the alternative method for determining their PBGC premium, they didn't see that same drop in liabilities that plans on the standard method would have, so they're potentially facing a large premium in 2023.

I have a plan that, historically, has been well funded on an accounting basis. They've avoided the variable premium for the last couple of years, but in 2023, because of the alternative method that they're on, they're facing a premium that's nearing the per participant cap. So pretty large swing in their premium.

Calculating the PBGC premium: The alternative vs. the standard method

Nina Lantz: So Ryan, in your article you looked at the difference in the variable rate premium between the standard and alternative methods for 2023. What did you find?

Ryan Cook: For 2023, the standard method interest rates are about one and a half percentage points higher than on the alternative method. And that's just because, like Casey said, there was this huge rise in interest rates in 2022, and those are fully baked into the standard method at this point. But with the 24-month average on the alternative method, it's only reflected a portion of that increase. And that 1.5 percentage point higher interest rate means liabilities are going to be around 10% to 20% lower under the standard method than they would be under the alternative method. And, with variable rate premiums, that's leverage because it's just compared to assets.

So I was looking at one example plan that, under the alternative method, their liabilities were going to be $209 million, which would be a $34 million shortfall and a $1.7 million variable rate premium they'd have to pay to the PBGC this year. But if they switch to the standard method, their liabilities drop from $209 million down to $177 million, which means their shortfall would only be $2 million and they'd only owe around $100,000 in variable rate premium this year. So a big swing going from $1.7 million variable rate premium down to only $100,000.

Should you switch premium methods now and be locked in for five years?

Nina Lantz: Now you noted that, if a plan switches methods for calculating the variable rate premium, they're going to be locked in for five years. So is now the right time to be making the change, or is it better to wait?

Ryan Cook: Yeah, so, that's a great question. This five-year lock-in can create some hesitancy for plan sponsors to want to switch methods. And so, the first thing to look at is when is it advantageous to be on the standard method versus when is it advantageous to be on the alternative method? The general rule is that when interest rates are going up, like they did in 2022, the standard method’s going to be better. However, the flip of that is then when interest rates are falling, that's when the alternative method’s going to give you lower premiums. So the risk would be that, if a plan sponsor switches now and then interest rates fall over the next three years, then over the next few years they may be paying slightly higher variable rate premiums than they would have if they’d stuck with their prior method.

In my article, I went through some analysis on just looking at this question of, when you can't predict what the interest rates are going to do, and you're facing this five-year lock-in, when is the right time to switch? When are savings that you're seeing this year large enough to be worth pulling that trigger and locking yourself in for five years? Pretty much everything I looked at, both in the numerical analysis and the other factors, all pointed to, if there's some savings to be had, pull the trigger and switch. Don't let fear of that five-year lock-in keep you from taking your savings now. There may be some scenarios where interest rates reverse and you would have been better off not switching, but you can't know that's going to happen ahead of time and, on average, you're going to be better off just taking the guaranteed savings now.

And all of the analysis I did, those were for traditional years—2023 is anything but traditional. This is the most extreme difference we've seen between the standard and alternative method interest rates in over 20 years, so it's very unlikely that we're going to see a big enough drop in interest rates to make plan sponsors regret switching to the standard method in 2023, especially since we're already halfway through 2023 and we haven't seen any drop in interest rates. They've been more or less level. So 2024 is looking like it's going to favor the standard method as well.

Using the full yield curve: An option for plans that can’t switch methods

Nina Lantz: So switching to the standard method sounds like a great choice for 2023, for plan sponsors that are eligible to make that change. But what about plan sponsors that can't switch in 2023 because of the five-year lock-in? Casey, in your article, you explored another option to help lower the variable rate premium for a plan you work on. What was that option?

Casey Baldwin: Yeah, so, Nina, that option is actually going to the full yield curve, and you do that for funding purposes. But the PBGC allows that full yield curve election to be recognized for premium methods. So plans that are within that five-year window, they can make that election on the funding side of things and it will impact their premium. It’ll give them somewhat of a result that's similar to the standard method, because it's just a one-month average they use for the full yield curve.

Nina Lantz: But if you switch to the full yield curve, won't that raise the minimum required contributions for funding purposes?

Casey Baldwin: Maybe it could, but we're not sure about that right now. What plans are doing, though, Nina, is when they switch to the full yield curve, they're effectively giving up the interest rate relief that was provided through recent legislation. So what plans are really doing right now is there's some savings available to them on the PBGC side, but that comes with the potential of risk exposure to interest rates. So if interest rates drop, that's what plans are afraid of, by going to the full yield curve.

Ryan Cook: It’s worth noting, though, that the risk isn't as great as it was before. Like you mentioned, interest rates are a lot higher than they have been over the past 10 years, which makes interest rate relief have much less impact on plans. And, with the recent legislation that increased the funding amortization period from seven years to 15 years, even if interest rates do fall, plan sponsors still get to spread any shortfall that gets created over a full 15-year period. Plus, with how many plans have moved their investment allocation heavily into fixed income over the past couple decades, moving to the full yield curve, while it does expose their liabilities to interest rate risk, a lot of plan sponsors are already hedging out that interest rate risk with how they've invested their assets. So this really just moves it so that their assets and liabilities are moving in tandem.

Will the full yield curve work for plans with a large equity allocation?

Nina Lantz: What about plans that still have a meaningful amount of equity exposure? Does going to the full yield curve make sense for them?

Casey Baldwin: You know, Nina, that’s a question I’ve been asking myself for the last several months. My initial reaction was the answer would be no, but I’ve changed my mind a little bit as I’ve looked into this. Obviously I knew there was some savings for plans by going to the full yield curve immediately, but that comes with the risk of some potentially large contributions, or at least I thought so, down the road.

So I happened to look at this for a plan that has 40% of their assets still invested in equities, and I was anticipating seeing a result where their contributions would increase significantly by going to the full yield curve. But as we got into that and did a stochastic study, we found that it had little to no effect on their anticipated contributions over the next 10 years. So that was quite a surprising result.

I think, in our case, we have a plan with a large prefunding balance, a plan that’s pretty well funded at the moment, so I think there’s a lot of factors for plans. If you’re just dismissing the opportunity to save on PBGC premiums this year just because you think your plan might have some interest rate risk, I think it’s worth looking into before you make a final decision.

Choose your PBGC premium method now to meet fall deadlines

Nina Lantz: Now PBGC premiums are due nine and a half months after the beginning of a plan year. Normally, premiums are due on October 15th for a calendar-year plan, but since October 15 lands on a weekend this year, premiums are due on October 16. Casey, when do plan sponsors have to make their decision on the method used for the variable rate premium?

Casey Baldwin: Nina, I think that’s going to vary by plan. Obviously you mentioned the October deadline. Certainly you’d want to have that election done if you’re going to make that change before you submit the filing.

But another date to consider is September 30th, and that is when your AFTAP (adjusted funding target attainment percentage) certification is due. So if this election to go to the full yield curve affects that AFTAP, you’re going to want to make that before 9/30, or at least consider the impact that it would have on your plan.

And the last thing I’ll mention is that, for plans that switch methods with the PBGC, that election to change is disallowed if you make your filing late. So we’re encouraging all our plans to get that filing in on time to avoid having the headache or potentially losing out on savings.

Nina Lantz: Well, there's a lot here for plan sponsors to think about, and they may want to consult with their actuaries about what the best method is based on their plan’s circumstances. Thank you, Casey and Ryan, for taking us through this.

For more information about what we talked about today, please visit Milliman.com to read the recently published articles on PBGC premiums by Casey and Ryan.