This article assumes the reader is familiar with Pension Benefit Guaranty Corporation (PBGC) premium terminology.
Introduction: Why PBGC premiums are different in 2023
Is your pension plan on the hook for a large PBGC premium in 2023? In 2022 a plan I work on using the alternative method was overfunded on a PBGC basis and avoided the variable-rate premium. In 2023, this same plan faces a variable-rate premium that approaches the per-participant cap. Plans that are unable to switch to the standard method, which is more favorable in 2023, may be stuck paying a historically high premium. However, there is another less common option sponsors can elect that could result in significant savings: the full yield curve (FYC).
This article will explore the FYC option for plan sponsors to reduce their PBGC premium. It is directed to single-employer pension plans that elected the alternative method within the last five years. We’ll discuss the ramifications of electing the FYC and review a stochastic case study. (Plans able to elect the standard method in 2023 should read our related article, “Should you switch to the standard method to calculate your 2023 PBGC premiums?”)
How did we get here?
The investment losses of 2022 resulted in many pension plans that use the alternative method facing a large PBGC funding deficit in 2023. The interest rates used for the alternative method are averaged over 24 months and still include historically low rates in the averaging period, resulting in higher PBGC liabilities than plans that use the standard method, which reflects current higher interest rates. Even plans that remain well-funded on an accounting basis after the investment losses are confronting a variable-rate premium if they remain on the alternative method, because the accounting basis uses current rates, similar to the PBGC standard method, to calculate liabilities. Additionally, the variable rate increased to 5.2% of unfunded vested benefits in 2023, leading to larger premiums.
Full yield curve election
The FYC election is technically a minimum funding election made in accordance with Internal Revenue Code Section 430. The PBGC requires plans that have elected the FYC for funding purposes to reflect it when determining premiums under the alternative method. The FYC is in essence a permanent election, as it can only be revoked with IRS approval. While the FYC will provide PBGC savings in 2023, plan sponsors must consider the impact on future contribution and PBGC premium requirements.
By electing the FYC, a plan sponsor is essentially forfeiting the interest rate relief provided under the Infrastructure Investment and Jobs Act (IIJA) in order to be able to use current higher rates for minimum funding and therefore the PBGC alternative method liability. Is the immediate PBGC savings available in 2023 worth the permanent exposure to interest rate volatility? Plans that have adopted liability-driven investment (LDI) may find that the FYC helps their liabilities to track assets more closely, but does this option make sense for plans that are not fully immunized through LDI?
Stochastic study projecting the impact of using the full yield curve
A client that has not fully immunized asked us to perform a stochastic study using 2,000 economic scenarios to project the potential impact of electing the FYC. The FYC was compared to the stabilized rates under IIJA while holding all other assumptions steady. Our objective was to examine the impact on the future cash contributions and future PBGC premiums. The primary stochastic assumptions are as follows:
- The plan in the case study has a large prefunding balance (PFB). The projections assume that the PFB would be exhausted prior to any cash contributions being made.
- The case study plan pays lump sums to participants. We assumed the sponsor would make cash contributions as necessary to maintain an 80% funding ratio.
- We assumed that the current asset allocation of 40% growth equities/60% fixed income would not change in future years.
My initial expectation was that the FYC would increase the likelihood of contributions or expose the plan to higher contributions, but I was surprised by the results.
Please see the appendix for more information on interpreting the figures.
Figure 1: Distribution of future effective interest rates
Figure 2: Distribution of future funding target
The tables in Figures 1 and 2 compare the distribution of effective interest rates (EIR) and funding target for both the FYC and the stabilized rates. As expected, the FYC exposes the plan to volatility in the EIRs and funding targets. Interestingly, this did not translate into a more volatile contribution pattern.
Will using the full yield curve require cash contributions?
We examined the distribution of contributions in each year as well as the 10-year present value of contributions for both the FYC and stabilized rates. Surprisingly, the distributions were nearly identical. The table in Figure 3 shows the distributions of 10-year present values for the 2,000 scenarios. The median outcome is $0 under both methodologies, suggesting that, in more than half of the scenarios, the plan will not have to contribute. The 75th and 95th percentiles for the FYC are nearly identical to the stabilized rates.
Figure 3: 10-year present value of contributions under stabilized rates and FYC
Why didn’t the FYC lead to a larger distribution of contributions? Below are some possible explanations:
- Both methodologies include asset smoothing and amortize underfunding over a 15-year period. The effect of interest rate relief is diminished with these other smoothing techniques in place.
- Investment returns will ultimately determine cash contributions. In the scenarios where returns are negative or do not meet expectations, the interest rate methodology may not matter that much.
- The biggest risk of the FYC is the exposure to low interest rates, which will increase liabilities. However, low interest rates are correlated with positive investment returns, which would offset the liability increase. Conversely, poor investment returns are correlated with rising interest rates. If investments underperform and funding is required, then high interest rates are preferred for calculating the minimum funding.
- The FYC scenarios get a leg up on the beginning market value because the 2023 PBGC premium, which is paid from plan assets, is much larger under the stabilized rates.
We did find individual scenarios within the 2,000 where the FYC was clearly better than the stabilized rates and other scenarios where the reverse was true. Our conclusion was that the two interest rate methodologies produce different risks, but they are both approximately equal in risk when it comes to contributions. Our client concluded that the risk of contributions under the FYC should not deter them from taking advantage immediately of the substantial PBGC savings available to them.
Switching to the full yield curve: What’s the effect on future PBGC premiums?
After locking into the FYC, it is unlikely the plan would benefit from a move between the alternative and standard methodologies. How does the FYC affect the plan’s future PBGC premiums?
We looked at the premiums in each year together with the 10-year present value of premiums, and the FYC was more favorable in both. The table in Figure 4 shows the distribution of the total PBGC premium under both methodologies.
Figure 4: 10-year present value of PBGC premiums
Like the comparison of contributions, the PBGC premiums are more favorable under the FYC because of the immediate savings. In other words, it is very unlikely that savings from the stabilized rates would ever offset the substantial savings available now. Below are additional observations regarding the future PBGC premiums:
- In addition to the savings gained in 2023 by using the FYC, we expect additional savings in 2024 as some low interest rates will still be included in the 24-month stabilized rates. The FYC was more favorable in all but five of the 2,000 scenarios for 2024.
- Only one of the 2,000 scenarios resulted in a higher 10-year present value of premiums under the FYC.
Conclusion: Talk to your actuary about switching to the full yield curve
Plan sponsors should not rely on the results of this case study to make their decision, as characteristics and situations will vary by plan. At a minimum, those with variable-rate premiums that are unable to switch off the alternative method in 2023 should discuss this topic with their actuary and decide whether it makes sense for their plan. Dismissing the opportunity simply because of the permanent nature of the FYC election could be costly.
