The Pension Benefit Guaranty Corporation (PBGC) is the federal government entity in the United States that insures corporate pension plans. The PBGC covers both single-employer and multiemployer plans, but this article focuses on single-employer plans. At a high level, the role of the PBGC is to take over sponsorship and administration of a pension plan if the plan sponsor goes bankrupt. If the plan is underfunded at the time of the bankruptcy, the PBGC will provide the extra funds necessary to ensure that participants still receive their benefits (up to certain limits). Note that there are many more details to this process, including some exceptions; please visit the PBGC website to learn more.

To pay for this insurance coverage, covered plans pay an annual premium to the PBGC. This premium consists of two parts:

• Flat-rate premium: Every covered plan sponsor must pay an annual premium equal to the number of participants in its plan times the flat-rate premium rate. The flat-rate premium is $96 per participant in 2023 and increases each year with inflation.
• Variable-rate premium: Any plan sponsor with an unfunded liability (as measured using PBGC rules) must pay an annual premium equal to 5.2% of its unfunded liability.
• Note that the variable-rate premium is subject to a cap of $652 per participant in 2023, increasing with inflation.

As mentioned above, certain rules must be followed when measuring the unfunded liability of the plan to determine the variable-rate premium owed each year. For the most part, the rules correspond to those used for determining minimum required contributions. However, one significant difference is the interest rates used to measure the liabilities. For minimum required contributions, plan sponsors can take advantage of funding relief measures that have been passed by Congress over the past decade through segment rate stabilization to reduce their liability measurements. However, plan sponsors are not allowed to use these stabilized interest rates when measuring the amount of the variable-rate premium. Instead, plan sponsors must pick between one of the two following options:

• Standard method: Use the yield on investment-grade corporate bonds averaged over the one-month period prior to the valuation date.
• Alternative method: Use the yield on investment-grade corporate bonds averaged over a 24-month period ending either zero, one, two, three, or four months prior to the valuation date
• Note that the look-back period of zero to four months must match the look-back period used for funding purposes.
• Note also that, if the full yield curve is being used for funding purposes, then it would also be used for PBGC premium purposes; however, this is rare and not discussed more in this article.

Plan sponsors are allowed to switch between these two methods (they have until the premium payment date to make an election to switch methods). Once they switch, they are locked into the new method for five years.

Difference between standard and alternative methods in 2023

For a calendar-year plan, with a valuation date of January 1, 2023, the standard method interest rates are the average corporate bond yields from December 2022 as determined by the IRS. In Notice 2023-12, the IRS announced that the December 2022 one-month average interest rates are as follows:

• 4.84% for benefit payments to be made within five years of the valuation date
• 5.15% for benefit payments to be made five to 20 years from the valuation date
• 4.85% for benefit payments to be made more than 20 years from the valuation date

Note that the above interest rate structure is called “segment rates” and is used when discounting future pension payments back to a valuation date for funding and PBGC premium purposes. To save space the above interest rates are referred to using the following format: 4.84%/5.15%/4.85%. These are the standard method interest rates for a calendar-year plan in 2023.

In the same notice, the IRS also announced that the 24-month average interest rates for the period ending December 2022 (which the IRS labels the January 2023 rates) are 2.13%/3.62%/3.93%. For a plan with a zero-month look-back period, they are the alternative method interest rates for 2023. As you can see, they are significantly lower than the standard method rates for 2023. This is due to the steep rise in interest rates that occurred in 2022, which are fully reflected in the standard method rates but are still being phased into the alternative method rates.

Lower interest rates result in higher liability measurements for plan sponsors, meaning larger measures of unfunded liabilities, meaning larger variable-rate premiums. The table in Figure 1 shows an example of how the standard and alternative methods could affect the 2023 PBGC variable-rate premiums for a sample plan.

In this sample plan, use of the standard method in 2023 will produce liabilities that are 15% lower than those from the alternative method. The exact difference will vary by plan, but most will see differences of around 10% to 20% in 2023. For this plan, that 15% reduction in liabilities results in PBGC premium savings of $1.6 million under the standard method as opposed to the alternative method.

For plan sponsors that have the option to switch from the alternative method to the standard method in 2023, there are significant savings to be seen. However, making this switch locks the plan sponsor into the standard method for the next five years. If interest rates fall over this period, then the savings seen in 2023 could be wiped out by higher PBGC premiums in future years. Given uncertainty about future interest rates, when is the right time for a plan sponsor to switch methods and lock themselves in for the next five years?

For plan sponsors that are locked into the alternative method due to switching within the past five years, check out "How pension plans can reduce their PBGC premiums using the full yield curve" for another option to achieve savings on par with switching to the standard method.

Determining an optimal strategy for when to switch between standard and alternative methods

The first thing to note is that, following a rise in interest rates, the standard method will produce lower premiums, and, following a fall in interest rates, the alternative method will produce lower premiums. Thus, if the plan sponsor, or its advisors, have a strong opinion that interest rates are going to trend a certain direction, then that should guide the decision of whether to switch PBGC methods. However, predicting changes in interest rates can be difficult, so an alternative approach is to view interest rate changes as a random variable and perform Monte Carlo simulations.

The table in Figure 2 shows an analysis of interest rates over the past 20 years for a calendar-year plan with a zero-month look-back period (as if the current law was always in effect).

As you can see, the differences between the standard and alternative methods have ranged from the standard method giving liabilities around 11% higher in 2021 to the standard method giving liabilities that are about 15% lower in 2023. For purposes of this Monte Carlo simulation, a simplifying assumption has been made that future differences in liabilities will be normally distributed with a mean of 0% and a standard deviation of 6.3% (the standard deviation of the above 20-year sample). Then 1,000 sets of 20-year trials were simulated. In each 20-year trial the plan sponsor starts off with the alternative method in year 0 and is eligible to switch in year 1. The question to answer is, “How large a liability difference is necessary to warrant using the once-per-five-year election to switch from the alternative to the standard PBGC premium method?” To answer this, various thresholds were tested, for example a threshold of 2%. Thus, in any year in which the plan sponsor was eligible to switch methods, the plan sponsor would do so if it resulted in a decrease in its PBGC premium liabilities (aka savings) of more than 2%. Any less than that, and the plan sponsor would stick with its current method. This resulted in average liability savings of 0.88% per year (compared to never switching methods). Various other thresholds were also tested. The table in Figure 3 summarizes the results.

Based on the simulation parameters, the optimal strategy is to switch PBGC premium methods whenever the liability savings in that year are at least 4%. Doing so will result in PBGC premium liabilities that are on average 0.95% lower than never switching methods. Applying this to the sample plan from the prior section, following this strategy would lower PBGC premium liabilities by about $2.0 million, which translates to a PBGC variable-rate premium savings of about $0.1 million per year compared to never switching methods.

A couple other observations from these simulations:

• While this strategy produced the highest savings on average, it doesn’t guarantee savings every year. There is plenty of variance on a year-to-year basis. For example, looking at the 5th and 95th percentile results shows that some years the liabilities were 9.5% lower than never switching methods, while in others the liabilities were 6.4% higher.
• There isn’t much difference in the savings for any threshold between 1% and 6%; all result in average savings of 0.85% to 0.95%.
• The difference in 2023 of 15.1% is way above any logical threshold derived from this analysis.

Other considerations

The simulations above are admittedly quite simplified. For example, it was assumed that the difference between the standard and alternative method liabilities from year to year are independently distributed random variables, when, clearly, they are going to be correlated from year to year because one is a two-year average. The focus was on a straight average of savings, with no accounting for changes in the magnitude of unfunded liabilities over time or assigning different time values of money to savings based on how far into the future they occur. Interest rate changes are often accompanied by swings in asset values as well, but this analysis focused just on the liability side.

Following are some additional considerations:

• Many plans with an unfunded PBGC liability are on a track to improve their funded status (either through contributions or through investment returns). For plans in this situation, their unfunded PBGC liabilities will reach zero down the road. At which point, their PBGC premium methods are no longer relevant. This would encourage plan sponsors to prioritize achieving short-term PBGC variable-rate premium savings while they still have a variable-rate premium (aka pick a lower threshold for switching methods).
• Some plans will hit the PBGC variable-rate cap in some years under one or both methods. This cap effectively lowers the standard deviation of the PBGC premium differences between the two methods, which would incentivize use of a smaller threshold.
• This analysis assumed no changes in statutes or regulations affecting PBGC premiums. Given the possibility of and uncertainty around future changes, this could encourage plan sponsors to prioritize achieving guaranteed short-term PBGC variable-rate premium savings and pick a lower threshold for switching methods.
• Volatility of PBGC premiums may be of concern to some plan sponsors. In our experience, most plans pay PBGC premiums out of trust funds, and so are more concerned with long-term savings than year-to-year volatility. However, some (especially plan sponsors that elect to pay PBGC premiums out of company funds) do more heavily prioritize stability of PBGC premiums. For these plan sponsors, whether the alternative or standard method is less volatile will depend on the investment strategy of the plan.
• For plans that are using liability-driven investment (LDI) strategies that use long-duration fixed income investments to hedge against the impact that interest rates have on liabilities, the standard method will produce PBGC premium liabilities that more closely track assets and thus will likely produce less volatile PBGC premiums.
• For plans that are using a more traditional investment strategy, without significant hedges against interest rate changes, the alternative method will likely produce less volatility in PBGC premiums due to the 24-month averaging of interest rates.

Conclusion

Strategically switching PBGC premium methods every few years can be a good way to save on PBGC premiums, and the analysis in this paper showed that there’s not much need to wait for the perfect time. Even if you switch when there’s only a 1% difference in the PBGC liability, you’re still within 0.1% of the average savings seen through the “optimal strategy” from those simulations. And considering that almost all the other considerations here incentivize prioritizing short-term savings, this further encourages the use of a small threshold.

So what’s the answer to the original question, “Given uncertainty about future interest rates, when is the right time for a plan sponsor to switch methods and lock themselves in for the next five years?” The answer is going to vary by plan, but, in general, it appears that the optimal strategy is to switch whenever there’s any significant savings to be had. Focus on short-term savings and don’t let fear of the five-year lock-in period keep you from switching in a good year. Of course, all this nuance is rather moot this year, because 2023 is a great year to switch to the standard method.

Caveat

Individual plan and plan sponsor circumstances will vary. Plan sponsors are encouraged to consult with their actuaries before making any decisions around PBGC premiums.