The COVID-19 pandemic has had a dramatic effect on economic markets. Two years ago at IAI, we posted a blog illustrating the potential impact of rapidly decreasing interest rates on pension plan benefits—now, with the Federal Reserve battling inflation, interest rates are rapidly increasing! For plans terminating soon, higher interest rates might present issues which should be addressed.
When defined benefit pension plans terminate, a common choice for participants is to rollover their accumulated annuity benefit into an IRA as a lump sum. When interest rates go up, the corresponding lump sum amount goes down. In many cases the interest rates used in the calculation are required minimum value rates published by the IRS. In June 2021 these mandatory rates were 0.63%, 2.70%, and 3.32%—one year later in June 2022 these rates are 3.64%, 4.80%, and 4.78%. Depending on the age of the participant, a lump sum based on current IRS interest rates might only be between 50% – 80% of the previous value.
For participants who don’t elect a lump sum at plan termination, an annuity contract is typically purchased from an insurer—and interest rates also determine the cost of annuities! A typical range of annuity rates a year ago was between 2.15% – 2.60%, and now that range has increased to 3.35% – 3.75%. Just like with lump sum amounts, the result of higher rates is a lower cost of annuity purchase.
While lower employee cost at plan termination (the total amount distributed as lump sums plus the cost of annuities purchased) might seem like a good thing, there is a potential downside. If a defined benefit pension plan sponsor has been funding their plan at levels near the maximum allowed, or if the plan investments have had high returns, the recent increase in interest rates may cause the employee cost to be much less than the plan assets. In such a situation the plan is said to be “over-funded”. If excess assets exist after the plan pays all benefits, the reversion of assets to the employer is subject to significant excise taxes.
The good news is that there are strategies to resolve the problem of plan over-funding! For example, for many of our clients we have designed the plan in such a way that the lump sum amounts available are not based on fluctuating interest rates.
If you are a plan sponsor who has been considering plan termination sometime soon, the first step is to contact your IAI consultant to learn whether you may be affected by the current rising interest rate environment.