PLAN SPONSOR UPDATE - Northern Trust

PLAN SPONSOR UPDATE

Managing funding and PBGC variable-rate premiums in a volatile interest rate environment

The following chart compares historical and projected 25-year average Highway and Transportation Funding Act (HATFA), 24-month average, and spot rates for a typical pension plan, reflecting changes in market interest rates through the end of August 2019.

We note that rates are currently at (literally) historic lows. The utility of the projections in this chart very much depends on whether these conditions will persist. The significance of the July-August rate declines for DB plans The last time we reviewed interest rates and funding (November 2018), we projected (based on November 2018 market interest rates) that HATFA interest rate stabilization (backward looking 25-year average rates) for many plans would "expire" in 2022, and that after that date spot or 24-month average segment rates would be higher than HATFA interest rate relief.

September 2019

SUMMARY In this article we review the issues that record low interest rates present for defined benefit plan sponsors and strategies sponsors can adopt to deal with them. Our focus is primarily on reducing Pension Benefit Guaranty Corporation variable-rate premiums, with respect to which many sponsors will have options.

PLAN ADVISORY SERVICES Northern Trust is dedicated to helping you succeed in today's fast-changing environment. We are pleased to offer access to this publication from Plan Advisory Services, to share developments that may be of interest.

FOR MORE INFORMATION Additional Plan Sponsor Update articles are available at the following link on :

Insights and Research .

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Since November 2018, long-term corporate rates have dropped 150 basis points. For a plan with a typical duration, that decrease in rates will result in a 20% increase in market liability valuations. These interest rate declines also, as the chart indicates, extend the period during which HATFA interest rate stabilization/relief will apply, to around 2028. That is generally bad news for DB plan sponsors ? during the period 2021-2024 HATFA relief is progressively reduced from 90% (in 2020) to 70% (in 2024 and after) of the 25-year average.

The bottom line: if current rates persist, many (traditional) DB plan sponsors will in the long run have to put more money into their plans to fund benefits.

While HATFA provides continued minimum funding relief, many sponsors will focus on reducing PBGC variable-rate premiums

Currently (and until 2021), however, HATFA interest rate minimum funding relief is robust (at 90%). In that context, the primary incentive for plan funding is the high level of PBGC variable-rate premiums.

Variable-rate premiums are (subject to a per participant headcount cap) determined as a percentage (4.3% for 2019) of the plan's unfunded vested benefits (UVBs). UVBs reflect net underfunding using liabilities valued based on spot or 24-month average rate valuations, not HATFA rate valuations. Thus, variable-rate premiums function as a 4.3% "tax" on underfunding (determined on something approximating a market basis), even for plans that are, because of HATFA interest rate relief, "fully funded" for ERISA minimum funding purposes.

Valuing UVBs for 2019 ? spot vs. 24-month average rate election

Sponsors may choose between using end-of-prior-year spot or 24-month average segment rates to value UVBs. For 2019, this choice will be particularly significant, because interest rates went up significantly during 2018. Once a particular method (spot or 24-month average) is elected, however, the sponsor can't switch to the other method for five years. So this decision should generally be made with a view to (among other things) the expected behavior of interest rates over the medium-term.

Table 1 ? 2019 variable-rate premium calculation: spot vs. 24-month average rates (December 2018 lookback month)

December 2018 24month average rates December 2018 spot rates

1st Segment 2nd Segment 3rd Segment

2.50%

3.92%

4.50%

3.38%

4.32%

4.69%

Difference

0.88%

0.40%

0.19%

Because of the higher 2019 UVB valuation rates under the spot rate

method, we estimate that a plan using it, with a typical duration, will have

liabilities 2%-6% lower than if it uses the 24-month average method. For

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a plan with a typical duration that is 80% funded using 24-month average segment rates, switching to spot rates could reduce PBGC variable-rate premiums by around 20%.

There is, however, a problem with such a strategy. As noted, a sponsor making a 24-month-average-to-spot-rate switch for 2019 variable-rate premiums is stuck with the spot rate method for five years. If rates continue at their current levels for the rest of 2019, spot December 2019 rates, applicable to the 2020 variable-rate premium calculation, are likely to be significantly lower than 24-month average rates.

This election generally must be made (for a calendar plan) by October 15, 2019.

Longer term strategies

For the longer term, sponsors will want to consider broader strategies for reducing PBGC variable-rate premiums and for maximizing the efficacy of funding. These strategies will often depend on what sort of plan you have and (critically) on the plan's funded status.

1. Plans that are fully funded on a non-HATFA basis. Sponsors of plans that are fully funded without regard to HATFA interest rate stabilization generally will not owe any PBGC variable-rate premium. 2019 interest rate declines will, however, if they persist, affect this "non-HATFA" calculation, and some sponsors who are in category 1 for 2019 may drop down to, e.g., category 2 for 2020. This calculation will, in addition to interest rate declines, be affected by (among other things) asset performance and contributions.

2. Plans that are fully funded on a HATFA basis but not on a non-HATFA basis. Sponsors of plans that are only fully funded if you apply the HATFA interest rate stabilization rules generally will owe PBGC variable-rate premiums. Sponsors of these plans may want to consider a borrow-andfund strategy, the cost of which in many cases may be less than not funding and instead paying the PBGC variable-rate premium ? projected to be at least 4.4% of UVBs in 2020.

3. Plans that are not fully funded but are at least 80% funded on a HATFA basis. Sponsors of these plans generally can reduce PBGC variable-rate premiums by accelerating the next year's quarterly contributions, treating those accelerated contributions as for the current funding year. Doing that accomplishes two things: (1) it creates a credit balance that can be used to satisfy the next year's contribution obligations; and (2) it reduces the plan's UVBs and thus the PBGC variable-rate premium obligation for the current year. Indeed, a sponsor may want to consider this strategy with respect to any contributions it intends to make in the relatively near future.

4. Plans that are not 80% funded on a HATFA basis. The acceleration strategy described in category 3 is generally not available to these plans. That is because that strategy depends on using a credit balance to satisfy

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future funding obligations, and a plan must be at least 80% funded to do that.

Plans in this group (as well as some plans in the previous group) are, however, often subject to the variable-rate premium cap, and sponsors of these plans may want to consider reducing variable-rate premiums by settling liabilities via lump sum windows and/or annuity purchases.

These headcount cap reductions can be very valuable. The combined premium (per participant premium + variable-rate premium headcount cap) for a single participant is likely to be around $640 in 2020, increasing per year thereafter. Given the drop in rates this year, some plans may find their premiums limited by the cap for many years into the future, increasing the reward for reducing headcounts now.

* * *

We will continue to follow these issues.

In the long run, lower interest rates mean, for most traditional DB plans, more funding. The challenge for sponsors will be to efficiently manage that funding, and related lump sum/annuity purchase de-risking, to reduce as far as possible the PBGC variablerate premium "tax" on underfunding.

Plan Advisory Services is solely responsible for the preparation and content of this publication. Northern Trust Corporation assumes no responsibility for this content. Neither Northern Trust, Plan Advisory Services nor any of their affiliates has verified the accuracy or completeness of any information set out or referred to above. Northern Trust, Plan Advisory Services and their affiliates shall not have any liability for any use of the information set out or referred to herein.

The information, analyses and opinions set out herein are for general information only and are not intended to provide specific advice or recommendations for any individual or entity. Nothing herein constitutes or should be construed as a legal opinion or advice. You should consult your own attorney, accountant, financial or tax advisor or other planner or consultant with regard to your own situation or that of any entity which you represent or advise.

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