As part of the Pension Protection Act of 2006 (PPA), plan sponsors have two options for calculating their “unfunded vested benefits” (UVB) to determine the variable premium owed to the Pension Benefit Guaranty Corporation (PBGC) each year. The amount by which the vested liability, called the funding target, exceeds the fair market value of plan assets determines the plan’s unfunded vested benefits. The required variable premium for 2014 is $14 per $1,000 of UVB.
The plan’s UVB is determined under one of two different methods: The standard premium funding target or the alternative premium funding target.
So what’s the difference?
The only difference in the two methods is the discount rate used. All other assumptions (mortality, turnover, etc.) are the same for both calculations. However, the discount rate plays a vital role in determining the plan’s funding target.
The standard premium funding target is the default method. The discount rate used for the calculation of the standard method is based on spot rates for the month prior to the plan year (i.e., a one month of average of such rates).
The alternative premium funding target is the other method. The calculation of the alternative method is based on the rates used to calculate a plan’s funding target for the premium payment year, before reflecting Moving Ahead for Progress in the 21st Century Act (MAP-21) stabilization rules. Typically, the discount rates used for the purpose are a 24-month average of the current spot rates.
When a plan sponsor elects to switch from one method to the other, they are locked into that election for five years.
Why is this important for 2014?
In a declining interest rate environment, as we experienced from the end of 2008 through the beginning of 2013, the trailing 24-month average produces higher interest rates than current monthly spot rates. Higher discount rates produce a smaller plan liability for PBGC purposes, resulting in smaller variable premiums. Many plan sponsors who had underfunded plans in 2009 elected to move to the alternative method. Over the past 12 months, we are in an increasing interest rate environment, making current monthly spot rates higher than a 24-month average.
So the question becomes: is 2014 the year to switch back to the standard method? Depending on funding status of the plan, it could decrease variable premiums by a significant amount. With the passage of the budget accord, as stated in Tim Herman’s blog, the amount of variable premiums is expected to increase significantly over the next few years. If the plan sponsor believes interest rates will continue to rise or stay flat over the next couple years, it may be time to make the switch. The flip side is that, if you switch and interest rates decline, you could be required to pay higher PBGC premiums and would be locked into this method for five years.