Many pension plan sponsors are facing a decision on the methodology of calculating the premiums payable to the Pension Benefit Guaranty Corporation (PBGC) that may result in significant savings. PBGC premiums are made up of variable rate and flat rate premiums. Variable rate premiums are based on unfunded vested benefits (UVB). In 2014, many plan sponsors are eligible to change the methodology used to calculate their plan’s UVB. The question is: should they make the switch?
The UVB is determined by the amount that the vested liability, called the premium funding target, exceeds the fair market value of plan assets. The required variable rate premium for 2014 is $14 per $1,000 of UVB and is scheduled to increase to $24 in 2015 and $29 in 2016. The PBGC allows plan sponsors to determine UVB for purposes of calculating the variable rate premium by either:
• Using the three spot segment rates for the month preceding the month in which the plan year begins (standard premium funding target)
• Using the 24-month average segment rates as of the plan’s previously elected look-back period (alternative premium funding target)
Many plan sponsors elected for 2009 to switch to using the alternative premium funding target to avoid the volatile and low spot interest rates basis for the standard premium funding target.
Plan sponsors making the switch are locked into it for five years. After five years, the plan sponsor can switch again. If the plan sponsor doesn’t make a switch, they can stay with the current method as long as they like.
Five years later, plan sponsors who elected in 2009 to switch to using the alternative premium funding target are eligible to switch back to using the standard premium funding target. For calendar year plans, plan sponsors would need to do this in time for the PBGC premium due date of October 15, 2014. With the rise in interest rates that occurred during 2013, plan sponsors are asking themselves if they should make the switch during 2014.
To answer this question, consultants can estimate the variable rate premium amounts under both options for both the 2014 and 2015 plans. Does the plan sponsor save over the course of two years by switching methods?
Let’s look at an example for a sample plan with a UVB of $14.90 million under the alternative method and $9.75 million under the standard method for 2014:
For a calendar year plan, rates used for the standard premium funding target in 2014 are generally higher than the rates used for the alternative premium funding target; therefore, in this example, the standard premium funding target results in a lower variable rate premium for the 2014 plan year by $72,000.
Although interest rates for determining the alternative and standard premium funding target for the 2015 plan year are not yet available, if we assume the rates currently in effect stay constant through the end of the year, rates used for the alternative premium funding target are generally higher than the rates used for the standard premium funding target for the 2015 plan year. Assuming these rates are still in effect for the 2015 plan year, most plans will have a smaller premium funding target under the alternative method for 2015, resulting in a lower variable rate premium. In our example, the alternative method election would produce a more favorable result in 2014 by an amount of $33,000.
Therefore switching in 2014 to the standard premium funding target would result in a projected net savings of $39,000 over the two-year period.
Just remember, the standard method uses volatile spot interest rates. If there is another dip in the market, the plans may face higher costs under the standard premium funding target method and won’t be able to switch back to the alternative premium funding target until 2019. However, they will be happy they switched if interest rates rise but that of course is anyone’s guess!