Even before the COVID-19 crisis struck, pension plans were bracing for major funding challenges heading into 2021. Funding relief for pension plans in the form of interest rate stabilization was scheduled to begin phasing out that year. Plummeting asset values and further declines in interest rates as a result of COVID-19 have significantly exacerbated the problem.
These conditions have put added stress on plans to maintain appropriate funding levels. Plan sponsors expect cash funding obligations to increase 98 percent in 2021, according to an April survey by the American Benefits Council (ABC). Additionally, the 703 companies surveyed by ABC expect to tack an additional $9 billion onto their expected contributions as a result of the current economic crisis and certain funding rules.
While the Coronavirus Aid, Relief and Economic Security (CARES) Act passed in March provided some relief for plan sponsors related to contribution and filing deadlines, the law did not address delaying the scheduled phasing out of interest rate stabilization rules. Groups like ABC are lobbying Congress for an extension, but until things change, plan sponsors should be aware of how legal and economic changes affecting the funding environment could affect their plans.
Interest Rate Stabilization Coming to an End
A 2012 law called Moving Ahead for Progress in the 21st Century, or MAP-21, has provided a significant measure of relief for pension plans by stabilizing interest rates for the past eight years. The law was designed to smooth out the impact of low interest rates, which increase liabilities and therefore force employers to increase contributions.
Instead of using a 24-month average of high-quality corporate bond rates, MAP-21 allows plan sponsors to use a funding rate equal to a 25-year average of high-yield corporate bonds multiplied by 90 percent. The multiplier in this rule, however, is set to decrease to 85 percent in 2021 and then drop five additional percentage points each year until the multiplier reaches 70 percent in 2024. In addition, the average 25-year rate will continue to decrease as older, higher rates leave the average and lower, more recent vintages enter. Together these changes will result in larger unfunded liabilities for plan sponsors, which will then require greater funding levels.
This is coming at a time when pension funds are dealing with portfolios that have eroded in value and operating profits that have been cast into uncertainty because of the COVID-19 crisis. It adds up to a situation that will make it difficult for many plan sponsors to meet their funding obligations.
Implications of Falling Funding Levels
A decrease in a pension plan’s funding level can have major implications for the plan and its participants. The Pension Benefit Guaranty Corp (PBGC), which serves as the insurance company for defined benefit plans, requires all single-employer plans to pay a flat-rate premium based on the number of plan participants. Underfunded plans pay an extra variable-rate premium based on the amount of unfunded vested benefits. In 2020, the flat rate is $83 per participant, and the variable rate is $45 for every $1,000 of unfunded vested benefits; this is capped at $561 per participant.
Plans whose funding levels fall below 80 percent face additional restrictions when it comes to lump-sum payouts. Plans that are between 60 percent and 80 percent funded are limited to paying out only half of a payable lump sum. Plans that are less than 60 percent funded are prohibited from paying out any lump sums. Lump sums that are $5,000 or less may be paid in full. Participants must be notified within 30 days of when the restriction goes into effect, as well as when it is lifted.
Meanwhile, the PBGC requires pension plans and their sponsoring companies to notify the PBGC when certain events affect the plan. Reductions in active participants, missed required contributions and inability to pay benefits are all scenarios that many plan sponsors may experience in the near future that the PBGC will want to know about. In addition, layoffs may result in a partial plan termination, which entails a host of considerations and requirements that plan sponsors need to be aware of.
Insight: Don’t Let COVID-19 Overshadow Other Changes on the Horizon
The impact of the COVID-19 pandemic on pension plans has been substantial. But the crisis shouldn’t distract plan sponsors from other major changes on the horizon that could significantly affect funding levels. While the CARES Act delayed contribution payments, it didn’t extend the current interest rate stabilization regime, which has relieved funding issues for pensions over the past decade.
Several lobbying firms are working to address this, but plan sponsors should work closely with their service providers to stay on top of how future obligations may change.