Long Story Short – The Environment to Settle Benefit Obligations Has Improved for 2023
2022 opened with very high stock prices and low interest rates. Thanks to some chaos in the bond, treasury, and equity markets during 2022, the nominal and relative costs for plan sponsors to settle inactive participant liabilities has dropped for 2023. At the same time, flexibility in limiting asset/liability volatility has improved thanks to fixed asset rates that allow sponsors to back liabilities with fixed assets without getting stuck with extremely low rates of return.
The two most common options for settling liabilities are:
- offering lump sum payments to inactive participants in payment or not yet in payment, or
- transferring obligations to an insurer by purchasing a group annuity contract
Given the amount of negative market news focused on investment losses, this may seem counterintuitive, but the explanation is simple. The cost to settle liabilities via lump sums or group annuities has gone down faster than most plan trusts. Considerations for plan sponsors are provided next, to be followed by a more detailed discussion of why the environment has changed and how declining assets under current circumstances could present an opportunity.
What should plan sponsors do?
If settling inactive liabilities is attractive, sponsors have several options in the near term:
- Consider one-time lump sum offers for inactive participants, in payment or not yet in payment
- Consider settlement by transferring inactive liabilities out of the Plan to a group annuity
- If the timing is not right for the prior options, consider working with the plan actuary and investment consultant to determine if there are investment strategies that would lower or eliminate risk and still meet sponsor objectives
Not all sponsors have the same plan year, and not all sponsors have fixed lump sum rates for a full year, and of course not all sponsors have the same plan objectives or resources. Sponsors should review their individual circumstances and work with plan professionals to develop a plan of action.
And that is the most important message here—consider analysis and tidying critical data now so that fast and accurate decision making can take advantage of market opportunities. Awareness and consideration often seem suitable, but there are often multiple stakeholders or the need for analysis that is more complex than expected, and the fast increase in rates in late 2022 occurred more quickly than most sponsors could react.
Sponsors should consider analysis how each of the following is affected by settling obligations or reducing risks:
- Cash contribution requirements
- Certain administrative expenses
- Financial accounting, including potential significant one-time charges or credits
- Funding percentages that affect whether accelerated benefit payments or amendments can be made
- Avoiding certain reporting triggers based on funded status
Opportunities may last days or weeks when rate change significantly. For example, in 2022, rates climbed steadily and then steeply in a period that lasted only several weeks. As of the date of this article, the environment is still favorable compared to prior years, but slightly less so than it was for sponsors able to act several months prior.
What Made Early 2022 Less Favorable than 2023?
Simply put, assets were high. Bond rate-based cost to pay lump sums or annuitize benefits were even higher on a relative basis due to low interest rates. There was an appropriate amount of fear that equities could decline without improvement in the interest rate environment, but fear of an eroding environment did not outweigh the costs at the time for most sponsors.
A typical calendar-year plan with a two-month lookback for lump sum rates saw effective interest rates between 2.75% and 3%. The effective cost of settling a typical retiree group via a group annuity purchase was 50-100 basis points lower, with some group annuity purchases hovering below 2%. The lower the rate against a fixed set of assumptions, the higher the cost.
At the same time, the Dow average for equities opened the year at nearly 37,000. The situation was much like finding yourself with an unexpected bunch of money and nowhere reasonable to spend it.
For most sponsors, the established lump sum rates are locked in for the full plan year. The environment was tricky for two reasons. First, sentiment that equity valuations were out of line was strong among investment consultants, even if some sponsors were bullish. Near and intermediate term expected returns lagged longer term expectations by several percent. The second reason is that as high as equities were, selling equities to annuitize benefits was still projected to increase contribution cost for sponsors in most scenarios.
The last option, mitigating risks by linking assets and liabilities closely would just lock in the high expected costs. And that would have been the case relative to this year as a dedicated bond portfolio locked in first quarter 2022 would have suffered enormously when rates rose later in the year.
And Later in 2023, Rates Rose, Assets Declined and Settlement of Plan Liabilities Actually Benefited in the End
The fear of most investment consultants was that the equity markets would decline. Fed guidance suggested that inflation was transitory, but few who considered the factors driving it felt it would be. Would it be allowed to continue indefinitely? The answer was no, even if it was a delayed no. Equity values were built on unreasonable growth expectations that would later lead to equity declines. The Fed increased interest rates and the bond market reacted significantly with increased bond rates and a lot of volatility.
When this is viewed in a vacuum, the result is seemingly very poor for defined benefit plans. Nearly every investment vehicle other than cash dropped in value. However, the bond rates rose so much through late fall that the overall relative costs of settling plan liabilities have dropped.
The explanation as to how this could occur is that most plan settlement, or de-risking options, move with long-term fixed assets that fare very poorly when interest rates increase. When de-risking the Plan is offering payment to relieve itself of an obligation that is similar to long term bonds. If long term bonds fare worse than most other plan assets, the actual cost of settlement to the plan sponsor is reduced.
Sticking with our calendar year plan, recall that the effective rates reflected in lump sums were 2.75%-3%. And for plans that adjust annually, as the bond rates rose well above 5%, the lump sum rates remained unchanged. Comparing plan assets to liabilities, this is not a good trade. While lump sums remain steady through the year, matching fixed assets would have declined 30% or more. With the new year, 2023 costs for the same plan are based on higher November 2022 rates, and a typical effective rate for lump sum payments to most participants tends toward 5.5% effective. The interest rate effect alone may reduce a typical plan’s lump sum costs by the same factor of 30% or more.
As of the date of this article, the group annuity costs have moved similarly, though those costs are set by the market and not by plan terms, so the actual effective cost will be continuous.
What that means for sponsors is that if 2023 lump sums are favorable enough to consider a one-time lump sum offering to inactive participants, there is also a chance that turmoil in the fixed asset markets may make an annuity transfer as or more attractive than lump sums. This leads back to assuring that the plan’s data is clean and correct and that analysis and what-ifs have been studied ahead of time.
Next Steps
At the beginning of this article, we discussed what plan sponsors should do. What is key is ensuring that plan data for inactive participants is absolutely complete and accurate to a very high standard, and contacting plan professionals to prepare analysis identifying when to take action and what action to take. Finding good market conditions and addressing these later may simply just lead to a very significant missed financial opportunity.
Contact Cowden for more details.