Reducing PBGC premiums in 2024 (and 2023) – smoothing vs. mark to market

For 2023, the method you used to determine plan underfunding and PBGC variable rate premiums – mark to market vs. 24 month smoothing – had a dramatic and unprecedented effect on how much premiums you paid in 2023. Sponsors that did not or could not elect (in 2023) a market rate still have the ability – on their 2023 5500 filing (generally due October 15, 2024) – to use a market rate for 2023 and get a refund of their premium overpayments.

In this article we explain why sponsors should seriously consider doing this and how to do it.

Because of the steep increase in interest rates in 2022, using market rates meant dramatically lower liabilities/UVBs/premiums for 2023. It’s impossible to overstate how consequential this decision was – the spread between liabilities/premiums for plans using market rates vs. those using smoothing was truly unprecedented – for many (larger) companies the difference in what they had to pay (in cash out of pocket) to PBGC was millions of dollars.

Companies that did not or could not elect the market rate effectively overpaid 2023 PBGC premiums – in some cases by millions of dollars. We believe that the savings from moving from a smoothed to a mark to market UVB/PBGC premium calculation for 2023 are so extraordinary that those companies that did not switch to market rates for the calculation of UVBs should simply move to mark to market for 2023 for all purposes – funding and PBGC premium calculation. If they make that election on their 2023 Form 5500 (generally due to be filed October 15, 2024), they will be able to get a refund those 2023 premium overpayments.

In what follows, we first describe why sponsors should do this, and then we describe how – even though the deadline for 2023 PBGC premium calculation has passed – they can still use mark to market interest rates to calculate 2023 premiums, thereby getting a refund of what in some cases will be millions of dollars in 2023 premium overpayments.

Why: Premiums spike in 2023 due to inflated liabilities – but not for plans using or switching to the Standard/mark to market method

The (smoothing-driven) “inflation” in plan liabilities for plans using the Alternative method resulted in huge increases in variable premiums for hundreds of plan sponsors, including many that were fully funded on a market basis.

Total VRPs, which had fallen from a high of $4.5 billion in 2019 to $2.8 billion in 2022 on the strength of improved pension finances, spiked in 2023 to $3.7 billion.

And it could have been a lot worse. Most plans that were able to switch to the Standard method in 2023 did so (more than 850 plans made the switch in 2023, reducing total premiums by $900 million). But at least another 60 plans that could have reduced premiums by $120 million missed this opportunity.

That election – switching to the “Standard” method for calculating UVBs for 2023 – had to be made (for most plans) by October 15, 2023. And at least 60 plans missed that deadline. Hundreds of other plans were unable to switch because of the five-year restriction on switching methods noted above. PBGC premium overpayments by these plans are why, even though on a market basis plan funding improved significantly in 2023, PBGC got an extra billion dollars in (overpaid) premiums.

How: The 2024 Plan B for sponsors who did not/could not switch to the Standard method in 2023

The good news is that there is a ‘Plan B’ available to almost all those sponsors, allowing plans to recalculate 2023 premiums based on 1-month average valuation interest rates rather than the (much lower) 24-month average rates. How? By opting out of the relief/smoothing funding regime altogether – that is, not just for PBGC variable premium calculations but also for minimum funding calculations – as part of the plan’s 2023 Form 5500 filing. For most plans, the filing date for the 2023 5500 is October 15, 2024.

Plans that take this approach give up, for ERISA minimum funding, 25-year smoothing of interest rates – the “interest rate relief” that has cushioned many plans from high liability valuations in prior years when valuation interest rates were at historically low levels – as well as 24-month smoothing available under the Pension Protection Act of 2006. Given the current interest context, however, that “give back” amounts to giving back the “sleeves from your vest” – moving to mark to market presents, in the near term, little-to-no risk of a net increase in PBGC premiums or significant net increased minimum funding demands.

We have identified 600 plans that were “stuck” with the Alternative method for 2023. 200 of these plans already “opted out” of the relief/smoothing regime in connection with their 2023 PBGC premium filing, saving $660 million in 2023 premiums. That leaves another 400 plans that could still opt out, potentially recovering $700 million in 2023 premiums. (Through August 27, at least 10 of these plans have elected to opt out, generating refunds of $50 million, and many of the remaining plans are currently reviewing this option.)

Living in a mark to market world

Moving to mark to market doesn’t change outcomes in the near term. As noted, unlike the five-year Standard vs. Alternative election (which only affects the calculation of PBGC VRPs), the 2023 5500 election we’re describing also affects ERISA minimum funding calculations. Because of the increase in interest rates during 2022, however, that election will not have a significant effect on 2023 or 2024 minimum funding requirements.

The chart below shows the path of effective interest rates for a typical plan using 1-month average (“market”) rates, 24-month average rates, and the funding relief 25-year average “floor” on rates. During 2012-2022, funding relief (the 25-year average floor – the green line) allowed sponsors to use interest rates consistently 200+ basis points above market rates, understating liabilities by 30% for a typical plan, substantially reducing required contributions and increasing FTAP/AFTAPs.

By 2023, that 25-year average rate-floor and market rates – which had climbed to 5% and remained at or near this level since – had converged. Thus, many plans will be able to opt out of smoothing/interest rate relief without triggering a negative impact on near-term FTAP/AFTAPs or funding requirements. Indeed, as noted, hundreds of plans have already taken that option.

Decision point

Sponsors that stayed on the Alternative method for 2023 are thus confronted with a decision. The amount of money at stake for 2023 is, in many cases, extraordinary. We think the benefits of switching to mark to market clearly outweigh the cost. Here’s why:

• There is a lot of money at stake. The 2023 penalty from the PBGC Alternative method (15%-25% liability overstatement) is unprecedented, more than twice as significant in dollar terms as any previous year and unlikely to be seen again. Unsurprisingly, more than 1,000 plan sponsors have already taken steps to avoid this penalty.

  • The 2024 penalty from the PBGC Alternative method is less dramatic than 2023 (5%-10% liability overstatement), but it translates to substantial additional savings for sponsors that opt out in 2023 (unless they are overfunded.)

• The “give back” in future increased minimum funding/PBGC premiums, in the near term at least, looks marginal. Based on current rates, underfunded plans that opt out of smoothing are expected to “give back” about half of any 2024 PBGC premium savings in the next two years (2025 and 2026), but any higher premiums in future years, if they materialize, will almost certainly be a fraction of the (known) 2023 refund.

  • Private pension plans are currently as well-funded as they have been this century. Many well-funded plans electing mark to market treatment are unlikely to owe any variable premiums in the future, and other plans that continue to fund shortfalls may reach full funding by 2025.

  • Smoothing is generally not helpful to plans with a significant liability driven investment (LDI) (interest rate-hedged) component, because these plans invest assets explicitly to track market-valued (1-month average) liabilities.

• PBGC premiums are real money, funding is (generally) cash flow. We note that the premium savings (from opting for mark to market treatment) is real money – PBGC premiums are in effect a tax – increases/reductions in premiums go right to the bottom line. Theoretically, increases in minimum funding (resulting, e.g., from future interest rate decreases) simply go to pay benefits which will, at some point, have to be funded anyway.

• Changing back to smoothing, for funding and premiums, is not guaranteed but is possible. Unlike the Standard vs. Alternative election, there is no guarantee that plans opting out of smoothing for funding purposes will be able at some point in the future to go back to smoothing – either for funding or for calculation of PBGC premiums. We note, however, that IRS has a long history of approving changes in funding method after a suitable interval (4-5 years). Our research has identified 32 plans that, based on Form 5500 reports, received IRS approval to “move back” to relief smoothing since 2013, sometimes in as little as three years after the original opt out election. Not surprisingly, many sponsors are making inquiries of IRS around expected guidance in this area this summer.

Bottom line

More than 1,000 plan sponsors have already reduced their 2023 variable premium cost by over $1.5 billion, by either electing to switch to the Standard method (in 2023) or by (subsequently) moving from smoothing to mark to market liability valuation.

At least 400 other plans can still adopt the latter strategy by October 15 and generate additional 2023 refunds totaling more than $700 million. 100 of these plans stand to recover at least $1 million apiece.

Given the dollar amounts at stake, sponsors should seriously consider the mark to market option.

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There are a number of technical issues involved in making this decision. Sponsors will want to discuss it with their actuaries, counsel, and financial advisors before making it.

We provide more technical detail on the calculation of UVBs and PBGC variable-rate premiums in our 2023 article, which also illustrates the savings from switching to the standard method (or adopting a “full yield curve”) for 2023.

We will continue to follow this issue.