Measuring UVBs for variable-rate premiums – the alternative vs. standard method election due October 15, 2022

Defined benefit plan sponsors that (1) are currently using the alternative (24-month average) method to determine unfunded vested benefits (UVBs) for purposes of calculating Pension Benefit Guaranty Corporation variable-rate premiums, and who (2) have the ability to elect to switch to the standard (spot-rate) method, may want to consider electing to switch to the standard method for 2022 (that election generally must be made (for a calendar plan) by October 15, 2022). While that election will generally not have a significant effect on 2022 variable-rate premiums, it is likely that it will (because of 2022 interest rate increases) reduce 2023 premiums significantly. And there are some “pros and cons” to making that election this year.

In what follows, we briefly describe the election, which sponsors may make it, the market factors that affect the variable-rate premium calculations, and the risks the election presents. But we are going to begin with a quick summary of how this election will affect (or not affect) different sorts of sponsors.

Bottom line:

Sponsors currently using the standard/spot rate method are (generally) in good shape and do not need to change anything.

Sponsors who elected the alternative/24-month average method for 2018 or later have no decision to make – they are locked into the current method for 2022. Sponsors who elected the alternative method beginning in 2018 will, however, be able to elect the standard method when it is likely to matter most – in 2023.

Sponsors of plans that are currently using the alternative method and elected that method in 2017 or earlier may want to consider switching to the standard method this year (by October 15). Doing so will (among other things) effectively shorten the standard method lock-in period. We discuss this decision in more detail below.

Sponsors of plans at the variable-rate premium headcount cap for 2022 generally will (at least until the cap no longer applies) be unaffected by the standard vs. alternative election.

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Let’s now review factors affecting the standard vs. alternative method election in more detail, beginning with some background.

Variable-rate premiums and valuing UVBs

Currently – in the context of interest rate relief that significantly limits the effect of ERISA minimum funding requirements – for many plan sponsors funding policy is framed with a view to reducing (so far as possible) PBGC variable-rate premiums. (As an aside, the premium-based funding regime has been relatively effective in incentivizing plan funding – by 2021 72% of plans with at least $400 million in assets were fully funded on a PBGC basis and owed no variable-rate premium.)

The amount of variable-rate premiums a sponsor pays for 2022 is 4.8% of the plan’s 2022 unfunded vested benefits (UVBs), subject to a $598 per participant headcount cap. UVBs are determined as the present value of plan liabilities (for vested participants) minus the fair market value of plan assets.

Election of method for measurement of UVBs

In determining UVBs, sponsors have a choice. They can use (for a calendar year plan): (1) December spot segment rates (the “standard” method) or (2) the 24-month average segment rates used for plan funding (the “alternative” method) (disregarding 25-year average interest rate stabilization).

There are a lot of technicalities in that description – the easy way to think of this is as a choice between end-of-prior year spot rates or 24-month average rates.

A sponsor’s ability to change methods (standard vs. alternative) is, however, limited. Once a particular method (standard or alternative) is elected, the sponsor can’t switch to the other method for five years. So, this decision should generally be made with a view to (among other things) the expected behavior of interest rates over the near- and medium-term.

Risk

The five-year lock in for changing methods presents sponsors with a set of risks.

First, there is what we’ll call “direction risk.” If over the entire five year period interest rates go up, and you have elected the alternative method, your valuation interest rate will be consistently lower (and thus produce higher PBGC premiums) than if you had elected the standard method. On the flip side, if over the entire five year period interest rates go down, and you have elected the standard method, your valuation interest rate will be consistently lower (and thus produce higher PBGC premiums) than if you had elected the alternative method.

Second, there is what we’ll call “December volatility risk.” This is only a feature of the standard method. If (e.g., because of some end-of-year, temporary market panic) interest rates in December spike down, and you are on the standard method, you will be stuck with a significantly lower valuation rate (and higher PBGC premiums) than if that one-month spike down in rates had been smoothed over 24 months.

With regard to these risks, two other factors to consider are plan funding policy and termination/glidepath strategy. If your plan is fully funded and fully “LDI-ed” (the plan’s portfolio is invested in duration matched fixed income assets), the risks we just described generally don’t affect you. Any decline in interest rates (even a “spike down” in rates in December) will be offset by an increase in asset values. For these plans, the standard method will generally be the preferred choice.

And if you (realistically) expect to terminate the plan in the relatively near future (e.g., the next 2-3 years), your “risk window” with respect to your standard vs. alternative method election is shortened.

The data: spot vs. 24-month average rates for 2021, 2022, and beyond

Sponsors using the alternative method may (in some cases) use any one of five lookback months (e.g., for 2022, August-December 2021) as the end-month of the 24-month lookback period. (A technical note: the election of the lookback month for measurement of UVBs is a function of the plan’s funding method and is made on Form 5500 Schedule B.)

The table below compares the spot (standard method) vs. 24-month average (alternative method) rates for 2022-2023, using a December lookback month for the 24-month average determination. We include the 2022 data because that will affect the 2023 UVB calculation – and the data we have thus far gives some idea of what the 2023 calculation will look like.

Table 1: spot vs. 24-month average for 2022 and currently

Looking at these numbers, the election for 2022 is (as we discussed above) nearly a push.

But for 2023 – which will be based on either a December 2022 spot rate or a 24-month average ending (depending on the elected look-back month) August-December 2022 – if the current trend holds, using the standard method produces a significantly higher valuation rate/lower UVBs/lower variable-rate premiums. The movement in rates this year has been the sharpest since 2008, making the PBGC method elected for 2023 the most momentous decision sponsors have faced under current law.

Considerations for plans that can switch to the standard method in 2022

It looks like the standard vs. alternative election will have little effect on the 2022 variable-rate premium but electing the standard method in 2023 (by October 15, 2023) will significantly reduce 2023 premiums.

Why might a 2022 election of the standard method make sense for these sponsors? We know what the relevant interest rates are for 2022 (and they have little effect on the premium calculation). And, as of the end of August 2022, we have a pretty good idea what the rates will be in 2023. So, making a standard method election in 2022 (vs. waiting until October 15, 2023) will (effectively) shorten the five year lock-in period by one year. The one risk factor in doing so – in electing the standard method this year rather than in 2023 – is the possibility that, between the time of election and December 2022 (when the standard method interest rate for 2023 will be determined), interest rates will fall by 100 basis points or more. All of which is (at a minimum) a good reason to put off making/not making this election until the last minute (to repeat, the drop dead date for this election is October 15, 2022, for a calendar year plan).

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We will continue to follow this issue.