Interest rates have fallen since the Pension Protection Act (PPA) became law in 2008. Consider that every spot rate on the December 2008 PPA yield curve was above 5% but by July 2012 the opposite was true. While rates stayed relatively flat for the following few years, the March 2016 PPA yield curve was the last time there was a spot rate above 5%, and the July 2019 PPA yield curve was the last time there was a spot rate above 4%. This can be seen by looking at the average monthly corporate bond rates as seen in the chart in Figure 1.
Figure 1: Monthly corporate bond rates
Since 2012, these are the segment rates used in calculating defined benefit (DB) plan lump sums under Internal Revenue Code (IRC) Section 417(e). Prior to 2012, these rates were blended with the long-term corporate bond rate to determine the segment rates used for IRC Section 417(e) lump sums. While there have been periods where the curve has gone up, predominantly rates have fallen month after month, primarily the long-term rates seen in the second and third segments. The chart in Figure 2 details the one-year change in the monthly corporate bond rates from January 2012 (i.e., the change from January 2011 to January 2012) through January 2022. A negative value indicates that rates fell during the year-over-year period, and vice versa.
Figure 2: One-year change in monthly corporate bond segment rates
While the first and second segment rates have consistently climbed over the past year, they are still lower than they were two years ago. For calendar year plans with a one-year stability period and a two-month look-back, the segment rates used to calculate IRC Section 417(e) lump sums for 2020-2022 are as shown in Figure 3.
Figure 3: Segment rates, 2020-2022 (assuming plan year is calendar year, one year stability period, two month look back period)
| Year | First Segment Rate | Second Segment Rate | Third Segment Rate |
|---|---|---|---|
| 2020 | 2.04% | 3.09% | 3.68% |
| 2021 | 0.53% | 2.31% | 3.09% |
| 2022 | 1.02% | 2.72% | 3.08% |
The sharp decrease in the PPA yield curve led to a large increase in the lump sum amount payable to participants from 2020 to 2021. Lump sums increased by at least 10% for most participants, and by at least 20% for younger participants. While rates generally increased from 2021 to 2022 the impact on lump sums is mixed; older participants saw a decrease in their lump sum values, but younger participants still saw a small increase because their lump sum values are calculated primarily by the third segment rate, which decreased by one basis point. Also note that any changes from one year to the next would include an increase due to improved mortality rates.
However, what if Section 417(e) segment rates spiked upward by (as an example) one full percentage point from one year to the next, so that the November 2022 IRC Section 417(e) rates would be the hypothetical segments of 2.02%, 3.72%, and 4.08%? A large increase is not out of the realm of possibility; each of the three IRC Section 417(e) segment rates increased from August 2018 to November 2018 by at least 30 basis points. An increase like that would impact a number of areas across DB plans.
Lump sums
We know that as interest rates rise lump sum values will decrease. Because plans generally have a one-year stability period neither participants nor the employer will notice the impact until the following year. By then it can be too late to take advantage of the smaller PPA yield curve rates.
As an example, assume a participant in a calendar-year plan turns 51 at the beginning of 2023 and that person has the option to take an unlimited lump sum at any time. If they elect to take a lump sum based on a monthly age 65 benefit of $1,000 as of December 2022, the estimated lump sum would be worth about $115,800. If rates do not change, due to being one month older and a resulting change in mortality, the estimated lump sum could increase to $116,200. However, if rates increased by one percentage point for calculating lump sums, then the estimated lump sum decreases to $92,000. This estimated 21% decrease in lump sum would vary by age; younger participants would see larger percentage drops, while older participants would see smaller drops.
Participants who recognize this could take advantage of the rising interest rates and request a payout near the end of the year before rates increase for plan calculations. The possibility of having drops in lump sum amounts of at least 10% might spur more active participants to retire and more participants than expected to take a lump sum.
Other benefit considerations
For employers, despite the possible wave of retirements and runs on the bank at the end of the year as participants take lump sums, there is some good news if the PPA yield curve were to spike. Because lump sum values would decrease, it is possible for the value for a number of participants to fall below the $5,000 small lump sum threshold. Employers could then cash out those participants. In addition, employers that wish to provide a lump sum window up to a certain dollar threshold would have a greater number of participants eligible for the window.
A spike in IRC Section 417(e) segment rates will not affect the annuity amounts for participants in a non-hybrid plan. However, for participants in cash balance or pension equity plans, where the conversion to an annuity benefit uses the IRC Section 417(e) rates, the amount of the annuities will increase. For participants close to retirement who would prefer an annuity over the payout of the cash balance or pension equity lump sum, this may cause them to wait until the end of the next year, when they can elect a larger annuity.
One area that actuaries might forget about if there is a spike in IRC Section 417(e) rates is the impact on IRC Section 415 benefit calculations. It is unlikely a 1% increase in IRC Section 417(e) segment rates will change the results much (because the factor using the 5.5% rate should be lower than 105% of the Section 417(e) factor), but larger segment rate increases could lead to decreases in the Section 415 maximum amount.
Even though the PPA yield curve has not shown signs of spiking well above current levels, participants and employers should be aware of what may happen if it does. On March 16, 2022, the Federal Reserve raised rates for the first time since December 2018. While the 2018 increase was at the end of a series of hikes, this hike may be the start of another series of hikes. And as we see what happened in 2018 in Figure 2 above, that one percentage point increase may end up happening on all three segments this time.