De-Risking? Consider Interest Rates

There are a variety of factors to consider regarding pension de-risking. Interest rates are one of them, observes a recent blog entry, which offers ideas on the key matters to keep in mind.

In “Markets 2020: Settling DB Plan Liabilities,” October Three suggests that interest rates are an important factor in de-risking, as they are central to calculating the cost of de-risking. To illustrate the importance of interest rates to de-risking and the complexity they pose, October Three suggests that there are four considerations related to interest rates when pondering de-risking, and applies them to a hypothetical plan and interest rates from November 2019:

1. Lump sum valuation rates vs. current market rates. Lump sum valuation rates usually are more favorable than current market rates, October Three says. For instance, they note, the interest rates present in late April 2020 were more than 50 basis points lower than the November 2019 rates used for its hypothetical plan. Therefore, they say, the gap between the cost of a lump sum payment and the value of a liability will show a “gain” for a participant, at least in the case of the hypothetical plan.  
2. Pension Benefit Guaranty Corporation (PBGC) premiums. De-risking, says October Three, can result in a reduction in PBGC premiums, which can be even greater in the case of sponsors subject to the PBGC variable rate premium headcount cap
3. Short-term results for participants. October Three notes that lump-sum payments can provide quick infusions of cash for participants.
4. Uncertainty concerning future interest rates. While interest rates may be low now, October Three points out that it is unclear what trends will be concerning interest rates in the future; it expresses the view that higher interest rates could make a plan sponsor less interested in de-risking.

The cost of de-risking either through lump sum payments or annuities “will depend primarily on (more or less current) interest rates,” October Three argues. But it adds that the costs entailed in either way of de-risking depend on how a plan sponsor evaluates the effect of the timing of de-risking on costs—for instance due to interest rate trends—and the merits of holding the pension liabilities and distributing payments according to plan provisions.