Higher interest rates impact a pension plan in a variety of ways. One key area is the effect it has on lump-sum payments. In general, higher interest rates produce lower lump sums. That means a smaller payment amount is required to completely “cash out” a participant’s liability in the plan. 

The interest rates used for determining lump sums are typically set, and held constant, for each plan year. That means that the current high interest rate environment will result in lower lump-sum payments for the entire next plan year.

See the section at the end of the article for more information about other ways interest rates affect pension plans.

Opportunities presented by lower lump sums

Cashing out participants from the plan has several cost and risk mitigation advantages, including reducing PBGC premiums and shrinking the risk profile of the plan. Lower lump-sum values may present plan sponsors with opportunities to cash out more participants than in a typical year.

Here are some opportunities to explore:

• Most plans have an “automatic cash-out” provision, meaning that participants whose lump-sum value is less than a small amount (i.e., no greater than $5,000) can be cashed out without the participant’s consent when a distributable event occurs. Lower lump-sum values caused by higher interest rates may allow sponsors to do more automatic cash-outs.
• Some plans have a cap on the dollar value of the lump sum (e.g., $25,000) that the plan will pay. Lower lump-sum values may result in more participants falling under this cap. Plan sponsors may want to consider reminding participants, especially terminated participants whose prior year lump-sum values exceeded the cap by a small margin, about the availability of this lump sum.
• Sponsors may want to consider doing a lump-sum window to take advantage of the higher interest rates. This may be cheaper than purchasing annuities through an insurance company, particularly depending on how interest rates move. In addition, while lump-sum interest rates are typically locked in for the year, annuity pricing will change throughout the year.

When considering whether to pursue any of the above opportunities, it is important for plan sponsors to be aware that paying many lump sums has potential ramifications. One is the possibility of settlement accounting. Another is a decline in the plan’s funded status, since the asset reduction (the cost of the lump sums) is typically greater than the liability reduction (measured on an IRS funding basis) due to the difference in the underlying interest rates. However, while that difference still exists, it is currently reduced due to the higher lump-sum interest rates.

Paying lump sums, whether through a window or similar activity, may be a key part of a plan’s risk-mitigation strategy, especially for a plan that is on the road to termination.

Plan sponsors should be prepared for how participants will react to lower lump sums

While lower lump sums are generally viewed as favorable for pension plans, since it is cheaper for the plan to settle liabilities and cash out participants, plan sponsors should be aware of how plan participants may perceive this significant drop in lump-sum values. Participant reaction will need to be managed, especially for participants who have been previously provided quotes with higher lump-sum amounts (e.g., via benefit statements, retirement estimates and self-service portals). Plan sponsors should be prepared to answer questions from participants who compare their 2022 (or estimated 2023) lump-sum amounts to actual 2023 lump-sum amounts.

Sponsors may even consider informing participants of the impact of the current interest-rate environment so participants who are considering retiring at the beginning of next year are not caught off guard. However, sponsors should be careful to do this in a manner that doesn’t cause an overwhelming amount of employee retirements at year-end, as this could negatively impact the plan (through drops in funded status and/or liquidity issues) or cause workforce concerns.

What plan sponsors should do now

Beyond being aware of, and prepared for, the implications of lower lump-sum values, plan sponsors are advised to speak with their actuaries to assess the specific issues and opportunities for their plan. This includes consideration of both actuarial and participant communication issues. Sponsors may also want to proactively consider actions now that will take advantage of higher interest rates to help achieve their desired strategies and outcomes for the plan.

Other ways in which interest rates affect pension plans

Changes in interest rates can affect these aspects of a pension plan in addition to lump-sum payouts:

• Liabilities
• Funded status
• Cash costs
• Accounting costs
• Investment performance
• The PBGC’s variable-rate premium
• Credit balance

While this article is focused on the impact on lump-sum values, if any of these other areas are of concern, speak with your plan’s actuary.