Three issues corporate plan sponsors should be aware of in 2024

Executive summary:

  • With interest rates at their highest levels in over a decade, now is a good time for most plan sponsors to de-risk their liabilities via a lump sum window. Because implementing a lump sum window takes time, sponsors seriously considering 2024 lump sums should begin the process as early as practical.
  • There are two different methods plan sponsors can select to determine the interest rate used to value their plan’s liabilities: the standard method and the alternative method. The sharp rise in rates made the standard method much more appealing in 2023. But plan sponsors thinking about switching methods this year will want to consider the risk/effects of future interest rate declines on future unfunded vested benefit (UVB) valuations.
  • Rising rates generally improved a plan's funded status, but this has not been the case for underfunded plans in the past two years. This is because high interest rates lowered the value of their assets—and this wasn’t offset by a decline in liabilities, as is typically the case.

It’s been an eventful few months in the defined benefit (DB) space, punctuated by IBM’s recent announcement that it’s replacing its 401(k) matching contributions with a new benefit earned within its previously frozen DB plan. While this groundbreaking decision has deservedly dominated headlines in the DB space, there are still a host of other issues for plan sponsors to pay attention to as 2024 unfolds, especially given the impacts of the sharp rise in interest rates over the past two years.

For more insight into these issues, we recently sat down with Mike Barry, president of O3 Plan Advisory Services LLC. Mike pointed to three issues in particular that plan sponsors should be aware of: de-risking via the lump sum window, PBGC (Pension Benefit Guaranty Corporation) premiums and the possible election of the “standard” method/valuation interest rate (December 2023 spot rate) for valuing liabilities, and the impact of rising rates on underfunded plans.

Following is our Q&A-style interview with Mike on these topics, with answers edited for clarity and brevity.


Let’s start with de-risking. Is now a good time for plan sponsors to de-risk their liabilities via a lump sum window?

Mike Barry:
For most plans, yes. This is because we are in a high interest-rate environment, and higher interest rates reduce the value of a plan’s liabilities, including the costs of lump sums. At around 5%, today’s rates are the highest seen in more than a decade—and that’s even down slightly from late last year, when rates briefly exceeded 6% in October.

How are lump sum valuation interest rates calculated?

Mike Barry: For plans that include an ongoing lump sum provision (or other accelerated form of payment), they’re calculated based on a designated lookback month and stability period. The lookback month is the month that is used to determine the (spot) valuation interest rate. This month can be anywhere from one to five months before the stability period—the period of time over which the rate will apply. So if a plan uses a calendar year stability period, the lookback months can be any month from August through December of the prior year.

You mentioned interest rates were at their highest levels in October 2023. Does this mean plan sponsors would be wise to use that month as their lookback month—since that would make a lump sum less costly than if other months were used?

Mike Barry
: That’s correct. Interest rates peaked in October 2023, so a plan sponsor will (if they can) want to use October 2023 as their lookback month so that they can pay a smaller sum. It’s worth stressing that for 2024 lump sum windows, sponsors need to be aware of what (if any) constraints apply to lookback months and stability periods.

Now, we don’t know exactly where rates will sit at the end of 2024—although consensus expectations are that they’ll continue to decline as the Fed begins easing. Already, February 2024 rates are lower than October 2023 rates. If rates stay at current levels (or decline) over 2024, paying out a lump sum using the October 2023 valuation rate will also produce a 2024 balance sheet gain.

The chart below helps illustrate this more clearly. It summarizes the five sets of PPA segment rates (in effect, monthly spot rates) available for calendar year plans (August, September, October, November, and December) for 2023 and 2024 with a 1-year stability period, and the delta (increase in rates for 2023 vs. 2022 lookback months) for each lookback month. (Note, 1st segment rates are generally not significant for most lump sum calculations.)

Lump sum raes

Are there timing issues with lump sums?

Mike Barry: Yes. Implementing a lump sum window (especially) takes time—participants must elect distribution and waive the default annuity, and that whole process must be explained. So sponsors seriously considering 2024 lump sums will want to begin the process as early as practical.


Speaking of high interest rates, aren’t PBGC premiums impacted by these too?

Mike Barry:
Yes. PBGC premiums are generally 5.2% of a DB plan’s unfunded vested benefits (UVBs). So, it matters what interest rate a plan is using to calculate the value of a plan’s UVBs. There are two methods—the “standard” and the “alternative” methods—that can be used.

Can you explain what each method is, and how they differ?

Mike Barry: The standard method uses (for 2024) December 2023 spot rates (those are based on the yield on investment grade (IG) corporate bonds one month prior to the valuation date) to value a plan’s liabilities (in order to determine the amount of a plan’s UVBs). The alternative method uses a 24-month average of those rates. Because of the increase in rates over 2022-2023, plans that use—or are able to switch to using—the standard method are using a higher valuation interest rate and paying smaller PBGC premiums than plans on the alternative (24-month average) method. Notably, since rates have gone up sharply, this has created opportunities for plan sponsors.

Can you tell us more about that?

Mike Barry: The Fed’s aggressive rate-hiking campaign, which began in the spring of 2022, led to a massive spike in rates from 2022 to 2023. The magnitude of the increase was essentially a once-in-a-lifetime event—and it created a staggering 200-basis-point (bps) difference between spot rates and the 24-month average valuation rates for 2023. The delta in 2024 is more modest—only around 50 bps—but still significant.

Needless to say, this trend has been a very good thing for sponsors using the standard method, and a less good thing for sponsors using the alternative method, because (with respect to the latter) 24-month averaging mitigates (or slows down) recognition of the rate increase. So, naturally, sponsors on the alternative method had a strong incentive to switch to the standard method, as the amount of money a plan could save by changing methods was tremendous, especially in 2023. By the way—if you’re switching methods, you must do so by the time PBGC premiums for the year are due, generally October 15—so elections for 2023 had to be made by October 2023.

There are, however, restrictions on switching—once you switch, you’re locked in for five years. This presents two issues. First, some sponsors on the alternative method (for less than five years) were/are unable to switch. And sponsors switching to the standard method will be locked into a mark-to-market valuation regime (for calculating PBGC premiums) for five years. This means that if there’s a steep decline in interest rates in the near term, that could cost them in future years. Because the savings were so great in 2023, the latter risk was not much of an issue. But plans/plan sponsors thinking about switching in 2024 will want to consider the risk/effects of future interest rate declines on future UVB valuations.


Let’s pivot to our final topic, which is how the rising-rate environment of the past few years has created challenges for underfunded plans. If I understand correctly, this is a bit unusual, because rising rates generally improve a plan’s funded status, right?

Mike Barry: Correct. When rates go up, liability valuations go down. And, as a result, these rising rates will (as we discussed) reduce the PBGC premiums paid by underfunded plans.

But, ironically, they won’t have much effect on plan funding requirements, because, as I said, market rates are now more or less the same as 25-year average rates. So the funding relief that in previous years had reduced funding requirements isn’t really there for 2024.

The challenge for underfunded plans is that rising rates are often associated with lower asset valuations, e.g., when rates go up, bond values go down. And so (generally) does the market’s P/E (price-to-earnings) ratio.

Can you explain all that a little more?

Mike Barry: Sure. The funding relief passed by Congress over the last decade-and-a-half has, for minimum funding purposes (but not PBGC premium purposes), allowed plans to use interest rates averaged over a 25-year period when valuing their liabilities, rather than the current market rate. Because, up until recently, the 25-year average rate has typically been north of 5% and the (otherwise applicable) 24-month average has been south of 5%, it was advantageous for underfunded plans to use the 25-year rate. Thus, when rates declined sharply at the onset of the COVID-19 pandemic, underfunded plans didn’t have to worry about ballooning liabilities since they were using the much-higher 25-year average interest rate.

Over the past two years, however, the dramatic rise in market interest rates has brought them in line with 25-year average interest rates. For underfunded plans, for ERISA minimum funding purposes, this has been a non-event, because they were already using those “high” 25-year average rates.

The problem, as I said above, is that in the real world, rising rates are typically associated with lower valuations. And we definitely saw that in 2022, with a 20% decline in stock values. For a plan that was living with real world interest rates (that is, current or at least 24-month average rates, rather than 25-year average rates), the decline in asset values was in fact more than offset by the decline in liability values. But for an underfunded plan focused on the cash funding demands of ERISA’s minimum funding requirements, there was no increase in valuation interest rates. All that happened was that funding relief went away.

In other words, a plan’s liabilities (for minimum funding purposes) did not shrink due to rising rates (because of funding relief)—but (especially in 2022) assets declined because rates went up. The net result of all of this has, for some underfunded plans, meant a further decline in funded status.

Let me make sure I got this straight. For underfunded plans, high interest rates lowered the value of their assets—and this wasn’t offset by a decline in liabilities, as is typically the case?

Mike Barry: Exactly.