SECURE 2.0, Part 2: How the new retirement law affects single-employer defined benefit plans

In this companion episode to our look at SECURE 2.0 and defined contribution (DC) plans, Milliman employee benefits expert Nina Lantz explores how the new retirement law affects single-employer pensions. She talks with Milliman Consulting Actuary William Strange about what it means for retirement that life expectancy is rising more slowly, how companies can incentivize long-term employees, and why a reduction in insurance premiums could make corporate pension plan sponsorship appealing again.

Transcript

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Nina Lantz: Hello and welcome to Critical Point, brought to you by Milliman. My name is Nina Lantz, Principal and Director of Milliman's Employee Benefits Research Group, and I'll be your host today. In this episode of Critical Point, we're going to talk about three changes in SECURE 2.0, the new U.S. law affecting retirement plans, and how they impact actuarial calculations for single-employer defined benefit (DB) plans. We'll also discuss how SECURE 2.0 changed a key rule for cash balance plans that may help plan sponsors provide higher benefits to older and longer-service employees.

Joining me today is William Strange, Principal and Consulting Actuary at Milliman and consultant to many single-employer defined benefit plans. He is also an expert on cash balance plan design. Hi William.

William Strange: Hi Nina, how are you?

Nina Lantz: Good. So, most of the attention in the media around SECURE 2.0 has focused on defined contribution plans. And for our listeners, we'll also have an episode of Critical Point about that. But today we're going to focus on a few SECURE 2.0 changes impacting defined benefit plans. Let's first tackle a topic near and dear to pension actuaries' hearts and that's mortality. So, William, is Congress telling us how long we're going to live?

William Strange: Well, not exactly. For years now, the assumptions used by plan sponsors for single-employer plans has used what we call an ultimate mortality improvement rate of 1%. And at a basic level that means that, throughout time, mortality rates—longevity, you might say—will improve at a rate of 1% a year. And what's been clear in the data for some time, as tracked by the Social Security Administration and Medicare, is that mortality is not improving at that ultimate rate of 1%. It's actually improving at a rate closer to 0.75%. So, what Congress is doing here is bringing in line the data collected by Social Security and Medicare with what plan sponsors are using for their pension valuations.

Nina Lantz: Does this impact all plans? Or is everybody having to make this change?

William Strange: Sure, yeah, so the IRS and Treasury set the assumptions that sponsors use for mortality. And so, for single-employer sponsors, they have to rely on these prescribed tables, and so this impact is really for specifically single-employer plan sponsors. However, many of the same studies are used for the public and multiemployer space as well.

SECURE 2.0 and new mortality assumptions: What’s the impact?

Nina Lantz: So, if these mortality improvements are lower, that just means that people are expected not to live as long? So what does that do to the liabilities of the plan? And—what is the impact?

William Strange: Yeah, sure, so we have calculated for a sample plan the impact that it would have on the liability and the knock-on effect that that would have for the minimum required contribution and variable-rate premium from the PBGC.

And for those that aren't familiar with that, the PBGC is the Pension Benefit Guaranty Corporation. They are a government-sponsored entity that has its own funding mechanism that provides insurance to both the single and multiemployer pension plans out there.

So, when we looked at it, we had a couple of sample plans. We looked at a traditional final average pay. We looked at a cash balance plan that had a legacy final average pay component. We were seeing decreases of anywhere from 1% to 1.5% on the liability. And for our plans that had a measure of unfunded liability, which is where many sponsors find themselves, we were seeing the contributions in the variable-rate premiums decrease by anywhere from 2.5% to 3% for those sample plans.

Nina Lantz: And when does this change go into effect? Is that something that's happening this year?

William Strange: Yeah, so it's plan sponsors that are certainly preparing for the impact. They're likely looking at estimates to understand what it will do for them. But the change actually begins in 2024, and there'll be another change I know we'll talk about soon on indexing the variable-rate premiums, and that also is going to start in 2024. So, a lot of this is top of mind for sponsors. They're trying to figure out what the impact will be for them, but the ultimate impact will begin next year.

Why corporate pensions should welcome SECURE 2.0’s PBGC premium cuts

Nina Lantz: All right, so we'll move on and talk a little bit more about PBGC premiums. As you noted, the change in the mortality is going to have an effect on premiums. And after years of significant premium increases for single-employer plans, it looks like Congress is easing off the gas pedal here. So, in their last projections report, the PBGC reported that the single-employer insurance program was expected to remain solvent over the next decade. So, William, how are PGBC premiums changing with SECURE 2.0 and will this affect all plans?

William Strange: Yeah, and I'm glad you asked, Nina. This is a big one for sponsors. For so many years now, there's been an almost unrelenting increase in PBGC premiums. It is one of the many reasons that defined benefit plan sponsorship remains a hurdle for many corporations. The cost of the premiums alone can be upwards of $100 a person just for a fully funded plan, never mind when you add in the cost of the unfunded liability premium. So, it's a welcome change, a good step in the right direction, but it's a small step. The change that they're looking at here is what they call indexing on the variable-rate premium, and so what that means is for plans that are not fully funded on their basis, the unfunded liability is multiplied by a rate, which continues to increase.

And this has been somewhat controversial because what you're saying is that, over time, as you increase the rate, those plans are inherently more risky. Because you're charging a higher and higher rate even though the level of risk is really supposed to be reflected in the amount of the unfunded liability.

So, this increasing rate did not make a lot of sense to many corporate sponsors. There's been a lot of pressure for a number of years just in general to rein in premiums, so I think this is welcome news that the indexing of that variable-rate premium component of what sponsors pay each year to the PBGC is now being capped at a fixed amount. So, the premiums will still be around at a significant level, they'll just see slower growth into the future.

Nina Lantz: And are you aware of any additional changes happening to the premiums going forward?

William Strange: There have been a number of proposals in the industry for a while now. A notable proposal from the American Benefits Council (ABC), for example, would tie PBGC premium rates to the funded level of the program.

So, for those of you out there listening that aren't as familiar with the PBGC, there are two separate and distinct programs that they sponsor or manage, the single-employer program and the multiemployer program, and they have different funded levels, different solvency expectations you might say.

And so what the ABC has done is proposed: If the funded status of the single-employer program hits certain levels, there would be commensurate decreases in both the variable-rate premium, which we talked about a minute ago, as well as the fixed-rate premium. And I know that a lot of sponsors out there would welcome that with open arms, as again, as I sort of alluded to earlier, PBGC premiums remain one of the largest non-investment-related expenses for plan sponsors. So, seeing some reduction in that could have the effect of potentially slowing the decline of corporate DB plan sponsorship, potentially even reversing the decline. So, PBGC cost or premium is a critical part of emphasizing and sort of making it attractive to sponsor corporate DB plans.

Nina Lantz: Yeah, so it looks like these variable-rate premium—the indexing is ending starting next year, in 2024. Do you have an estimate about how much a plan might save on PBGC premiums because of this change?

William Strange: Yeah, we sure do. We have calculated the premium savings over a period of 10 years for a sample plan—and for our purposes, we used a plan with 10,000 participants—unfunded vested liabilities of about $100 million to remain level over that 10 years, so that's a critical assumption. It's assuming the plan's funded status does not materially improve on a dollar basis and, absent the presence of SECURE 2.0, increases to the variable-rate premium of about 3% a year.

So, in the case of our sample plan, that was about a $6.3 million decrease in premiums over a 10-year time period, so about 14% on that part of the premium. So, to put that in context, over a 10-year time period in the absence of SECURE 2.0, the sponsor would expect to pay about $55 million to the PBGC, and then with SECURE 2.0 about $48.6 million. Which again highlights how large PBGC premiums are for sponsors. I mean, this is a plan with $100 million of unfunded vested benefits. Ten thousand participants. It's a large plan, but there's a significant drag on assets from these premiums that are being charged. And where they're going into the PBGC is into a program that is in surplus. And so, I think that highlights why high premiums going into a program that's in surplus is so controversial for many sponsors.

How SECURE 2.0 could reward older participants in cash balance plans

Nina Lantz: So, the last thing we'll talk about today relates to cash balance plans. So, William, can you briefly describe what a cash balance plan is?

William Strange: Sure, yeah, so a cash balance plan is a defined benefit plan that operates like a defined contribution or 401(k) plan. It has pay credits, which are akin to 401(k) contributions, and it has interest credits, which are akin to investment earnings on a 401(k) plan. So, there's a hypothetical account balance that reflects the benefit of the person, the pay credits, and the interest credits, and then, when people commence their pension benefits, they can either take that as, of course, a lump sum, because that's how the benefit is described to people and viewed, or they could take it as an annuity and the plan then converts that balance into a monthly income stream which then pays for the life of the individual.

Nina Lantz: So, are these pay credits something that the participants decide on, or is that written in the plan document?

William Strange: It's written into the plan document and that's what makes it a DB plan. With a 401(k) plan, you can obviously increase or decrease your contribution over time as your compensation changes, but for a DB plan it has to be defined as whether it's a percentage of pay or a dollar amount. So, there can be some variability from year to year, but it's not something the participant can elect.

Nina Lantz: And can the plan sponsor just choose any pay credit? I mean, can you provide really large pay credits to those people that have been with the company for a long period of time?

William Strange: Yeah, so I'm glad you asked, and that kind of hits on the change that's coming down from SECURE 2.0 on this topic, for—the answer is, it depends. There are two fundamental types of interest credits for cash balance plans.

You have what you might call a fixed interest credit, which could for some people also include a bond-based credit, so that's an interest credit generally speaking that's always a positive number. And so, for some sponsors to keep it simple, they use a fixed interest credit, then for others they may use the yield on a 30-year Treasury or another bond index. And there's all sorts of options that sponsors have for putting in annual floors on those numbers if they use a bond rate, for example.

Then the other category of interest credits are variable, and one of the most appealing types of variable credits for sponsors today is the trust rate of return. So, you can with the final cash balance regs for Pension Protection Act (PPA) use the trust rate of return to credit interest on the account, so that makes a cash balance plan very similar to a 401(k) plan in terms of the risk profile. So, for sponsors of those variable types they have never been able to have older, longer-service employees earn a pay credit that's more than 133-1/3% of the pay credit for a shorter-service employee. So, this is looking to change that.

Nina Lantz: And how is it changing it? What is SECURE doing?

William Strange: Sure, so SECURE 2.0 is allowing the sponsors of cash balance plans with a variable interest crediting rate to use a rate not to exceed 6% for purposes of passing the accrual rule testing. And so, what this means, real basic practical level, is the types of designs that you've seen with fixed interest credit sponsors that incentivize longer service, so you'll see, for example, pay credits with age and service, so points-based formulas, or you'll see them either be age-based or just service-based, and they were always able to do that by virtue of having a fixed rate or using a bond index to prove that they can pass that critical test.

For variable-rate sponsors, they have always had to assume that their design would pass even in a year where there was a negative or zero return. And when you're doing that, the way the math works is you can't give more than 133-1/3% of the rate at a younger age, so if you had a pay credit of 3% of pay, for example, you wouldn't be able to give more than 4% at a later age. So, this allows them, the sponsors of those variable designs, to have a similar pay credit structure to sponsors that have a fixed credit. So, a basic example, you could do 3%, 6%, 9% of pay at different levels of service for a company, similar to what you might see from the sponsors that have fixed designs.

Nina Lantz: So, is there something that current cash balance plans have to do? Is this a requirement or a change that they have to make to their plans?

William Strange: No, so the rule has been around for a long time. So the rule hasn't changed, they've just introduced a new way to satisfy the rule. That's the way I would think about it. So, the 133-1/3% rule still applies, they're just recognizing the special nature of variable plans and allowing them to use what's viewed as a reasonable long-term market return type of assumption in that 6%.

Nina Lantz: So, ultimately these plans could actually look at their plan designs if they really want to make a change to provide larger accruals to their longer-service employees.

William Strange: Absolutely. And the space of the market where these variable plans tend to be more common is in the professional service firm space. So commonly, doctor groups or law firms sponsor them, and this could certainly have an impact on them.

But I think where the impact would be felt more is on the corporate plan sponsor side of things, where there could be a number of reasons they haven't yet considered setting up a DB plan, but if one of the reasons is that they're not able to incentivize long tenure within a variable-rate environment, this gives them that ability to start doing that. So, it gives you the ability to—if you're having workforce transition issues—have a plan design that has a similar risk profile to a 401(k), but has the incentivized design to help people stay longer with the company. So, I think that's where this could be felt the most is potentially on the corporate plan sponsorship side for those that either have a cash balance plan today or are considering putting one in.

Nina Lantz: So, thank you for your time today, William. For more information about what we talked about today, please find our article "Actuarial Impact of SECURE 2.0 on Single Employer DB Plans," on Milliman.com, and watch for our related podcast episode about SECURE 2.0 and defined contribution plans.

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