Many Sponsors Believe They Already Fully Accounted for New Mortality Tables, but They May Get Unexpected “Hits,” Like Higher-than-Expected Contributions, Because of an IRS Delay, According to Cambridge Associates
BOSTON (June 1, 2017) – By 2016, financial executives of organizations with defined benefit plans had largely modified their financial statements to reflect mortality assumptions that the Society of Actuaries released in 2014. The upshot was a 4% to 8% drop in reported funded status – since the new assumptions revealed that participants would require benefit payments for two to three years longer, on average, than previously believed – and a hope among many sponsors that the issue of longevity risk was behind them.
Yet the story continues, perhaps to the surprise of some sponsors, according to a new report, Thought Mortality was Dead?, from global investment firm Cambridge Associates. The Internal Revenue Service decided, somewhat unexpectedly, to delay its implementation of the new mortality tables until at least 2018. As a result, CFOs and sponsors now face new decisions and obligations related to three areas that are at least partially prescribed by IRS guidance: minimum contribution requirements, premiums that must be paid to the Pension Benefit Guaranty Corporation (PBGC) and lump-sum distributions to vested former employees.
“The IRS’s delayed implementation of these mortality tables definitely creates a wrinkle for CFOs, and the answers aren’t straightforward,” says Greg Meila, Senior Investment Director in the pension practice at Cambridge Associates and coauthor of the report.
The report points to several topics that CFOs and sponsors may have to address:
- Contributions to the plan may have to increase. The funded status used to determine the level of minimum required contributions will decline, due to the new mortality assumptions (similar to how accounting funded status dropped following the initial 2014 mortality table update). A lower funded status means higher required contributions to make up the deficit. And some plans that are already in a weakened position may feel compelled to make even greater near-term contributions to avoid regulatory consequences of funding levels dropping below critical threshold levels.
- Premiums due to the PBGC (the government agency designed to provide a backstop to failing pensions plans) may rise dramatically for certain plans. One source of the hike is the jump in underfunding levels due to the IRS adopting the new mortality tables, since lower funded status means higher PBGC premiums. That’s on top of a requirement, resulting from recent legislation, to pay higher rates per $1,000 of underfunding.
- Lump-sum distributions may become key topics of discussion and decision-making. For sponsors that were already considering offering lump sums to their terminated vested participants over the next few years, the remainder of 2017 offers a rare window in which the value of the lump sum required to be paid will be lower than next year, when the IRS actually adopts the new mortality tables. But making those distributions now isn’t a “no brainer” for many plans. Paying out benefits – especially large lump sums – while the plan is underfunded results in a lower funded status in percentage terms. And depleting funds means it will necessarily be harder to make up for shortfalls with investment returns.
“Effectively addressing questions about how the IRS’s delayed implementation of new mortality expectations may affect minimum contributions, PBGC premiums and lump-sum distributions requires financial executives to think hard about the objectives they care about the most,” Meila says. “For example, the CFO of a publicly traded corporate plan may care a great deal about the volatility of financial statement impacts, while a privately-held company CFO or non-profit CFO may care more about the timing and volatility of required contributions or the impact on debt covenants. Tackling these issues calls for sponsors to craft an overall pension strategy that both incorporates and prioritizes the objectives most relevant to them, subject to their unique constraints and risk tolerances.”
To access the full report, please click here.
About Cambridge Associates
Cambridge Associates is a global investment firm founded in 1973 that builds customized investment portfolios for institutional investors and private clients around the world. Working alongside its early clients, among them several leading universities, the firm pioneered the strategy of high equity orientation and broad diversification, which since the 1980s has been a primary driver of performance for these leading fiduciary investors. Cambridge Associates serves over 1,100 global investors – primarily foundations and endowments, pensions and family offices – and delivers a range of services, including outsourced investment (OCIO) solutions, traditional advisory services, and access to research and tools across global asset classes. Cambridge Associates has more than 1,300 employees – including over 150 research staff – serving its client base globally. The firm maintains offices in Arlington, VA; New York; Boston; Dallas; Menlo Park and San Francisco, CA; Toronto; London; Singapore; Sydney; and Beijing. Cambridge Associates consists of five global investment consulting affiliates that are all under common ownership and control. For more information about Cambridge Associates, please visit www.cambridgeassociates.com.