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IRS will permit switchback to smoothed interest rates for 2010

Oct 08, 2009

As we discussed in our article 2009 pension funding – Where are we now?, earlier this year the IRS announced that it would allow, for 2009, the use of "spot rates" for any of the five "applicable lookback months" (rather than only for the month preceding the valuation date) to value 2009 defined benefit plan liabilities. That announcement meant that calendar year plans could use the October 2008 PPA full yield curve for 2009 valuations, significantly reducing 2009 funding requirements. Our article analyzes the impact of that guidance on 2009 funding in detail.

After the issuance of that guidance, however, a key question remained: Would sponsors be allowed, for 2010, to switch back to 24-month valuation interest rate smoothing? Doing so would be beneficial in a couple of ways. First, smoothing generally enhances predictability, reduces volatility and increases companies' ability to plan. And second, in this particular case, smoothing will allow consideration, again (in the 24-month average), of the "super-high" October and November 2008 interest rates.

On September 25, 2009, in another "Special Edition" of the IRS newsletter "Employee Plans News," the IRS announced that it would allow such a switchback for 2010. Quoting: "The final [PPA DB funding] regulations will provide automatic approval for a new choice of interest rates for the first plan year beginning in 2010 (regardless of what choices were made for earlier plan years)."

As the IRS noted in its newsletter, this announcement came out just in time for the October 1, 2009 Adjusted Funding Target Attainment Percentage (AFTAP) certification applicable to calendar year plans and provides reassurance to sponsors considering using spot rates for 2009 (and, critically, for the 2009 AFTAP certification) that they will be able to switchback to smoothing in 2010.

In the newsletter the IRS also announced that it expects to issue final regulations on PPA DB funding and benefit restriction rules "in the near future." There had been rumors that those regulations would be out right after Labor Day, but that publication date slipped.

Finally, the IRS stated that "For plan years beginning after 2009, the final regulations will not allow the use of the full yield curve with a lookback month as permitted by the [March, 2009 IRS newsletter]." So, after 2009, there will be no more picking from five different months' spot rates.

Aside from reduced funding requirements for 2009, there is another benefit to using the October 2008 yield curve for 2009 valuations for most plans – reduced premiums to the Pension Benefit Guaranty Corporation (PBGC). For calendar year plans, the "default" method for calculating PBGC variable rate premiums is to use the December spot yield curve. However, the PBGC allows plans to calculate variable premiums on an "alternative" basis, using the same rates as used to calculate minimum funding requirements. Plans that use the October 2008 yield curve for funding and elect the "alternative" calculation for the PBGC variable premium may see significant reductions in 2009 variable premiums. And, as we've pointed out before, while funding relief allows plans to defer (but not ultimately avoid) contributions, lower PBGC premiums are pure savings to the sponsor.

Electing the PBGC "alternative" does lock plans into this methodology for five years. However, due to sharp drops in rates from late 2008 levels, 24-month smoothed rates are higher than spot rates right now. So, for plans that elect to switch back to smoothing in 2010, the PBGC "alternative" premium calculation will likely produce lower premiums for 2010 as well.

We will provide full coverage of the final PPA DB funding regulations when they are published.