The decision by British voters in a June 23, 2016 referendum to leave the European Union has significantly affected both the equity and debt segments of international financial markets. As with other market dislocations, the decision has also affected US tax-qualified plans, since they invest in those markets as a source of funding and use corporate bond rates for a variety of derivative purposes. The effects differ, however, between defined benefit (DB) and defined contribution (DC) plans.
Potential Effects of Brexit on DB Plans
In the case of DB plans, Brexit potentially has implications for funding levels, lump sum payments, Pension Benefit Guaranty Corporation (PBGC) premiums, and financial accounting results—all of which are the responsibility of the plan sponsor (rather than participants).
Specifically, the vote has triggered a decline in interest rates—including corporate bond rates—that may have at least a short-term adverse effect on the funded status of many DB plans, since (i) corporate bond rates are the proxy used to determine the present value of liabilities for minimum funding purposes, and (ii) a decrease in rates triggers an increase in liabilities (present value inversely goes up as interest rates go down).
This effect will be mitigated somewhat, however, since DB plans generally can use a 25-year average of interest rates (with a 90% floor) for funding purposes, which tends to “smooth out” periodic spikes like Brexit. Still, if interest rates (which are already at historically low levels) decline further or continue to be depressed by the aftershocks of Brexit, more headwinds for DB plans seeking to improve their funded status will be created.
By contrast, DB plans must use a market rate of interest—that is, without “smoothing”—for lump sum, PBGC variable premium, and financial accounting purposes. As a result, any downward trajectory of interest rates triggered by Brexit will more directly affect DB plans for these three purposes. Thus, for example, the dollar amount of lump sums paid to employees will increase as rates fall (that is, lump sum present values grow inversely to interest rates).
This effect on the calculation of lump sum payments may be delayed somewhat, since most plans use a “look back” date for the related interest rates (such as the rate in effect two months before the start of the plan year in which the lump sum was paid). Nevertheless, if interest rates stay low or decline, these lower rates ultimately will roll into effect for lump sum calculation purposes. Plan sponsors that are otherwise so inclined may view this as an impetus to offer lump sum windows or annuity buyouts—sooner rather than later (and before any lower interest rates roll into effect). This is especially true of annuity buyouts, since insurance companies tend to use rates for premium calculations that are even more conservative (i.e., lower) than the corporate bond rates used under ERISA.
Similarly, the PBGC variable rate premium is essentially determined using the same rate as is used for lump sums, but without a lag. This will increase the liabilities that form the basis for determining the amount of the variable premium.
Finally, the use of spot fixed income rates for financial accounting purposes will have an adverse effect on a company’s balance sheet to the extent they trigger an increase in reportable plan liabilities. The impact will be much more pronounced than is the case with minimum funding considerations, since the use of spot rates does not allow the impact of currently falling rates to be offset by the prior year increases used in a “smoothing” approach.
Potential Effects of Brexit on DC Plans
In the case of DC plans, participants generally bear the primary risk (and reward) of their investment choices, as allowed by ERISA Section 404(c). Thus, they will bear the risk of both declining bond prices and more volatile financial markets generally. Plan fiduciaries may want to consider alerting participants to the issues raised by Brexit, the possible impact on plan investments, the advisability of staying the course in turbulent markets, diversification considerations, and any other Brexit-related issues relevant to participation in the DC plan, but should be careful to avoid providing specific investment recommendations or advice that may be subject to ERISA’s fiduciary obligations.
In the case of both DB and DC plans, the fiduciary responsible for selecting investments (such as an investment committee) should continue to monitor developments in the financial markets and react as appropriate, in light of the plan’s investment policy statement and the general fiduciary requirements of ERISA. Federal courts and the US Department of Labor have consistently stated that ERISA fiduciaries are not held to a standard of omniscience, but they are required to exercise “procedural prudence” in selecting and monitoring plan investments. This sort of prudence would include adhering to the processes and other mandates established in the fiduciary’s charter or other governing document.