Many traditional defined benefit plans, such as final average pay plans, offer a lump sum distribution as an optional form of benefit. The amount of the lump sum distribution is sensitive to the applicable interest rate (calculated under Internal Revenue Code Section 417(e)) and varies inversely with the rate level. Higher interest rates result in smaller lump sums, and lower rates result in larger lump sums. Plans must update the applicable interest rate on a monthly, quarterly, or annual basis. With interest rates increasing rapidly, upcoming changes to the applicable interest rate may cause lump sum payments to decrease. In some cases, the decrease may be significant.

For example, if a plan updates the applicable interest rate at the end of each calendar year, the applicable interest rate for lump sum distributions taken in 2023 is likely to be much higher than the applicable interest rate for distributions taken in 2022. Specifically, a lump sum distribution taken at the end of 2022 may be in the range of 25% higher than a lump sum d tion of the same benefit taken in early 2023.

As a consequence, deferred vested participants who are eligible to elect a lump sum distribution may decide to do so before the plan’s applicable interest rate rises. Likewise, active employees may choose to terminate employment in order to receive a larger lump sum distribution before the rate increase takes effect. This will result in increased liquidity needs for the plan in order to fund the distributions, and may also give rise to an accounting charge for a settlement, which can occur when lump sum distributions for a given year exceed a threshold. If the plan is less than 100% funded, lump sum payments will cause the plan’s funded status to decline further. If the plan’s funding level drops below 80%, Code Section 436 may restrict or prohibit the plan from paying lump sums. Even more significantly, a large increase in retirements or other employment terminations at year-end may result in staffing challenges.

Plan sponsors who believe they may be in this position should begin planning now, especially with regard to staffing concerns. There are a number of strategies that plan sponsors can use to reduce the likelihood of staffing crises, including offering an in-service distribution option under the pension plan for older employees who meet specified age and service requirements, or offering targeted cash retention bonuses to partially or fully offset the reduction in lump sum distributions.

Notably, this issue does not typically arise with cash balance plans with a lump sum distribution option, because the lump sum is generally the participant’s account balance, which is not sensitive to the applicable interest rate. What will change as interest rates rise is the amount of the monthly annuity that is the actuarial equivalent of the cash balance account payable in a lump sum. The monthly annuity payment will be larger for an annuity that commences after the rate increase takes effect, as compared with an annuity with respect to the same cash balance account that commences under rates that are currently in effect. This may lead to more participants electing an annuity form of payment.

Morgan Lewis has helped many clients prepare participant communications that address these considerations, taking into account the plan administrator’s fiduciary obligations under ERISA.