At the end of March 2020, the CARES Act was signed into law. One impact of this legislation for defined benefit plan sponsors is that any contributions that were required during 2020, either quarterly contributions or those to satisfy minimum requirements, can be delayed until January 1, 2021. However, sponsors with materially underfunded plans are facing the prospect of rising Pension Benefit Guaranty Corporation (PBGC) premiums, and many are considering lump sum offerings or other risk transfer activities in order to reduce the size of the pension plan on the corporate balance sheet, an activity which may further strain the funded status of the plan. Combining this backdrop with the current stress many businesses are under due to the pandemic-related economic slowdown, there is a natural tension between desiring to contribute more and having cash available to do so.
PBGC requirements and contribution deadlines
For calendar-year plans, the final date at which contributions can be made to increase beginning-of-year funded status for purposes of calculating PBGC unfunded vested liabilities is typically September 15. This is also usually the last day to fulfill contribution requirements. With the extension of this minimum funding deadline to January 1, 2021, there have been questions regarding the timing of contributions to reduce unfunded PBGC liabilities for variable-rate premium purposes. The PBGC recently issued guidance extending the deadline for making these contributions to October 15, 2020, which is the current due date for PBGC variable-rate premium filings.
Any assets contributed to an underfunded plan by this deadline would immediately earn an implied return of 4.5% in the form of reduced PBGC variable-rate premiums¹. This may be an attractive return, particularly with the assets not being invested for a full year.
¹ As long as the plan is not already at the PBGC per-participant premium cap.
The impact of risk transfer on funded status
Plan sponsors may be considering lump-sum or other risk-transfer activities during the second half of 2020. In the case of lump sum-offerings, many lump sums are currently being valued using interest rates that were in effect at or near the end of 2019. Given that interest rates are currently lower than they were in 2019, the cost of offering lump sums could increase significantly, should an offering be delayed into 2021.
Partial plan annuitization2 may also be under consideration for sponsors seeking to reduce the size of the plan. Demographic trends and competition among insurers may make pricing on this type of activity attractive in the current market environment. Also, removing participants from the plan can have an impact on PBGC premiums paid, especially if this activity also pushes the plan sponsor above the per-participant premium cap.
2 Purchasing annuities from an insurance company for a subset of the plan liabilities, typically some or all the retiree population.
Consideration must be given, though, to the impact of any such activity on the remainder of the plan assets and liabilities. Consider the following simple example, which demonstrates the impact of a partial annuitization on an underfunded plan.
As demonstrated here, even a costless transaction, where every dollar of assets paid out directly pays for a dollar of liability removed from the plan, reduces the funded status of the plan by nearly 10%. As such, we strongly recommend that plan sponsors undertaking risk-transfer activities in materially underfunded plans consider contributing additional assets to their plans to at least maintain funded status equivalence and maintain the security of benefits for the remaining plan participants. Note that the dollar amount of unfunded liability has not changed, but a subset of the population has had their benefits fully guaranteed, while the rest are left with lower coverage and a smaller asset base to generate return to fill the same dollar deficit.
Contributing to reduce PBGC unfunded liability and the related variable-rate premium, as well as to offset the funded status erosion of any risk transfer activity may be attractive to plan sponsors. Recognizing that many organizations do not currently have ready cash available to contribute to their plans, or wish to preserve financial flexibility in the current environment, we are left to consider other ways to source funds for contributions.
Low borrowing rates present an opportunity
Given a confluence of low interest rates, a market seeking corporate debt issuance, and rising PBGC premiums, conditions appear favorable for sponsors of significantly underfunded defined benefit plans to borrow funds or issue debt and use the proceeds to improve the funding levels of their plans. (Of course, individual company considerations will impact the attractiveness of borrowing to fund a pension plan, including items such as outstanding debt and leverage, impact on cost of capital, share price, and others.) There was increased activity around accelerating defined benefit plan funding with the passage of the Tax Cuts and Jobs Act of 2017 (TCJA)³. For those plan sponsors who did not take advantage of that opportunity, or for those who are considering making additional discretionary plan contributions, the current low interest rate environment may provide an opportunity to benefit from borrowing to reduce the level of unfunded pension liabilities.
PBGC variable rate premiums are essentially a tax on unfunded vested benefits. These premia do not serve to increase the funded status of the plan but instead pay for insurance against the possibility that the PBGC will be required to take over payment of plan benefits. Given the steady increase in this premium amount over time (see table below), many plan sponsors are considering accelerating the funding of their plans in order to avoid paying this penalty. For those sponsoring organizations that do not have cash on hand to fully fund their plans, or for those that do but have budgeted other uses for that cash, it may make sense to consider issuing debt to contribute to the plan.
Annual PBGC variable rate premium under current legislation. Dollars shown are amounts payable per $1,000 of unfunded vested benefits. PBGC variable rate premiums are subject to annual increase using a national average wage index; for this purpose, we have assumed that rate to be 3.0%.
Issuing debt to fund the plan
In order to investigate the potential benefits of issuing debt to increase the funding level of a pension plan, we need to understand the trade-offs between required contributions (including PBGC premiums) and debt service payments.
Funding the plan via annual required contributions (plus annual PBGC premiums) or annual financing costs on debt issued to immediately fund the plan are both series of cash payments made by the plan sponsor. It is possible to calculate the debt coupon rate at which these two series of payments have the same net present value, here referred to as the break-even rate. Were the sponsoring organization able to issue debt at a rate lower than the break-even rate, it would be cost effective for them to do so.
Corporate income tax rates also influence this break-even rate. Generally, contributions to a defined benefit pension plan are tax deductible for the sponsoring organization,⁴ as are debt service payments (subject to certain limitations as modified by the TCJA). This, of course, assumes that the corporation has taxable income, For those that have had a substantial decrease in income in 2020 due to the COVID-19 pandemic, it may be beneficial to wait until 2021 to make a large contribution, assuming a rebound in taxable income.
⁴ Unless, of course, the sponsor is a tax-exempt entity.
Balancing risk post-contribution
Making a sizeable contribution to drastically improve the funded status of your plan will likely trigger a re-evaluation of the plan’s investment strategy. Some level of stochastic simulation or scenario stress-testing is likely necessary to understand the full range of potential outcomes for your plan. Plans that are more well-funded generally invest more heavily in liability-driven investing strategies, so some thought must be given to how contributions are allocated to help guard against future funded status declines (and thus future PBGC premium requirements) due to adverse market movements.
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