Tag Archives: funding strategy

Tax reform provides incentive to accelerate pension contributions

The end of 2017 saw the passage of significant tax reform in Congress. With this tax reform, the corporate tax rate has dropped from 35% to 21%, generating quite a bit of attention due to the significant savings that will result for corporations. One relatively unpublicized result has been the additional funding of cash contributions to corporate defined benefit plans.

While contributions made for the 2018 plan year will generally be deducted at the new lower corporate tax rate of 21%, contributions for the 2017 plan year will generally be deducted at the higher rate of 35%. For many corporations with underfunded pension plans, contributing additional dollars or accelerating already planned contributions will generate a net tax savings because underfunded plans are expected to eventually require additional contributions.

More and more, the plan sponsors are issuing corporate debt to make additional pension contributions. For example, General Electric recently announced that it was making a discretionary contribution of $6 billion into its pension plan funded through debt.

In addition to recent tax reform, here are three other reasons we are seeing this trend on the rise:

1. Skyrocketing Pension Benefit Guaranty Corporation (PBGC) premiums. The variable rate premium that corporations pay on underfunded liabilities has increased from 3.4% of the underfunding in 2017 to 3.8% in 2018 (and 4.2% in 2019, as listed in the PBGC website). Any contribution in 2018 to the pension plan immediately reduces the PBGC premium by 3.8% in 2018 (and more in future years). Additionally, that money would then be invested and anticipated to grow with the plan’s expected return (say 6.25%). This leads to an effective return on capital of 10.29% in 2018 (and 10.71% in 2019), and higher returns are anticipated in future years.
2. Updated mortality will drive PBGC liabilities higher by approximately 4%, leading to significant increases in the variable rate contribution.
3. Corporate interest rates remain low and corporations are able to borrow at relatively low costs.

For the purpose of example, let’s look at a theoretical additional contribution of $10 million into an underfunded pension plan. This additional contribution would:

• Reduce fees paid to the PBGC by $380,000 in 2018 (and $420,000 in 2019, and growing in following years)
• Be invested in the trust, and therefore would be anticipated to grow by a company’s expected return on assets in 2018 (likely 5% to 7%, which translates to $500,000 to $700,000 on a full-year basis)
• Reduce the Financial Accounting Standards Board (FASB) accounting expense in 2018 and beyond (by an amount similar to investments in the trust, depending on timing)—to the extent these contributions were anticipated at the beginning of the fiscal year
• Be tax-deductible at the 2017 corporate tax rates because any contribution before September 15, 2018, can count as a 2017 plan year contribution for calendar-year plans

However, there are some limitations:

• While plans that are fully funded on a PBGC basis will not see additional PBGC savings, they will see the additional tax and expense savings as outlined above
• Because of the structure of the PBGC variable rate premium, additional contributions to plans at the PBGC variable premium cap (due to head count) may not share the PBGC advantages, but will see the additional tax and expense savings as outlined above

With tax reform now in place, many corporations are poised to take advantage of opportunities to improve the financial status of their defined benefit retirement plans. Acting sooner rather than later on this opportunity will enable them to stabilize and move their plans more firmly into the black.

Plan-specific substitute mortality tables

In October 2017, the U.S. Department of the Treasury and the Internal Revenue Service (IRS) released final regulations prescribing new mortality tables that apply to single-employer defined benefit pension plans for the purpose of calculating the actuarial liabilities for minimum funding requirements, benefit restrictions, and Pension Benefit Guaranty Corporation (PBGC) variable-rate premiums. As with the prior regulations, the new regulations give plan sponsors the option to use either the standard mortality tables developed by the IRS, or to develop plan-specific mortality tables.

The new regulations significantly revised the rules regarding plan-specific substitute mortality tables. Under the prior rules, a plan was required to have fully credible mortality experience in order to use substitute mortality tables. The new rules allow for the use of substitute mortality tables for plans with smaller populations that do not have fully credible mortality experience. As a result, Treasury and the IRS expect that significantly more plan sponsors will request approval to use substitute mortality tables.

Using substitute mortality tables should theoretically improve the fit between expected and actual mortality rates, thereby producing smaller experience gains and losses over time. In addition, for plans employing a workforce that exhibits heavier mortality than the standard tables, using substitute mortality tables could potentially lower both minimum required contributions and PBGC variable-rate premiums.

For these reasons, plan sponsors may want to consider the use of substitute mortality tables. A written request must be submitted by the plan sponsor at least seven months before the first day of the first plan year for which the substitute mortality tables are to apply.

Note that the regulations do not allow plan sponsors to use plan-specific tables for determining minimum lump-sum values; standard IRS tables continue to be used for this purpose.

Funding strategies and policies for single-employer defined benefit pension plans

As far as determining the funded status of a defined benefit (DB) pension plan, many factors are out of the control of the plan actuary, such as investment performance, liability interest rates, and how much a plan sponsor is able to contribute to the plan. However, the actuary can discuss with the plan sponsor possible funding strategies and policies designed to maintain the funded status of a fully funded plan or to improve the funded status of an underfunded plan.

In general, the discussion can be broken down into three possible scenarios. If a plan is fully funded, the plan sponsor should consider ways to stabilize annual costs to avoid the possibility of becoming an underfunded plan. If a plan is underfunded, the plan sponsor can consider ways to stabilize annual costs and then commit to making contributions gradually over time to bring the plan to fully funded status. Alternatively, a plan sponsor can subject an underfunded plan to annual cost volatility with an equity-based investment allocation in the hope of bringing the plan to fully funded status through a combination of favorable investment performance and contributions.

Some cost stabilization strategies that can be considered are liability-driven investment (LDI) tactics or a change to a more conservative investment allocation that is much less based on equities. In an LDI strategy, the plan’s investment allocation is changed to primarily fixed income with the objective of plan assets and plan liabilities moving in tandem as liability interest rates rise and fall. In a more conservative investment strategy (e.g., an allocation of 35% equities and 65% fixed income), annual costs are more stable, which is due to less investment risk related to a low equity allocation.

One possible funding policy to consider is annual contributions in the amount needed to hit a given Pension Protection Act of 2006 (PPA) funding target (e.g., at least 80% to avoid benefit restrictions for the current year). Another funding policy to consider is having the actuary determine an annual contribution amount projected to meet a plan sponsor’s funded status goal (e.g., become 100% funded by the year 2017).

A plan sponsor can choose to combine any of the above strategies and policies to meet its goals. Reviewing long-term cost projections is suggested when considering any new strategy and/or policy.

Finally, plan sponsors need to be careful about taking full advantage of any type of legislative funding relief—e.g., Moving Ahead for Progress in the 21st Century (MAP-21) funding relief legislation passed during 2012—because later this may result in much higher minimum funding requirements. Therefore, plan sponsors should consider making higher-than-required contributions despite the availability of funding relief.