DB Sponsors to See Extended Funding Relief

August 6, 2014 (PLANSPONSOR.com) – A bill awaiting President Barack Obama’s signature would provide extended funding relief for defined benefit (DB) retirement plan sponsors.

The bill provides temporary funding to ensure that the Highway Trust Fund does not run out of money, in part from lowering corporate tax deductions and increasing corporate taxes from allowing companies to defer pension funding requirements. The bill extends relief provided in the Moving Ahead for Progress in the 21st Century Act (MAP-21)—passed in 2012—which allowed defined benefit plans to discount future benefit payments to a present value using a 25-year average of bond rates rather than a two-year average.

In a report from Moody’s Investor Services, “US Highway Bill Defers $51 Billion of Required Pension Contributions,” Wesley Smyth, vice president and senior accounting analyst for Moody’s in New York City, explains that MAP-21 created a “corridor” of rates on either side of a 25-year average that were also permissible for discounting purposes. “If the two-year average falls outside this corridor (as is currently the case), a company can use the 25-year average that is closest to the two-year average in the corridor. This corridor was narrow to start with and will gradually expand until 2016,” the report says. The new bill resets the corridor’s boundaries.

Under the new bill, for 2013 through 2017, the “corridor” is 90% to 110% of the 25-year average. As an example, Smyth tells PLANSPONSOR, if the two-year average is 5%, and the 25-year average is 10%, the closest point of that corridor to the two-year rate is 90% of the 25-year average, so defined benefit plans could use a 9% rate to calculate liabilities. He notes that, even though the new bill sets the corridor from 2013, DB plan sponsors may not go back and adjust their pension contributions in prior years.

According to Smyth, the Congressional Budget Office estimated that the new legislation would result in $18 billion of additional tax revenue, this year through 2019. Using an assumed tax rate of 35%, this additional revenue would equal more than $51 billion in lower deductions (i.e., pension contributions).

However, Jon Waite, SEI’s chief actuary and director of investment management in Oaks, Pennsylvania, notes that the bill tells the basics of the formula, but the Internal Revenue Service (IRS) still has to set the rate structure after the president signs the bill. (SEI is a provider of asset management, investment processing, and investment operations solutions for institutional and personal wealth management.) Waite tells PLANSPONSOR that when MAP-21 was passed, defined benefit sponsors were unsure what universe of bonds the IRS would use, but since the agency issued the rates following MAP-21, it is now clearer what will be used.

According to an SEI report authored by Waite, 2013 effective rates might increase 35 basis points (BPS). Plan sponsors may opt to use the relief or not use it. Final 2013 contributions, due September 15, could change, but not until IRS guidance is received. The 2014 effective rates might increase 65 BPS, and the new rates are mandatory, so any valuation reports for this year issued already will have to be changed.

Waite notes that some defined benefit plan sponsors continued to contribute more than the new minimum required under MAP-21, and he thinks even more plan sponsors will do so following passage of the new bill, “because 2013 was a great year for DBs.” (See “Pension Funding Up Sharply in 2013.”) He also believes plans that are pretty healthy and have moved down a liability-driven investing (LDI) path, will continue on this path because they can see a point on the horizon where they can liquidate their plans. “Funding relief is just background noise” for them, Waite says.

Those plans that are not as healthy will take advantage of the new minimum contribution requirements because they continue to read and hear that interest rates will rise in the coming years, he says. There is hope that, when the relief expires, rates will be high enough that contributions will not rise so sharply.

Waite notes that there may be a problem for plans with funded status below 80% that had to put restrictions on benefit payouts to participants. The new calculation could push some plans back over 80%. “If they restricted benefits, and now have a new regime that goes back retroactively, maybe they should not have restricted benefits,” he says. The IRS will give guidance about that as well, which Waite believes will only require plan sponsors to change restrictions prospectively.

“Ultimately, for plan sponsors, [the legislation] provides a lot more flexibility, which is a very good thing,” Waite concludes. “They can do what makes sense for their business and view of market.”