How Can Plan Sponsors Handle PBGC Premiums for Underfunding?

October 28, 2014 (PLANSPONSOR.com) - The Pension Benefit Guaranty Corporation (PBGC) charges pension plans a portion of their underfunding each year.
By PS

Through 2013, the charge was 0.9% of the underfunding. By 2016, that rate will triple to approximately 2.9%. For example, a plan that is $20 million underfunded will be charged a premium of $580,000 per year.

How can plan sponsors handle this? Options are somewhat limited. PBGC rules offer a choice of two calculation methods, and that can offer occasional relief. But, plan assets and liabilities are largely at the mercy of market forces. The most straightforward answer is to contribute cash into the pension plan.

Plan sponsors may not have the cash to contribute to their plans; another option is to borrow money to fund the pension plan.

This may sound like leverage, but plan sponsors already owe the pensions. The PBGC values those pensions as if they were AA-rated corporate debt. If a plan sponsor borrows money, funds the pension plan, and invests the borrowed proceeds in AA-rated corporate debt, it has roughly swapped one type of debt for another. The goal here is not to beat the market; the goal is to avoid paying a “tax” of 2.9% per year.

How should plan sponsors structure the borrowing? One possibility is to look at borrowing terms that approximately replace a plan sponsor’s projected cash contributions to the pension plan. For example, a seven-year amortizing loan with equal payments. Another possibility is to issue a bond with interest-only payments until maturity. Generally speaking, the longer it takes to pay down the principal, the higher the interest costs. So the faster plan sponsors pay off the debt, the greater the savings.

How much can plan sponsors save? Illustratively, if a plan sponsor pays 6% interest on its debt, invests the proceeds at 4% in long-duration corporate bonds, and forgoes 2.9% PBGC premiums, it saves 0.9% per year. On $20 million, that would be $180,000 per year, prior to taxes.

In addition, the pension contributions and the interest on the plan sponsor’s debt are generally tax-deductible. That may mean some tax relief above and beyond the PBGC premium savings. The higher the company’s taxes, the greater the potential tax advantages.

What happens when the markets move? If interest rates rise unexpectedly, the market value of the bonds a plan sponsor bought will go down. But so will the PBGC liability. The reason for investing in long-duration corporate bonds is to roughly immunize the previously unfunded PBGC liabilities. That said, there are a lot of moving parts. Financial modeling may help determine the potential savings and financial risks. The larger the transaction, the more detailed the modeling that might be warranted.

What should plan sponsors do with the other assets in the pension trust? That depends. If the pension plan is frozen, this may be a good opportunity to de-risk by investing mostly in corporate bonds. If the pension plan is still open, the plan sponsor might consider partially de-risking the portfolio, but that depends on its risk tolerance, among other factors.

What will this do to the plan sponsor’s income statement? That depends on a number of factors. If the plan sponsor de-risks all the pension assets, its pension expense may go up. Financial Accounting Standards Board (FASB) rules allow plan sponsors to count their expected pension investment returns before they’re realized, so there is a short-term disincentive to investing conservatively. Bottom line, though, if borrowing to fund can provide some combination of lower investment risk and lower PBGC premiums, there’s a net gain.

Before borrowing, plan sponsors should consider their credit rating, bond covenants, legal considerations, and professional fees, among other things.

If the plan sponsor can’t borrow easily, it could consider contributing company stock or property (such as land) in lieu of cash. This approach may have significant legal issues to address, so plan sponsors should proceed carefully.

The decision to borrow money to fund a pension plan is likely to be a team effort, involving the plan sponsor’s tax and finance people, Employee Retirement Income Security Act (ERISA) counsel, investment advisers, and actuary. More details and ideas are available here.   

 

Will Clark-Shim, FSA, EA, MAAA, principal and consulting actuary at Milliman in Portland, Oregon    

 

NOTE: This feature is to provide general information only, does not constitute legal advice, and cannot be used or substituted for legal or tax advice. Any opinions of the author(s) do not necessarily reflect the stance of Asset International or its affiliates.

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