The Pension Protection Act of 2006 (PPA) defined specifically how defined benefit (DB) plans should measure funded status—using high-quality corporate bond interest rates and a specific mortality table. It also prescribed a calculation for minimum required contributions each year, and plan sponsors had seven years to get their plans fully funded.
However, since the passage of the PPA, there have been six efforts to give funding relief to DB plan sponsors.
Currently, funding relief is available until 2020. What happens if no further funding relief is provided?
Jodan Ledford, head of U.S. Solutions at Legal & General Investment Management America (LGIMA), who is based in Chicago, notes that while some DB plan sponsors are using the funding relief, there are several factors which may impact their funding strategies: an increase in Pension Benefit Guaranty Corporation (PBGC) premiums that will cost less-funded plans more; recording deficits on their balance sheets; and the potential that funding more offers more tax relief on the heels of potential corporate income tax relief.
For those that use funding relief, assuming the interest rate environment will stay the same their discount rate could fall as much as 1.5%, Ledford says. Considering a duration of 12 or 13 years, they could see a 19% increase in funding liability, and conceivably will have to contribute more to their plans annually as a result.
John Lowell, partner and retirement actuary with October Three, who is based in Atlanta, notes that in 2012, $100 billion was contributed to DB plans—that was before passage of the Highway and Transportation Funding Act (HAFTA). Over the last few years that’s decreased to as low as $44 billion. Lowell says October Three’s projections are, that in 2020, plan sponsors may need to make contributions of $150 billion, even given the number of plans that are frozen. “Not necessarily a rule of thumb, but in aggregate, DB plan sponsors are looking at contributions 50% higher than before HAFTA,” he says.
While Ledford and Lowell both concede there is no way to project what will happen in the stock and bond market, they don’t anticipate that higher interest rates and positive investment returns will mitigate the effect on losing DB funding relief. According to Ledford, if interest rates rise to closer to the 25-year average, they would be harmonizing to the relief provided anyway.
Lowell says higher interest rates and positive returns may dampen the effects of losing funding relief, but that said, “How much do we really think interest rates will go up between now and then?” he queries. He speculates that interest rates will not get to the point they were pre-funding relief. In addition, he says, if investment returns are large enough, it could help, but many think the market is overvalued right now and we won’t see those returns in the future.NEXT: What should DB plan sponsors do?
According to Lowell, there are essentially three kinds of DB plan sponsors. Those committed to sticking with their DB plans can choose to fund it if they have the capital. Others that don’t have access to cash will have to fund when contributions come due. Those looking to exit DB, probably don’t have the capital and are stuck.
Lowell suggests borrowing to fund is an option. “Plan sponsors are paying large PBGC premiums right now. If they think about premiums and paying on a loan—typically DB plan sponsors are looking at paying on a loan at a 12% interest rate. Unless they have really bad credit, if someone offered you a chance to borrow money at 12%, you may say they were crazy, but by not borrowing to fund, sponsors are in essence paying 12% to the PBGC,” he says.
Assuming a DB plan sponsor has access to cash and there are not other obligations more compelling, it should look into the future and begin to fund its plan in the way the PPA intended. If it plans to offload the DB, it will have to get fully funded plus some to cover insurance company premiums.
Pension forensics is a name October Three uses for looking into the future. Lowell says, for the most part, the big plans, jumbo plans, more sophisticated plans are using multiple consultants to do some detailed forecasting for future on multiple scenarios. “What we do with forensics with our own clients and others is take a good look out into the future and show what happens in multiple scenarios. If that shows there may be a shock to the company, they’ll say ‘What can we do to fix it,’” he says.
Ledford adds, “I would imagine that a lot of those conversations are going on with actuaries. It’s a byproduct of actuarial services to do projections.” He says DB plan sponsors and their actuaries should do scenario testing—flat interest rates, wear away of relief, interest rates go up—and see if it makes sense to pre-fund their plans at this time. “They have to balance out the best use of corporate cash. In a lot of cases, it makes sense to pre-fund due to PBGC variable rate premiums of $34 per $1,000 of underfunding today escalating to an estimated $42 per $1,000 of underfunding in the coming years. That’s an excise tax,” he says.
Any analysis should reflect that, even if interest rates go up, it will just be a new normal, and asset returns will be more in the range of 6% to 7%, not the 10% plan sponsors were banking on 20 years ago, according to Lowell.
Ledford says with his clients, it doesn’t seem funding relief wear away is a top topic; they are focused more on PBGC premiums and they think additional relief will keep coming.But, Lowell says, all DB plan sponsors should be looking into the future.