By Eddie L. Vaughn
Pension sponsors often deal with fluctuating annual contributions and a funded status that never seems to improve. A troubling reality since a well-funded plan and predictable plan contributions would obviously be ideal.
A pension plan’s annual contribution can be determined by considering the plan sponsor’s funding policy (limited by ERISA’s minimum contribution requirements). Nevertheless predictable annual contributions and a well-funded plan are both difficult to achieve. Even more so for under-funded plans.
When it comes to the more volatile under-funded plans, are fluctuating annual contributions the best strategy to improve the plan’s funded status? Maybe there’s a better way.
Plan sponsors of any size, especially organizations with a strong balance sheet and debt capacity, may have an untapped resource that could help, i.e., the capacity to borrow.
First, consider a one-time, larger contribution that could be financed. The amount might be determined as follows:
- The next five years (or some specific period) of plan contributions
- An amount to fully fund the PBGC variable-rate premium liability
- Half of the plan’s current shortfall based on the funded status on the company’s balance sheet
What are the benefits of a larger single contribution to the pension plan?
- Eliminating the minimum required contribution for a period of time, creating a contribution holiday
- Paying back the loan with fixed annual payments that are potentially less than current contributions
- A balance-sheet-neutral transaction, exchanging a variable pension debt for a fixed debt
- A higher funded status that lowers investment risk by swapping volatile return-seeking assets for stable liability-hedging assets
- More benefit security allows additional de-risking action such as annuitization, or lump-sum settlements
- Increasing corporate earnings if the pension cost is lowered as a result of an immediate increase to plan assets
- Potentially lower PBGC variable-rate premiums
- Potential for taxable entities to deduct the borrowing costs
There are several considerations in evaluating whether a borrow-to-fund strategy is optimal:
- A large, financed contribution requires careful evaluation of the investment strategy for the plan, including the borrowed assets
- An organization’s debt capacity may not be sufficient, or the company may need to keep some debt capacity for other business needs, such as acquisitions or capital improvements
- Taxable entities may want to delay a larger one-time contribution if higher corporate tax rates are expected soon
- Depending on a variety of factors, the contribution may not generate a significant reduction to the PBGC variable-rate premium
It takes careful analysis to see if a borrow-to-fund transaction is right for your plan. For certain plan sponsors, a larger one-time financially engineered contribution could be an advantageous tactic. This approach may create a positive outcome on the funded status of the plan and reduce risk. It can lead to lower cash flow commitments for the near future, a balance-sheet-neutral transaction, and improved earnings.
McGriff Retirement Practice Leader