Creative Funding Strategies DB Clients Should Consider

The average funding ratio of corporate defined benefit (DB) plans has gone up over time, from 78.8% in 2012 to 89.4% this year, but there is still some room for improvement, Robin M. Solomon, a partner at Ivins, Phillips & Barker, told attendees of the 2018 PLANSPONSOR National Conference (PSNC), in Washington, D.C., last week.

With funding relief starting in 2008 and extended through 2020, there is still a lot of flexibility in setting actuarial assumptions for determining funded status. However, Solomon noted, with funding relief, DB plan sponsors may get a false sense of security. Their funded status may be good, but if they terminate the plan or do a pension risk transfer (PRT), calculations are different and funded status will be lower.

She contended that Pension Benefit Guaranty Corporation (PBGC) premiums have become a tax on using funding relief. Premiums are growing increasingly higher, costing plans more for unfunded benefits. Since 2012, flat PBGC premiums and variable premiums have been increased by legislation, and are now about double what they were. Next year, there will be an $80 per person flat rate. In addition, plan sponsors have been looking at persistently low interest rates, which drive up plan liabilities, and new mortality tables for 2018/2019 increase liabilities by approximately 5%.

Solomon said DB plan sponsors may want to consider voluntary pre-funding of their plans. Why? Tax reform may generate repatriated cash—it offers a one-time opportunity to bring money from overseas at a decent tax rate. In addition, there’s an opportunity this year only to make a contribution and deduct it at the 2017 35% corporate tax rate. Tax reform changed the corporate tax rate to 21% as of this January 1, so the value of a pension contribution deduction will go down. “We think there is enough IRS authority to support that these accelerated contributions can count as 2018 contributions,” she said.

Other reasons Solomon cited for pre-funding are that continued pension volatility gets tiresome; pre-funding can be preparation for de-risking; and plan sponsors can avoid the PBGC variable rate premium.

There are challenges to consider with pre-funding a DB plan:

• Weighing the cost against other business priorities;
• Resisting the desire to invest in growth assets while hoping that funding levels improve; and
• The risk of trapped surplus funds.

“For many years, companies defaulted to the minimum required contribution, and, around 2013, long-term interest rates went up, pension deficits started to close, and plan sponsors got confident, so they didn’t think about contributing more to their plans,” Solomon said. “It’s time to sit down and think of a funding strategy. How much of your plan will be closed by asset growth or interest rate changes? How much in contributions should you make? Identify the appropriate funding level, and what you plan to do with your DB plan—freeze it, close it, terminate it or transfer risk.”

Ways to Pre-Fund Other Than Cash

Aside from making a cash contribution, Solomon suggested borrowing to fund. “It replaces variable/volatile debt[—the type associated with underfunded pensions—]with a fixed-predictable obligation,” she said. “Plan sponsors can compare costs of borrowing with the PBGC variable rate premium.” However, she added the caveat that borrowing to fund is popular now, although this may not continue because deductions on interest will change.

DB plan sponsors can also make in-kind contributions of real property, employer stock, employer notes and Treasury bills. In the first three cases, DB plan sponsors sell property and lease it back to the plan. Solomon points out this may create Employee Retirement Income Security Act (ERISA) issues—plan sponsors need to think about the value of the asset and whether it is prudent for the plan to acquire. In addition, they will need to get a statutory exemption—ERISA Section 408(e) says the selling price may not exceed 10% of plan assets—or plan sponsors can request an individual exemption.

When using Treasury bills, plan sponsors can only get an individual exemption. But unlike a cash contribution, a contribution of T-bills will not reduce a company’s credit rating.

But the “pro” of using these strategies is that plan sponsors can use assets they have lying around and avoid spending cash. “It’s a great strategy if the property is paid for and is heavily depreciated,” Solomon said.

Other creative funding strategies mentioned by Solomon include converting after-tax contributions to pre-tax and converting a noncontributory plan to a contributory plan.

Finally, Solomon told conference attendees if they are lucky enough to have a funding surplus, they can use it to offset future contributions, offset administrative fees, merge with another plan, or fund retiree medical benefits—i.e., in a 401(h) account. If the surplus reverts to the employer, it will have to pay a 50% excise tax, which is reduced to 20% if the assets are applied to a qualified replacement plan.