On December 18, Congress passed into law the Bipartisan Budget Act of 2013 (BBA). I noted in a recent blog that the increases in PBGC premiums included in BBA give pension plan sponsors an incentive to fund up their plans. It’s worth a closer look at just how big that incentive might be.
Mike Barry points out in a recent note that if the cost of borrowing is exactly equal to the return earned on plan assets, then it follows that it is cost-neutral whether a plan sponsor:
(a) makes up a pension plan shortfall over a fixed period, or;
(b) issues short term debt with the same repayment schedule as the planned contributions, and puts the proceeds of that debt into the pension plan immediately.
Or, rather, that would be cost-neutral if it were not for the PBGC variable rate premiums that are payable in case (a). The effect of these premiums is to raise the breakeven rate at which it is worthwhile for a plan sponsors to borrow in order to fund. Jim Gannon has extended that analysis to capture the typical corporate debt issuance term of 10 years, and to include the impact of the tax benefit that exists for many corporations: contributions are tax-deductible whether made immediately or over a period of time, but borrow-and-fund also leads to a tax deduction on debt interest. That makes the case for the strategy even stronger.
A brief summary of Jim’s results is shown below. The actual variable rate premium payable in 2016 will likely be higher than the 2.8% shown, since this rate is (bizarrely) linked to wage inflation. But note how the jump from 0.9% to 2.8% raises the breakeven borrowing rate.
For example, assuming an effective tax rate of 25% and a ten-year borrowing term, borrow-and-fund has a breakeven borrowing rate 2.98% higher than the return earned on plan assets. That means that for just about any plan sponsor with a pension shortfall and access to the debt markets, borrow-and-fund is something they’ll likely want to consider.
The required cost of borrowing to make and fund preferable to paying the minimum required contribution each year:
Source: Russell Investments
Obviously, the available choices and the detail of the math will vary for any given corporation (and there are a far wider range of options in the capital structure than just the one I describe here), but it’s clear that the latest PBGC premium increases will have a significant impact on many corporations’ analysis and funding strategies.
As for the projections that showed the Moving Ahead for Progress in the 21st Century Act (MAP-21) to be a revenue-raiser, they looked questionable based on 2012 data and probably turn into pure fantasy for future years if corporations do indeed start acting on the math shown above.
Borrow-and-fund would have implications for investment strategy, too. One reason that many plan sponsors have preferred not to fully fund their pension plans is that, in the event of favorable market conditions, there is a risk of too much surplus arising in the plan. Surplus in the plan cannot easily be transferred back to the sponsor, so too strong a funding policy can lead – especially if new accruals in the plan have been frozen – to trapped capital. So taking risk can turn into a heads-you-win, tails-I-lose proposition once a plan has been fully funded. This explains the popularity of liability-responsive asset allocation (LRAA) strategies, which take the form of de-risking glide paths to reduce risk as full funding gets closer. So a strategy of borrow-and-fund accelerates investment decisions and strengthens the case for liability-driven investing.
So these proposed premium increases are going to lead to some hard thinking by plan sponsors, and the consequences could be far-reaching.