With recent legislation greatly increasing premiums payable to the PBGC, they have now reached a level at which they become a material consideration in decisions such as funding, risk transfer and investment policy.
Now too big to ignore
There are a number of considerations that go into corporate (single-employer) pension decisions. Until recently, PBGC premiums were not a major consideration, representing a marginal (albeit unwelcome) charge. But these premiums got bigger as a result of the Moving Ahead for Progress in the 21st Century Act of 2012 (MAP-21) and increased again under the Bipartisan Budget Act of 2013. As a result, they are now hard to ignore when policy decisions are being made.
The PBGC premium has two components: a flat-rate (per headcount) premium and a variable-rate premium based on the funding shortfall of assets below vested benefits. The variable-rate premium is, however, subject to a cap. When that cap applies, it changes the incentives that apply to certain decisions—more on that below. But I’ll start with the background.
Up to a threefold increase
The flat-rate premium was $35 per participant as recently as 2012, is currently $57 per person, and will be $64 per person in 2016, rising with wage inflation after that. The variable-rate premium was 0.9% of the vested benefit funding shortfall in 2013, is currently 2.4% of the vested benefit funding shortfall and will be at least 2.9% of the vested benefit funding shortfall in 2016. This percentage will also increase with wage inflation. So that adds up to something between a two-fold and a three-fold increase over the period 2012 to 2016. The variable-rate premium is, however, now capped—currently at $418 per participant, rising to $500 per participant in 2016.
Route 1: pay down the shortfall
Many corporations are currently taking advantage of funding relief that was provided in the Highway and Transportation Funding Act of 2014 (HATFA), and have reduced contributions into their plans. But the penalty on a funding shortfall will soon be running at almost 3% a year. That’s effectively dead money.
HATFA’s funding relief uses an adjusted discount rate to produce a lower liability, but the shortfall used for the PBGC premium calculation does not use that adjusted discount rate; you could be fully funded for the HATFA calculation, yet still find yourself paying a substantial variable-rate premium to the PBGC. So this is a big enough penalty that in many cases it will change the balance in the funding decision, encouraging sponsors to put in more than the minimum required contribution. Consider this statement by a CFO:
I like the flexibility of having dry powder in the balance sheet. But the math is now overwhelming: PBGC premiums mean it is too expensive for us to sit on cash while there is a significant deficit in the pension plan.
That’s a hypothetical quote that Jim Gannon, Justin Owens and I put into a case study in a recent handbook about frozen plans. We haven’t yet seen the first real-life CFO quotation along those lines in the pensions press, but don’t be surprised when we do.
Route 2: reduce headcount
The variable-rate premium depends on the shortfall, but the flat-rate premium depends on headcount. The main ways to reduce headcount are to transfer the liability either to the participant (via payment of a lump sum) or to an insurance company (via purchase of an annuity.) In a recent report, with the clear (albeit less-than-catchy) title of “Participants need better information when offered lump sums that replace their lifetime benefits,” the Government Accountability Office highlighted this premium as one factor that is encouraging sponsors to offer lump sum windows to terminated vested participants.
They note (citing Justin Owens’ paper on risk transfer) that these terminated vested participants may represent less than one-sixth of a plan’s liabilities, but nearly a third of the plan headcount. So that’s a segment of the plan membership where the payment of lump sums can be particularly effective at driving down PBGC premium costs.
Be aware of the premium cap
When the premium cap applies, however, the dynamics of the calculation change, and so does the nature of the incentive for the plan sponsor. Once the cap applies, the PBGC premium is no longer affected by changes in the funding shortfall (unless it’s reduced by enough that the premium cap no longer applies.) So the incentive to pay down the shortfall (route 1 above) goes away in this case. But the incentive to reduce headcount (route 2) becomes no longer $64 a year from 2016 but $564 a year.
That’s perhaps enough that maybe I should have added “and the impact of #3 will blow your mind!” to the title of this blog. It’s certainly enough that for plans who are affected by the cap – or are close to being affected by it—there is a very substantial incentive to reduce headcount. If $64 a year is factoring into some decisions, then $564 a year screams for attention.
To get a quick sense of who falls into that category, the cap kicks in when the vested benefit funding shortfall is around $19,500 per participant. There are certainly plans out there—albeit a minority—for whom that is the case. For those plans, a reduction in the plan participant headcount can be a big cost saver.
So—whether the best action turns out to be route 1 or route 2—PBGC premiums have become too big to ignore.