In a quarterly earnings call on April 20th, Verizon Communications CFO, Matt Ellis, described a $3.4bn discretionary pension contribution as “net present value positive”. The math behind that statement is driven by tax considerations and a sharp increase in Pension Benefit Guaranty Corporation (PBGC) premiums.
Net present value (NPV) analysis
A detailed description of NPV analysis for pension funding decisions is set out in a 2015 Russell Investments practice note “Borrow to fund” by Jim Gannon.
Borrowing money in order to fund a pension plan can be seen as replacing one form of debt – an obligation to fund the pension plan’s benefit promises – with another form of debt – an obligation to repay the borrowed money. The cost-effectiveness of the decision therefore depends on the cost of borrowing and the return that will be earned on plan assets. Those are not, however, the only considerations. Ellis’ comments in the earnings call point to two other key factors in particular: tax considerations and PBGC premiums:
“The discretionary pension contributions are net present value positive on an asset tax basis given the reduction in our variable rate PBGC premiums and the expected net return on planned assets.” 1
His comments also touched on the impact of the decision on future contribution requirements, funded status and the credit rating metrics used by rating agencies.
Tax affects the NPV calculation because pension contributions are tax-deductible, whereas only the interest on corporate debt is tax-deductible (while principal repayments are not.) Tax effects therefore generally have tended to favor a borrow-to-fund strategy.
On top of the tax impact is the effect of PBGC variable rate premiums, which have increased significantly in recent years, and are set to continue increasing. The economic effect of the variable rate premium is equivalent to a tax on pension shortfalls, so this is another factor that tends to favor borrow-to-fund.
Jim Gannon’s note provides representative analysis of the breakeven interest rates necessary in order to support borrow-to-fund. Results vary from case-to-case depending on the effective tax rate of the corporation and other factors. It also notes additional considerations (such as the effect of the timing of contributions and of the per-participant cap on PBGC variable rate premiums.) So not every corporation will necessarily reach the same conclusions from NPV analysis as Verizon did.
But running the numbers is probably worthwhile.
1 Verizon Communications Quarterly Earnings Call, April 20, 2017. Accessed at: www.SeekingAlpha.com.