The Pension Benefit Guaranty Corporation (PBGC) recently released its 2016 financial status report. The good news is that the single-employer program pension deficit improved slightly from last year. Hopefully, this means additional PBGC premium increases are not on the horizon. However, PBGC fees are continuing to increase per built in premium escalators that continue to be onerous for plan sponsors. What options do plan sponsors have to mitigate increasing PBGC premiums?
Each year as the PBGC premiums increase, plan sponsors are feeling pressure to be creative in search of remedies to mitigate increases. The PBGC premiums are composed of both a flat rate premium and a variable rate premium. The variable rate premium has a maximum limit based on a per participant amount. The PBGC variable rate premium is limited to $500 per participant (for 2016), which is a significant amount. In addition, both premiums have built in escalators for future years. There are a few solutions that plan sponsors can consider, depending on their situation, to reduce both of these fees. In this case study, we will look at options that one plan sponsor considered to reduce the variable rate premiums portion of the fees. For this plan sponsor, the plan is an open pension plan and the PBGC variable rate premium is at the maximum per participant amount.
We discussed three possible options to reduce PBGC premiums, listed below:
1) Make additional contributions from corporate assets, credited to the prior plan year.
2) Borrow at a lower interest rate than the PBGC variable rate to fund out of this part of the PBGC premiums.
3) Split the pension plan into two plans-one plan with only actives and a second plan with the remaining retirees and terminated vested participants.
Let’s take a deeper look into these options and spend a little extra time on the third option, splitting the pension plan.
Additional contributions are a great way to reduce PBGC premiums, assuming the plan sponsor has the extra cash and doesn’t have other opportunity costs for that money. For each dollar of extra contribution, the variable rate premium is reduced by 3.0% of the unfunded PBGC liability each year (and the 3.0% increases in subsequent years). This may be a good strategy for an open plan, but for frozen plans, this may not be desirable. Funding all of the PBGC liability would make the plan overfunded. Excess plan assets are difficult to recapture for plan sponsors. Pennies on the dollar are returned when they do, usually only at plan termination. For this plan sponsor, extra contributions would have to be very sizable to reduce the PBGC variable rate premium to below the maximum per participant cost. As such, they would have to contribute tens of millions of dollars before the extra contributions would reduce the variable rate premium.
There is also a good argument for borrowing capital to fully fund the liability and reduce or eliminate the variable portion of PBGC fees. Tax-adjusted borrowing rates for some plan sponsors are lower than the PBGC variable premium rates. And with premium rates increasing each year, the argument strengthens. Again, this strategy makes most sense for open pension plans for the same reasoning as above.
Now we will explore the third option in a little more detail–splitting the pension plan into two plans. Let’s start off by looking at the numerical analysis. Below is a chart with a comparison of the PBGC savings along with the change in required contributions. As a reminder, this plan is paying the current maximum PBGC premium ($ in millions):
|2016 valuation results
|Est. yearly PBGC savings
|*Combined PBGC flat rate and variable rate premiums
Based on Internal Revenue Code (IRC) rules for pension plans, retirees get the lion’s share of assets upon a plan spinoff. As such, you can see that the funded status of the inactive plan is now 137% funded. This eliminates the PBGC variable rate premiums for this plan (only the flat-rate PBGC premium remains). This is where the savings is captured. For the active plan, the funded status drops to 80% (after waiving the prefunding balance to stay at 80% funded). One might expect the variable rate premiums to skyrocket for this plan. However, because the PBGC premium maximum is a per person cap, the premiums can’t go up any higher for these participants.
In this situation, the PBGC premiums went down by $0.7 million. This savings would continue each year until the active plan is no longer at the PBGC maximum. As a consequence, the minimum required contributions went up $9.0 million and all of the prefunding balance had to be waived. Plan sponsors realize they have to fund the pension plan. Higher contributions also reduce the PBGC premiums. However, some plan sponsors may not be able to make the increased contributions to obtain additional PBGC savings.
There are other considerations to take into account as well. Some examples are:
- How to communicate the drop in funded status to active employees. Active employees will see the funded status drop in their plan in the next Annual Funding Notice, if not communicated earlier. How this gets communicated is critical.
- In some cases (like the above example), credit balances may need to be waived. This will affect cash contribution flexibility in future plan years.
- How should the investment policy change? The separated plans have different funded statuses than the original plan. For the inactive plan, should the investments be conservative to preserve principal given that the plan may be overfunded? Should the active plan take on significantly more equity investments to improve funded status more quickly? Will the new investment policies expect to achieve a lower combined rate of return than the current investment policy? If so, the lower combined expected asset returns would reduce the PBGC savings and possibly be greater than the total savings. And finally, should the inactive plan be terminated?
- Actuarial, legal, administration, and audit fees would go up given that there would now be two pension plans. This could be 10% or more of the PGBC savings in this case.
- Will future legislation change if many plan sponsors utilize this PBGC savings technique, thus eliminating the savings at some point in the future?
As you can see, there is a lot of discussion and analysis that must be addressed when considering splitting a pension plan for the PBGC savings.
For this plan sponsor, the two biggest concerns were changing and adding a new investment policy this year and the possible reaction of the active employees, if the funded status significantly drops. They felt that the expected return of two investment policies could likely return less than the current investment policy and that the difference may be sizable. In the end, the plan sponsor needs more time to think through the investment implications of two separate plans. For the time being, they made larger cash contributions and credited them to the prior plan year. The plan sponsor felt this was the best approach for the company for this year. The plan sponsor appreciated knowing that splitting the plan into two plans is an option and wants to keep it in mind for future years. They always appreciate new ideas to help manage the pension plan.