Accelerating DB Funding an Important Strategy to Discuss

Tax reform has only increased the incentive to accelerate contributions to defined benefit plans, and there will still be incentives in the future, but plan sponsors won't benefit if they don't lock in those gains.

The Tax Cuts and Jobs Act of 2017 has already sparked acceleration of defined benefit (DB) plan funding by corporate plan sponsors.

Goldman Sachs Asset Management’s (GSAM’s) Senior Pension Strategist Mike Moran, based in New York City, previously noted that Kroger and Valvoline are two examples of companies that explicitly cited potential corporate tax reform as one of the reasons for making a voluntary contribution earlier in 2017.

An article posted on October Three Consulting’s website explains the ways accelerating funding now will save DB plan sponsors money. Corporate tax rates are going down, from a top marginal rate of 35% in 2017 to 21% in 2018. DB plan contributions for 2017 must be made by the tax return due date, with extensions. For a calendar year plan/tax year, that would generally be September 15, 2018. Non-calendar year plan/tax year taxpayers have longer to execute this strategy.

October Three offers a simple example of how much DB plan sponsors will save by making an accelerated contribution now, considering a corporation that pays taxes at the highest marginal rate and sponsors a defined benefit plan with $100 million in unfunded benefits. If the sponsor contributes that $100 million for the 2017 year, it reduces its 2017 taxes by $35 million; if it contributes that $100 million for a later year, it reduces its taxes for that later year by $21 million. Making that contribution for 2017 nets the sponsor $14 million in tax savings.

But, Brian Donohue, partner at October Three Consulting, based in Chicago, points out that is not the only way DB plan sponsors will save money. DB plan sponsors must pay Pension Benefit Guaranty Corporation variable-rate premiums (VRPs) on the amount of their unfunded vested benefits (UVBs) for the prior plan year. As a general matter, contributions for 2017 will reduce VRPs for 2018, and fully funding plan liabilities will eliminate them. For the example plan with $100 million in unfunded benefits, a $100 million contribution this year saves the company $3.8 million in premiums—Donohue explains this is $3.0 million net of taxes because the company will get a tax deduction for premiums, so the cost for the company is a little less. And, “putting contributions in the plan now will eliminate a string of premiums for many years,” he points out.

The question for plan sponsors regarding whether they can pursue this strategy is, “What is the limit for how much they can contribute and deduct for 2017?” Donohue says the amount is generally larger than the appetite the plan sponsor has. One constraint he notes is that a plan sponsor won’t get the benefit of accelerated funding if it makes a contribution that eliminates taxable income and puts it in a carry forward provision—for a big company that would be a huge number. The more practical question, according to Donohue, is, “How much cash do we have or want to borrow to accelerate funding?” He says the law allows DB plan funding of up to 150% or more.

Accelerated DB plan funding had already begun to be a conversation, but the change in corporate tax rates makes it more valuable, Donohue says. “It is very rare in the pension world to have this opportunity.” Donohue feels the conversation isn’t getting the traction it should be, given its big benefits. “[The conversation] is not being driven by consultants, but within companies. One would think this is a huge conversation to have right up until September,” he says.

Accelerating funding in future years

Even before the Tax Cuts and Jobs Act, DB plan sponsors were accelerating funding. Eighty percent of defined benefit (DB) plan sponsors have accelerated funding, largely due to increasing Pension Benefit Guarantee Corporation (PBGC) fees and the prospect of lower corporate taxes, according to results of the Mercer/CFO Research 2017 Risk Survey.

“Certainly, there is incentive to do something sooner due to tax reduction, but even before, plan sponsors were doing it due to PBGC premiums,” Moran says. He expects to see a lot of activity pulled forward to the first three quarters of this year, and afterwards there may be a slow-down, but it will still make sense to accelerate funding due to premiums, he adds.

Whether now or in the future, if DB plan contributions get plans to a higher funded level and the plan sponsor doesn’t shift the plan’s allocation to lock those gains in, then plan sponsors could lose the benefit of accelerated funding, Moran warns. As contributions lead DB plans to hit triggers on a liability-driven investing (LDI) glide path, plan sponsors need to shift allocations. “It’s not just about making higher contributions; it’s also about what plan sponsors are doing as a hedging strategy not to lose benefits,” he says.

According to Moran, the DB space has hit an inflection point; more DB plan sponsors are accelerating funding than taking funding relief that was extended in the Budget Act of 2015. “Three to five years ago plan sponsors were putting in only the minimum contribution, taking advantage of funding relief,” he says. “But as [PBGC] premiums went higher, plan sponsors saw the advantage of contributing more. Now with tax rates changing, it makes even more sense.”

Moran concludes: “We have seen a lot of activity in this area already, but tax reform just adds another log on the fire of incentives to accelerate funding. We will see more activity as the window closes on this opportunity.”