The challenge
The Pension Benefit Guaranty Corporation (PBGC) is a U.S. government agency established to protect defined benefit (DB) pension plan participants. Sponsors of tax-qualified DB plans are generally required to pay annual insurance premiums to the PBGC. In the event of a covered plan’s failure, the PBGC will assume ongoing payment of pension benefits (subject to statutory limits). While PBGC coverage offers additional security for DB plan participants, the cost of annual premiums is a concern for many plan sponsors. The Moving Ahead for Progress in the 21st Century Act of 2012 (MAP-21) provided near-term funding relief for DB plan sponsors, but it also included PBGC premium hikes.
For single-employer plans, MAP-21 prescribes increases in the annual “flat-rate” or per-participant portion of PBGC premiums from $35 in 2012 to $42 in 2013 and $49 per participant in 2014. The $49 rate will be adjusted for inflation after 2014.
The other portion of annual PBGC premiums for single-employer plans, known as the “variable-rate” portion, is based upon the funded status of a plan. Any funding shortfall—measured by comparing a plan’s assets to its liabilities on a PBGC-mandated basis—is subject to a variable-rate premium charge. For 2013, the charge is $9 per $1,000 of underfunding. MAP-21 adds an inflation adjustment to the variable-rate premium after 2012 and specifies additional increases of $4 per $1,000 of funding shortfall in 2014 and $5 per $1,000 of funding shortfall in 2015. This is likely to result in total variable-rate premium charges of $14 per $1,000 of funding shortfall in 2014 and $19 per $1,000 of funding shortfall in 2015. Additionally, the funding relief under MAP-21 does not apply for PBGC premium purposes, meaning there is no “relief” or reduction in the variable-rate premium liability.
Given the increases outlined above, one of our clients asked us to explore its options for reducing PBGC premiums.
Recommendations: Lump-sum payments, credit balance, borrowed funding
The client sponsors two underfunded single-employer DB plans with a total of approximately 11,000 participants and unfunded PBGC liabilities in excess of $100 million in 2012. Its total PBGC premium for 2012 was about $1,500,000, of which roughly $400,000 was flat-rate premium and roughly $1,100,000 was variable-rate premium. We came up with several recommendations for its case.
Recommendation 1 – Amend the plans to offer a lump-sum form of payment to terminated vested participants with small benefit amounts.
DB plans can offer a lump-sum payment option in which a one-time payment is made in lieu of stream of income. In general, payments can only be made after a participant terminates employment. Plans can provide for mandatory cash out of de minimis lump-sum payments, where the de minimis present value threshold is currently defined as $5,000 or less. We recommended that the client amend the plans to cash out such small benefit amounts of terminated vested participants because it has outsized fixed administrative costs, including PBGC flat-rate premium costs. For example, a plan sponsor would likely have to pay several decades worth of flat-rate premiums at $49+ per year for a participant who terminates employment at age 30 and is due a mere $5 per month benefit beginning at age 65. The present value of all future flat-rate premiums for the participant in this example is about $1,000 using reasonable assumptions (whereas the lump-sum benefit cash-out would only be around $100 to $150).
Once a participant’s benefit is completely cashed out, however, the plan sponsor does not pay further PBGC premiums for that participant. In this case, cashing out all participants with de minimis benefits would remove a total of roughly 400 participants from the plans, for a total savings of roughly $17,000 in 2013 flat-rate premium. This savings adds up over time. We estimate the present value of all flat-rate premium savings to be roughly $340,000 due to cashing out the 400 participants.
In addition to de minimis lump sums, we suggested amending the plans to establish a higher voluntary lump sum threshold (e.g. up to $10,000 or $20,000). The higher threshold could be put in place as part of a limited-time offer known as a “window,” or it could become a permanent part of the plan. As a permanent form of payment option, ongoing lump sums can occur as eligible participants leave employment in future years. The main point here is to cash out the smallest benefit amounts because they have outsized premium costs. In this case, cashing out all participants with lump-sum values under $20,000 would remove approximately 1,600 additional participants from the plans, for an additional savings of roughly $67,000 in 2013 flat-rate premium. We estimate the present value of the additional flat-rate premium savings to be roughly $1,360,000 due to cashing out the additional 1,600 participants. Of course, elections for lump-sum amounts over the de minimis threshold must be voluntary, so the actual savings will depend upon the take-up rate.
We discussed with the client the many considerations in adopting a lump-sum strategy, including the calculation method, setting the amount of the voluntary lump-sum threshold and the potential for additional accounting expenses under settlement accounting rules. For larger benefits, the client might simply decide not to offer lump sums at a time when low interest rates result in relatively larger lump-sum values. In addition, the plans’ underfunded status might trigger lump-sum payment restrictions. There are also implementation costs to consider.
Recommendation 2 – Designate the current year’s quarterly contribution requirements as funding for the prior plan year.
We recommended that the client designate the quarterly contributions during 2013 as 2012 contributions. Pension funding rules allow for this as long as the contributions are made before September 15, 2013. The first two quarterly installments obviously fall before September 15. By moving the October 15, 2013, and January 15, 2014, quarterly installments to the earlier date of September 15, 2013, the client could designate them as contributions for 2012 as well.
Assuming each plan’s minimum funding requirement was already met for 2012, the plan sponsor can elect to create credit balance from the additional 2012 contributions. The plan sponsor can then elect to use the credit balance to meet 2013 quarterly contribution requirements. The sponsor in this case was not in a position to adopt such a strategy in the past because there are rules restricting credit balance usage for its underfunded plans. However, funding relief under MAP-21 meant that the client could use credit balance in 2013.
The advantage of this strategy is that the newly designated 2012 contributions will be included in the calculation of the January 1, 2013, funding shortfall for PBGC variable-rate premium purposes. Thus, the strategy achieves savings of roughly $9 per $1,000 of the newly designated 2012 contributions. The savings might sound small, but $9 per $1,000 will add up because we are talking about millions of dollars per quarterly installment. Savings from this strategy will be doubled in 2015 when the variable-rate premium increases to $19 per $1,000 of shortfall. Although this contribution designation strategy can be somewhat confusing, it achieves real PBGC variable-rate premium savings. For this client, designating all required 2013 quarterly contributions as additional 2012 contributions would save roughly $215,000 in 2013 variable-rate premium.
Recommendation 3 – Borrow cash to fund the plans and eliminate the shortfalls that lead to variable-rate premiums.
The most obvious way to reduce variable-rate premiums is to make additional contributions to the pension trusts. If fully implemented, this strategy completely eliminates PBGC variable-rate premiums because any funding shortfalls are eliminated; however, this client would have difficulty in making contributions sufficiently large enough to reduce shortfalls significantly. One way to come up with the necessary funds is to borrow. In this case, the client would need to borrow roughly $100 million to fully fund the plans on a PBGC-mandated basis.
The variable-rate premiums of $14 per $1,000 of shortfall in 2014 and $19 per $1,000 of shortfall in 2015 are equivalent annual charges of 1.4% and 1.9% of shortfall, respectively. Borrowing to fund the plans could eliminate the variable-rate premium charges. Given the current low interest rate environment, the client could cover a significant portion of the borrowing costs using the premium savings. Once contributed to the pension trust, the funds might also return more than the borrowing costs, depending on investment performance, and DB plan contributions are generally tax deductible. The large contributions to shore up funding shortfalls would be tax deductible in this case. So, there are several positive results associated with borrowing to fund the plans.
Of course, there are other considerations. The client needed to determine if adopting such a strategy would constitute the best use of its borrowing power. Depending on plan asset allocations, there is downside risk if the plan investments have poor returns. In the case of rising interest rates, the client might end up stuck with overfunded plans. We discussed the pros and cons of this strategy with the client.
The outcome: Client combines options for significant PBGC premium savings
The client in this case has acted on some but not all of our recommendations. Regarding our first recommendation, it added mandatory de minimis lump-sum provisions to reduce flat-rate premium head counts and other administrative costs. Removing all of the participants with de minimis benefits will save the client roughly $17,000 in total 2013 flat-rate premium and even more in subsequent years. Management is still exploring whether to pursue adding lump-sum provisions at a threshold higher than $5,000. The client also acted on our second recommendation. Three of the 2013 quarterly installments for each plan have been designated as 2012 contributions, accelerating the October 15 installments to a date prior to September 15 as required. This action will reduce the total 2013 variable-rate premium by about $162,000. As for our third recommendation, the client took borrowing to eliminate the entire funding shortfalls under serious consideration. It has not yet decided to make such an extreme move, though. Regardless of further action, the smaller steps that the sponsor has taken will lead to significant PBGC premium savings.