Compliance October 29, 2014

Attorney Explains TDF Annuity Rule

October 29, 2014 (PLANSPONSOR.com) – What does the new guidance about annuity investments in target-date funds (TDFs) mean for retirement plan sponsors and participants?
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While at the 2014 America Society of Pension Professionals and Actuaries (ASPPA) Annual Conference, S. Derrin Watson, an attorney with SunGard, spoke with PLANSPONSOR about what exactly the guidance allows and how annuities in TDFs will work for participants. Watson notes the IRS is trying to find ways to provide for at least part of participants’ retirement savings to be invested in annuities that will provide them with lifetime income.

In a TDF series, funds start at a certain participant age—say 55—to move underlying investments from equities to fixed income. The guidance allows the funds that are making this shift to invest in an annuity as part of the underlying investments, Watson explains. The annuity can either be an annuity that starts payments to participants shortly after retirement age or at some age in the future, say 85, to protect a participant against outliving his assets. Watson says at a participant’s retirement date, the fund manager will issue the annuity or a certificate for a group annuity to the participant, and the other assets of the TDF will be retained in the fund and reallocated.

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According to Watson, insurance companies will not issue annuities without knowing the age of the annuity recipient, so the TDF series that uses annuities will have to restrict how participants invest in the series. For example, if a 30-year-old participant wanted to invest in a more conservative TDF than the one corresponding to her age, she could not invest in the 2020 fund in the series because if offers annuities. However, if the series did not include annuity investments, the 30-year-old participant could invest in the 2020 fund.

Watson says the IRS provided in its guidance that the age restriction on TDFs in a series that offers annuities will not violate antidiscrimination rules as long as younger participants will have the same investment opportunities at the same as age as older participants do.

The IRS then asked the Department of Labor (DOL) if such funds could be used as a plan’s qualified default investment alternative (QDIA), Watson notes. The DOL said yes, as long as the TDF series that offers annuities meets all other QDIA requirements. “The DOL also said the TDFs would qualify for the safe harbor from liability against a participant claim provided by the QDIA requirements as long as there is nothing inherent in the annuity chosen that would disqualify it,” he adds.

The DOL also said plan sponsors could limit their fiduciary liability for offering annuities to participants by offering them through TDFs. The plan sponsor has a fiduciary liability to prudently select the TDF manager; the TDF manager selects the underlying investments in the TDF. According to Watson, the DOL mentioned that TDF managers could use the Employee Retirement Income Security Act’s (ERISA) safe harbor rules when selecting the annuity in which to invest participants’ money.

Opinions October 28, 2014

How Can Plan Sponsors Handle PBGC Premiums for Underfunding?

October 28, 2014 (PLANSPONSOR.com) - The Pension Benefit Guaranty Corporation (PBGC) charges pension plans a portion of their underfunding each year.
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Through 2013, the charge was 0.9% of the underfunding. By 2016, that rate will triple to approximately 2.9%. For example, a plan that is $20 million underfunded will be charged a premium of $580,000 per year.

How can plan sponsors handle this? Options are somewhat limited. PBGC rules offer a choice of two calculation methods, and that can offer occasional relief. But, plan assets and liabilities are largely at the mercy of market forces. The most straightforward answer is to contribute cash into the pension plan.

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Plan sponsors may not have the cash to contribute to their plans; another option is to borrow money to fund the pension plan.

This may sound like leverage, but plan sponsors already owe the pensions. The PBGC values those pensions as if they were AA-rated corporate debt. If a plan sponsor borrows money, funds the pension plan, and invests the borrowed proceeds in AA-rated corporate debt, it has roughly swapped one type of debt for another. The goal here is not to beat the market; the goal is to avoid paying a “tax” of 2.9% per year.

How should plan sponsors structure the borrowing? One possibility is to look at borrowing terms that approximately replace a plan sponsor’s projected cash contributions to the pension plan. For example, a seven-year amortizing loan with equal payments. Another possibility is to issue a bond with interest-only payments until maturity. Generally speaking, the longer it takes to pay down the principal, the higher the interest costs. So the faster plan sponsors pay off the debt, the greater the savings.

How much can plan sponsors save? Illustratively, if a plan sponsor pays 6% interest on its debt, invests the proceeds at 4% in long-duration corporate bonds, and forgoes 2.9% PBGC premiums, it saves 0.9% per year. On $20 million, that would be $180,000 per year, prior to taxes.

In addition, the pension contributions and the interest on the plan sponsor’s debt are generally tax-deductible. That may mean some tax relief above and beyond the PBGC premium savings. The higher the company’s taxes, the greater the potential tax advantages.

What happens when the markets move? If interest rates rise unexpectedly, the market value of the bonds a plan sponsor bought will go down. But so will the PBGC liability. The reason for investing in long-duration corporate bonds is to roughly immunize the previously unfunded PBGC liabilities. That said, there are a lot of moving parts. Financial modeling may help determine the potential savings and financial risks. The larger the transaction, the more detailed the modeling that might be warranted.

What should plan sponsors do with the other assets in the pension trust? That depends. If the pension plan is frozen, this may be a good opportunity to de-risk by investing mostly in corporate bonds. If the pension plan is still open, the plan sponsor might consider partially de-risking the portfolio, but that depends on its risk tolerance, among other factors.

What will this do to the plan sponsor’s income statement? That depends on a number of factors. If the plan sponsor de-risks all the pension assets, its pension expense may go up. Financial Accounting Standards Board (FASB) rules allow plan sponsors to count their expected pension investment returns before they’re realized, so there is a short-term disincentive to investing conservatively. Bottom line, though, if borrowing to fund can provide some combination of lower investment risk and lower PBGC premiums, there’s a net gain.

Before borrowing, plan sponsors should consider their credit rating, bond covenants, legal considerations, and professional fees, among other things.

If the plan sponsor can’t borrow easily, it could consider contributing company stock or property (such as land) in lieu of cash. This approach may have significant legal issues to address, so plan sponsors should proceed carefully.

The decision to borrow money to fund a pension plan is likely to be a team effort, involving the plan sponsor’s tax and finance people, Employee Retirement Income Security Act (ERISA) counsel, investment advisers, and actuary. More details and ideas are available here.   

 

Will Clark-Shim, FSA, EA, MAAA, principal and consulting actuary at Milliman in Portland, Oregon    

 

NOTE: This feature is to provide general information only, does not constitute legal advice, and cannot be used or substituted for legal or tax advice. Any opinions of the author(s) do not necessarily reflect the stance of Asset International or its affiliates.

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