Reasons Not to Use Pension Funding Relief

Single-employer defined benefit (DB) plan funding relief that was part of the American Rescue Plan Act (ARPA) has been extended with the passage of the Infrastructure Investment and Jobs Act. Whereas previous funding relief allowed for a 10% “corridor” of rates on either side of a 25-year average that were permissible for discounting purposes, ARPA moved that corridor to 5% and extended it until 2025. The infrastructure bill extended it to 2030.

Brian Donohue, a partner at October Three Consulting in Chicago, says pension plan sponsors were not counting on the extended relief—and many don’t need it. In presentations to clients, Donohue says he has been stressing the need to shore up funding deficits because of the expense of Pension Benefit Guaranty Corporation (PBGC) premiums.

“Using the funding relief will allow plan sponsors to reduce their contributions, and it might give them more room to take risks and implement settlements of pension obligations, but there is no change in the total financial obligation of the plan, or to the company balance sheet, or PBGC premiums or the cost to terminate a plan,” Donohue says. In fact, a look at his calculations used for client presentations shows that using the funding relief could increase PBGC premiums by approximately $8 million from 2021 to 2030 and would increase the cost to terminate a plan by an even greater amount.

Donohue says the breathing room is only meaningful for sponsors that have historically only contributed the minimum required amount for their plan, but most plans don’t do that.

“One of the things we’ve observed is that two-thirds of plans are fully funded on a PBGC basis, so plan sponsors have been putting in more than what the law says they have to,” he says. “If they were putting in more than the minimum before ARPA, they should keep doing that for the reasons they have been.”

Donohue says most DB plan sponsors put in more than the required minimum because the PBGC rules have become the de facto funding rules for the majority of plans; sponsors are looking at premiums when deciding what to put into their plans.

Determining what a DB plan’s funding policy will be is a complex decision that is integrated with other strategic considerations—whether that’s accounting outcomes, PBGC premiums owed or planned pension risk transfer (PRT) transactions, says Colyar Pridgen, Capital Group LDI [liability-driven investing] strategist in Los Angeles. However, he says, trying to reduce PBGC variable rate premiums is a practical reason for foregoing funding relief, as these premiums make it “painful to maintain a deficit.”

The other practical reason to forego funding relief, according to Pridgen, is that combining investment policy with a funding policy that accelerates contributions relative to the required minimums can create a smaller pension expense from an accounting standpoint. “Contributions can also be used for PRT and other initiatives,” he says. “Really the only drawback for plan sponsors to contributing to their plans exists if they have a real need for that money elsewhere.”

Pridgen adds that much of the analysis that takes place when making contribution decisions hinges on whether plan sponsors view pension contributions as more similar to an expenditure or to a debt reduction. Plan sponsors have to ask, “‘Are contributions the most profitable use for our money or is this really more of a balance sheet issue of pensions being a debt and we need to reduce that?’” he says. The latter is why Capital Group has seen an interest from plan sponsors in borrowing to fund their plans, with the PBGC variable rate premium climbing all the way to 4.8% of the plan’s deficit in 2022. “The longer plans carry a deficit, the more onerous cumulative PBGC premiums become, which creates a greater sense of urgency to fund the plan,” Pridgen says.

Pridgen notes that while in practice, the math is more complex and plan-specific, simply adding up the variable rate premium amounts for the eight years ending in 2022 exceeds 30% of the funding deficit. For the following eight years, barring legislative changes to PBGC premiums, that figure will likely substantially exceed 40%. “At some point, it becomes irrational for sponsors to maintain plan funding deficits,” he says.

In addition, Pridgen notes that borrowing costs are low for many sponsors in a historical context and that may persist or that window might close. So, from a timing standpoint, there could be some urgency in accelerating plan funding.

“There are reasons at the moment that borrowing to fund is worth a look, including that there are tax advantages to borrowing and funding,” he says. “It’s a plan-specific decision, but in a lot of cases, it could make sense.”

It makes sense for severely underfunded plans to use the funding relief because they are already at the PBGC premium cap—if their plans become more underfunded, premiums don’t increase, Donohue says. But, for moderately funded plans, it would be a mistake to use the relief “because premiums would go through the roof,” he explains.

Sponsors with plans that are frozen and moving toward PRT or termination should also not use the relief because putting more funding into their plan is helping them get out from under it, he adds.

The ultimate reason DB plan sponsors should continue to make progress on funding their plans is that they made a promise to participants and they have to fulfill this promise, says Donohue. “It’s like a forbearance on your mortgage. Even if it’s allowed, it’s not necessarily a good idea because you will owe more later or won’t be able to pay your obligation,” he says.

Overfunded, mildly underfunded and severely underfunded plans face different strategic considerations, Pridgen says, adding that many plan sponsors are facing a different set of problems than they were one year ago by virtue of being at a different funded status and, therefore, subject to different PBGC premiums.