Borrowing to Fund Is a De-Risking Strategy for DB Plans

The enduring low interest rate environment offers a unique opportunity for plan sponsors to fund their pension plans, according to an article from Prudential.

Sponsors of underfunded defined benefit (DB) plans can borrow at attractive rates and contribute the proceeds to their pension plan, thereby reducing—or even eliminating—their pension deficit.

Rohit Mathur, head of Global Product & Market Solutions, Pension & Structured Solutions at Prudential Retirement in Newark, New Jersey, explains to PLANSPONSOR that borrowing to fund means the DB plan sponsor issues a contractual debt in the marketplace. The interest rate is based on creditworthiness.

“Borrowing to fund pension deficits provides plan sponsors with a way to replace variable and potentially volatile debt obligation—the underfunded pension—with a known, certain amount of debt at a fixed funding cost,” says Mathur. “A range of plan sponsors—with small, large, frozen or ongoing plans—could benefit from a ‘borrow-to-fund’ strategy.”

The strategy benefits plan sponsors by reducing variable premiums to the Pension Benefit Guaranty Corporation (PBGC)—premiums that are expected to rise to 4.1% of unfunded liability in 2019. In addition, the economic benefit of this approach is also driven by lower after-tax debt service compared to annual plan contributions, and acceleration of tax deduction on pension contributions.

Comparing two scenarios—making regular annual required contributions and borrowing to fund—shows a hypothetical plan could be fully funded in 10 years under the first scenario or fully funded in one year in the second scenario. A Prudential article notes that borrowing to fund yields a net present value (NPV) economic benefit of $150 million, compared to the pay-over-time strategy. This is based on a model BBB-rated company sponsoring a $7 billion pension plan that is 85% funded. The plan’s population is assumed to be split evenly among retirees and non-retirees; the average age of plan participants is 65; and plan participants receive an average annual benefit of approximately $8,200.

According to Mathur, part of the analysis in deciding whether to borrow to fund is determining if the interest on the debt is cheaper than PBGC premiums. DB plan sponsors should also look at the overall funding deficit and contribution requirement and compare that to the benefit of contributing to the plan more quickly.

Mathur also says DB plan sponsors should look at their creditworthiness. A Prudential analysis found borrowing to fund may be optimal for companies across the credit ratings spectrum based on current debt market conditions. “We believe such a strategy is optimal for most plan sponsors, except in situations where a restrictive leverage covenant in credit facilities could become adversely impacted by the issuance of contractual debt,” the Prudential article says.

"We believe borrowing to fund is an important first step to consider in the context of an overall risk-reduction strategy, and should be utilized based on a plan sponsor’s end goal for pension de-risking,” Mathur says. He tells PLANSPONSOR borrowing to fund can be an important part of any strategy, including liability-driven investing (LDI), offering a lump-sum payment window or completing a pension risk transfer.