Q&A: Tax reform for DB plans
The Tax Cuts and Jobs Act of 2017, with its signature provision of reducing the corporate tax rate from 35% to 21% in 2018, may have an indirect impact on defined benefit plan sponsors. We explore this further in the following Q&A.
Q: How has tax reform affected defined benefit plan sponsors?
A: The recently passed Tax Cuts and Jobs Act of 2017 has not changed any DB funding rules, but given how it has reduced future corporate tax rates, this act created a greater incentive for DB sponsors to contribute now and receive a higher federal tax deduction than if they contribute down the road.
Q: What is the deadline for making these contributions to receive the higher tax deduction?
A: DB sponsors can generally contribute up to eight–and–a–half months after the end of the applicable plan year (2017 in this case). So for calendar year plan years, the deadline is September 15, 2018 to make 2017 contributions. Any contributions made after the deadline, or not properly attributed to the 2017 plan year, would receive tax deductions under the 2018 year, which will have lower tax rates and therefore lower tax deductions.
Q: Is there a limit to how much a DB sponsor can contribute?
A: Yes; but it will apply to very few sponsors in practice. The actuary calculates the “maximum deductible contribution” annually, which effectively allows a plan to contribute to a funded status of at least 150%. Nearly all DB plans are far below this funding threshold. Also, for frozen or mature closed plans, contributing to a funding level above 105–110% may lead to trapped capital.
Q: What is trapped capital?
A: Once assets are placed in the plan, they cannot revert back to the sponsor unless the plan is terminated. Even then, excess assets will be subject to a heavy one–time excise tax (unless some of those assets are used to fund a replacement plan). There are ways to use these excess assets, such as improving benefits or transitioning benefits from other plans, but these creative solutions may not be desirable to the plan sponsor.
Q: What other advantages are there to funding more than the minimum required contribution?
A: Many sponsors have recently been paying only the minimum required, which has been zero for some sponsors during this phase of funding relief. However, there are several important downsides to this strategy. First, the Pension Benefit Guaranty Corporation (PBGC) penalizes underfunded plans, and the rate at which they penalize them has more than quadrupled since 2013. Premiums paid to the PBGC are effectively a tax paid by plan sponsors, and while they may be out of mind due to their being paid from plan assets, they can be a headwind to asset growth.
Underfunded plans experience benefit payment drag, which reduces the funded status percentage every time a benefit is paid. Consider a simple example where a plan is 75% funded with $3 million in assets and $4 million in liabilities. If the plan pays out $1 million in benefit payments, the assets become $2 million and the liabilities become $3 million. This leads to a funded status of 67%, which is an 8% reduction. The better funded the plan is, the effect becomes less pronounced.
Finally, larger–than–required contributions will improve the overall funded position of the plan. Higher funded statuses will better position plan sponsors to implement de-risking actions like increasing their liability hedging asset allocation or completing a pension risk transfer transaction.
Q: Will a large contribution reduce future required contributions to the plan?
A: Generally, yes. Funding requirements are determined based on the funded status of the plan, and contributions always improve funded status. In addition, plans that contribute more than the minimum required amount may establish a prefunding credit balance that can help satisfy future contribution requirements. Very large contributions could delay contribution requirements for several years.
Q: What is the industry trend for discretionary contributions?
A: Many companies have announced sizeable discretionary contributions to their DB plans in the last several months—even before tax reform was formally passed. In 2017, UPS contributed $7.4 billion, Boeing contributed $4 billion, and DuPont contributed $3.1 billion—all for tax savings. Others also announced unusually large contributions for undisclosed reasons, such as GE’s $6 billion, Verizon’s $4 billion, or Lockheed Martin’s $5 billion. We expect more announcements to be forthcoming.
Q: Where are companies finding the funds necessary to make these contributions?
A: Many companies are using corporate cash on hand, while others are issuing debt specifically for this purpose. In at least one case, company stock was used. Given that borrowing rates are relatively low and company stock values high, both options may be attractive. I should mention, however, that tax reform does also impose some limits to the tax deductibility of corporate interest expense, which may be a deterrent to issuing debt in order to fund up the pension plan.
Q: Is there anything else DB sponsors should be considering?
A: Sponsors should consider their asset allocation implications after a large contribution.
Closed and frozen plans that are better funded have less need for large investment returns than do poorly funded plans, and can therefore take the opportunity to dial back unneeded equity risk while also scaling back on interest rate risk through heavier allocations to liability–hedging fixed income. A large discretionary contribution that funds up the plan creates an opportunity to lock in funded status gains and effectively places the plan in hibernation mode until the economics of a plan termination makes sense.
For sponsors of closed and frozen plans that have already implemented a glidepath strategy, a large discretionary contribution would accelerate the steps to their ultimate asset allocation. While the split between return seeking and liability hedging assets may be determined, the composition of each will likely require some attention. The return seeking allocation may need to be simplified to use more liquid assets, and the fixed income may attempt to more closely match the interest rate sensitivity of the underlying liabilities.