Tax Reform has been signed–what could this mean for DB plan sponsors?
The Tax Cuts and Jobs Act, with its signature provision of reducing the corporate tax rate from 35% to 21% in 2018, may have an indirect impact on DB plan sponsors. While the bill makes no changes directly to DB minimum funding or maximum deductibility laws, it could create an additional incentive for DB sponsors to accelerate contributions attributable to the 2017 plan year. This is most applicable to corporate DB sponsors seeking to maximize the tax effectiveness of their contributions.
The simple math behind discretionary contributions after tax reform
While pension contributions will continue to be federally tax deductible in the coming years, the relative tax deduction could be higher if the contributions are attributed to the 2017 plan year (when a higher tax rate applied). Let’s take an example of a sponsoring company having $100 million in cash that they intend to contribute to the plan over the next few years (2018 and after). Assuming a 21% tax rate, this would roughly mean they could reduce their tax burden by $21 million over that time period (ignoring the effects of other deductions, discounting, etc.). However, if they accelerated those contributions to be attributable to 2017 – under a 35% tax rate (noting company tax rates are often less than this) – then the reduction in tax could be $35 million, a $14 million tax savings. This assumes all contributions still fall under the maximum deductible amount calculated by the plan actuary.
In addition, if the $100 million contribution were used to reduce a vested funding deficit (as used for PBGC premium purposes), the sponsor could save nearly $4 million in PBGC premiums each year the contributions are accelerated. Note that this reduction only applies until the plan is fully funded on a vested liability basis and assumes the per participant cap didn’t previously apply. This may be considered indirect (or delayed) savings, as many sponsors pay for PBGC premiums out of plan assets.
This example is simple, but it illustrates the basic math behind the decision process. Sponsors should note that while the 2017 calendar year is behind us, they can still generally contribute for the 2017 plan year until September 15, 2018 (assuming calendar year plan year). This gives sponsors some time to thoughtfully consider discretionary contribution options and their effects on overall plan strategy. For a taxable DB sponsor, the option is likely worth exploring.
Many sponsors already making discretionary contributions
It’s worth noting that 2017 has already been a banner year for discretionary contributions (above the minimum required amount). Despite ongoing funding relief, we expect that in 2017, single employer DB plans will take in the highest level of contributions since 2012, the year MAP–21 funding relief was passed. A key motivator for accelerating contributions includes rising PBGC variable–rate premiums, which are scheduled to increase through 2019 (and with inflation after that). The fact that sponsors are making contributions above the minimum is not surprising—it has been clear for quite some time that paying just the minimum to an underfunded DB plan in the current PBGC premium rate environment can lead to an inefficient use of cash. New corporate tax rates now make the case for discretionary contributions (through cash or borrowing) even more compelling.
Changes to asset allocation; increased risk transfer activity
Discretionary contributions create a ripple effect on the plan. For example, sponsors will need to consider what the asset allocation will look like after a large contribution. Accelerated funding leads to higher funded status, which has been remarkably unimproved in the industry for the last several years despite strong equity returns. Given the ubiquity of funded status–based glidepaths, improved funded status could lead to greater overall allocations to liability–hedging fixed income and higher hedge ratios. Improved funded statuses may also lead to even more interest in risk transfer transactions, such as lump sum offers (though new mortality rates are about to applied) and annuity purchases, as the lifecycles of more pension plans wind down.
In summary, the new tax law has no direct impact on corporate DB plan funding laws, but by changing corporate tax rates, it creates a new incentive to accelerate contributions to 2017. This in turn could lead to improved funded status, updated asset allocations, and further advancement of DB plan lifecycles.