Tax Reform has been signed–what could this mean for DB plan sponsors?

January 3, 2018 | by
Justin Owens, CFA, FSA, EA
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These views are subject to change at any time based upon market or other conditions and are current as of the date at the top of the page. The information, analysis, and opinions expressed herein are for general information only and are not intended to provide specific advice or recommendations for any individual or entity.

This material is not an offer, solicitation or recommendation to purchase any security.

Forecasting represents predictions of market prices and/or volume patterns utilizing varying analytical data. It is not representative of a projection of the stock market, or of any specific investment.

Nothing contained in this material is intended to constitute legal, tax, securities or investment advice, nor an opinion regarding the appropriateness of any investment. The general information contained in this publication should not be acted upon without obtaining specific legal, tax and investment advice from a licensed professional.

Please remember that all investments carry some level of risk, including the potential loss of principal invested. They do not typically grow at an even rate of return and may experience negative growth. As with any type of portfolio structuring, attempting to reduce risk and increase return could, at certain times, unintentionally reduce returns.

Frank Russell Company is the owner of the Russell trademarks contained in this material and all trademark rights related to the Russell trademarks, which the members of the Russell Investments group of companies are permitted to use under license from Frank Russell Company. The members of the Russell Investments group of companies are not affiliated in any manner with Frank Russell Company or any entity operating under the "FTSE RUSSELL" brand.

The Russell logo is a trademark and service mark of Russell Investments.

This material is proprietary and may not be reproduced, transferred, or distributed in any form without prior written permission from Russell Investments. It is delivered on an "as is" basis without warranty.

Investing involves risk and principal loss is possible.

Past performance does not guarantee future performance.

Investments that are allocated across multiple types of securities may be exposed to a variety of risks based on the asset classes, investment styles, market sectors, and size of companies preferred by the investment managers. Investors should consider how the combined risks impact their total investment portfolio and understand that different risks can lead to varying financial consequences, including loss of principal. Please see a prospectus for further details.

Indexes are unmanaged and cannot be invested in directly.

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.


AI-26209-12-21

Disclosures

These views are subject to change at any time based upon market or other conditions and are current as of the date at the top of the page. The information, analysis, and opinions expressed herein are for general information only and are not intended to provide specific advice or recommendations for any individual or entity.

This material is not an offer, solicitation or recommendation to purchase any security.

Forecasting represents predictions of market prices and/or volume patterns utilizing varying analytical data. It is not representative of a projection of the stock market, or of any specific investment.

Nothing contained in this material is intended to constitute legal, tax, securities or investment advice, nor an opinion regarding the appropriateness of any investment. The general information contained in this publication should not be acted upon without obtaining specific legal, tax and investment advice from a licensed professional.

Please remember that all investments carry some level of risk, including the potential loss of principal invested. They do not typically grow at an even rate of return and may experience negative growth. As with any type of portfolio structuring, attempting to reduce risk and increase return could, at certain times, unintentionally reduce returns.

Frank Russell Company is the owner of the Russell trademarks contained in this material and all trademark rights related to the Russell trademarks, which the members of the Russell Investments group of companies are permitted to use under license from Frank Russell Company. The members of the Russell Investments group of companies are not affiliated in any manner with Frank Russell Company or any entity operating under the "FTSE RUSSELL" brand.

The Russell logo is a trademark and service mark of Russell Investments.

This material is proprietary and may not be reproduced, transferred, or distributed in any form without prior written permission from Russell Investments. It is delivered on an "as is" basis without warranty.

Investing involves risk and principal loss is possible.

Past performance does not guarantee future performance.

Investments that are allocated across multiple types of securities may be exposed to a variety of risks based on the asset classes, investment styles, market sectors, and size of companies preferred by the investment managers. Investors should consider how the combined risks impact their total investment portfolio and understand that different risks can lead to varying financial consequences, including loss of principal. Please see a prospectus for further details.

Indexes are unmanaged and cannot be invested in directly.