Impending premium increases to the Pension Benefit Guaranty Corp. means more sponsors of defined benefit plans should consider borrowing money to fully fund their plans, according to new analysis from Russell Investments.
The Bipartisan Budget Act of 2015 insisted new increases in both the per-participant and variable premium rates sponsors pay to PBGC.
Sponsors that pay a variable premium do so at a rate based on their plans’ unfunded liability.
That rate is scheduled to go up incrementally to $45 for every $1,000 of unfunded liability by 2019, or a 50 percent increase in the $30 per $1,000 in liability sponsors will pay in 2016.
The cost of increased premiums makes the case for borrowing via bond issuance to fully fund liabilities immediately, argues Jason Gannon, managing director, asset allocation and risk management, at Russell, in a research note.
Any mass movement on the part of sponsors to fully fund their plans would affect PBGCs top line: It would reduce the premium payments PBGC collects annually, a prime source of the agency’s revenue.
Gannon lays out a case for borrowing money to fully fund a plan’s liability, demonstrating how doing so could be more cost-effective for sponsors, even when accounting for the cost of servicing the debt on a new bond.
Higher variable premium rates means that sponsors could issue debt at higher interest rates, totally fund their plan, thereby relieving premium obligations to PBGC.
“Borrowing to fund the pension plan both eliminates PBGC variable rate premiums and allows the sponsor to take advantage of tax arbitrage, especially if contributions and loan interest payments are tax-deductible,” writes Gannon.
“We believe that the changes brought about by the recent legislation should prompt sponsors to review their contribution strategies and to consider whether they can benefit by borrowing to fund their plan,” he added.
The latest increases to the variable premium only strengthen the argument to consider borrowing, he says.
A plan that is $20 million underfunded and applies a 5 percent discount rate to future liabilities—higher than what is paid now—would pay $3.5 million annually over a seven-year period to fully fund the plan.
The same plan would also pay about $3.2 million in variable PBGC premiums over that time, Gannon’s math shows.
A 10-year bond, issued at 6.77 percent—what Gannon calls the break-even point—used to immediately fund the plan would mean sponsors could “avoid having to pay the PBGC premium,” he wrote.
Gannon applies the strategy to one hypothetical plan. Other considerations, like potential market volatility and pension smoothing, could help strengthen the case to borrow, or make it less advantageous, he wrote.
Source: Benefits Pro