As Congress continues to struggle with setting annual federal budgets, pension plans are increasingly looked at as an alternative source of government revenue. While the Pension Protection Act of 2006 was once considered the definitive law to secure the private pension system, lawmakers since have repeatedly eased pension funding requirements while enacting a series of rapidly rising pension insurance premiums payable to the Pension Benefit Guaranty Corporation (PBGC).
What are the effects of this taxation on sponsors of private pension plans? First, higher direct PBGC premiums means the IRS can earmark less government tax revenue to the PBGC. Second, smaller required tax-deductible pension contributions means fewer tax deductions given to small business owners up through large corporations. This creates a significant amount of federal tax revenue according to the way the government accounts for private pension plans.
But what is the downside to this cash funding flexibility that Congress has given to pension plan sponsors through budgetary laws such as the Moving Ahead for Progress in the 21st Century Act (MAP-21) and the Highway and Transportation Funding Act (HATFA)? Frankly, at a time when many mid to large size pension plans are frozen and sponsors are waiting for a better day to terminate the plan to eliminate cash and accounting risks, these patchwork laws are delaying pensions from becoming fully funded on a termination basis while increasing the cost to keep the plans in existence.
While this seems to put plan sponsors in a difficult situation, there are alternative funding strategies to achieve a lower cost and accelerated path to termination.
- Think beyond the minimum funding rules. After all, these rules outline a minimum requirement for ongoing plans, not a mechanism to help fully fund on a termination basis. Consider funding greater than the minimums, which are now being modified regularly at a macro level to help the government achieve operating budget objectives.
- Determine the plan’s funding shortfall on a termination basis. This isn’t as easy as the old days when you would just go to an insurer for an annuity quote for a full buyout (as that is now the most expensive path to termination). Instead, work with an actuary who can model and present termination scenarios based on a combination of paying new benefits in the form of lump sums vs. those who elected, or might elect, an annuity.
- Amortize the estimated terminal funding shortfall over a customized time horizon. On an ongoing basis, the government requires the plan’s actuary to calculate liabilities at higher interest rates (thus lower liabilities) than on a termination basis and, in turn, amortize any unfunded amounts over 7 years. If a company wants to terminate its plan within 5 years, wouldn’t it be better off setting its own funding policy whereby the higher terminal funding shortfall estimated by the plan actuary gets amortized over 5 years? Set the time frame that works for your situation.
- By all means, review the plan’s investment policy and adjust accordingly. Many desire their frozen plans to terminate within 3 to 5 years, yet they continue to invest in risky assets hoping to achieve a higher long-term asset return even though short term volatility presents a greater risk to their objectives. Plan sponsors should work closely with both their actuary and investment consultant to identify the appropriate investment horizon for a frozen plan.
- This in turn leads to the adoption of an integrated funding and investment policy. The short term focus may be to reduce funded status volatility while getting some positive risk adjusted return. An integrated policy also needs to consider greater liquidity needs for lump sum distributions, which could result in additional asset allocation changes and special cash funding contributions for large lump sum payout projects.
In short, over the past 10 years, Congress has repeatedly used the private pension system as a source of revenue for government spending. This has had the effect of delaying many plan sponsors’ path to plan termination, whether through lower required pension contributions or taking more money out of a plan to pay the PBGC. A more advanced approach to setting an integrated funding and investment policy can help curtail the negative effects of this evolving federal pension taxation policy, and accelerate the path to termination for many frozen plans.
