PBGC variable-rate premium vs. borrow-and-fund

For defined benefit plans that (1) are underfunded (using market interest rates and asset values) and (2) are not at the Pension Benefit Guaranty Corporation variable-rate premium (VRP) headcount cap, the “go to” strategy for reducing VRPs is to make current contributions to increase the plan’s funded status.

After the passage of SECURE 2.0, which froze the VRP rate at 5.2% of unfunded vested benefits (UVBs), determining when it is economically more efficient to borrow-and-fund vs. funding the plan over time (at ERISA minimums) and paying the 5.2% VRP “tax” is, in some respects, relatively straightforward. In this article, we review this calculation. We conclude with some observations about future interest rate risk and how it might affect borrow-and-fund decision-making.

Key parameters of the borrow and fund calculation

PBGC variable premium rate. Beginning in 2023, the VRP rate was fixed at 5.2% of a plan’s UVBs. (Note that VRPs are subject to a headcount cap – we are assuming that the headcount cap does not apply for purposes of this article. If a plan is at the headcount cap, then contributions will, at the margin, not reduce VRPs. Only headcount reductions will reduce them.)

Cost of borrowing. This rate will determine the relative cost of borrowing-and-funding; it will vary from sponsor to sponsor; and it is probably the most important variable in the analysis, defining the breakeven point – the point at which it is more efficient to borrow and fund immediately rather than fund over 15 years and pay PBGC premiums on the plan's UVBs.

Plan valuation rate. Each year, the value of plan liabilities will "grow" at the plan valuation rate. This is, in effect, the interest rate on plan liabilities.

Basic formula

One intuitive way to consider alternative strategies here – funding over 15 years and paying the PBGC variable premium vs. borrowing and funding immediately – is to view the unfunded plan balance as a loan (in effect, from plan participants). With that framing, the borrow-and-fund decision reduces itself to the question: which loan is cheaper, the plan underfunding loan or the cost of an external loan the proceeds of which would be used to fund the plan?

Under current rules, the answer to that question is relatively straightforward. The cost of the “loan” to the plan is the plan’s valuation rate (i.e., the discount rate used for financial reporting, tied to market interest rates) + 5.2%. So, if the plan’s valuation rate is, say, 5%, then the cost of the “loan” to the plan is 10.2%. If the sponsor’s (external) cost of borrowing is greater than 10.2%, then the “loan” to the plan is a good deal. If it is below that rate, then it makes (financial) sense to borrow and pay down plan underfunding. (We note that sponsors generally have until September 15, 2025, to make contributions that will reduce 2025 PBGC VRPs. The latter are due September 15, 2025.)

Bottom line: borrowing and funding still remains an attractive strategy to reduce the overall cost of funding underfunded plans that are not at the VRP headcount cap.

Reducing interest rate risk

In the above analysis, we have assumed that interest rates stay at current levels. On that basis, we project that interest rate relief – 25-year smoothing rates – is effectively over.

If, however, market interest rates (the “Spot Rates” red line in the above chart) were to go down in the near- or medium-term, several of the variables we’ve considered above would change.

First, the (market) interest rate used to (1) accrue interest on plan liabilities and (2) value plan liabilities (e.g., for financial statement and PBGC UVB/VRP purposes) would go down.

Second, as a result of the decrease in the valuation interest rate, the value of plan liabilities would increase. If there is not a corresponding increase in asset values, then the amount of the plan’s UVBs and the amount of VRPs the sponsor would have to pay with respect to the plan would also increase.

Third, the interest rate used for determining ERISA minimum funding would, because of 25-year smoothing and the ARPA changes, not decrease as much as market rates. As a result, the plan would be allowed to determine plan contributions based on liabilities determined at an above-market interest rate, and the plan could be systematically underfunded, effectively increasing the period over which the plan would have to be funded.

Fourth, the cost of borrowing would (presumably) go down.

There is no easy way to summarize the interaction of these variables in this situation. What can be said (briefly) is that where the sponsor has not fully funded the plan and implemented an LDI strategy, in the event of a decrease in future interest rates:

The plan’s financial condition will have worsened, because of the increase in liability values (assuming no (or an insufficient) offsetting increase in plan asset values).

On the other hand, the annual cost of funding the plan over time and the cost of borrowing-and-funding will have gone down (because of the lower interest rate cost/cost of borrowing).

This is all to say consideration of the direction of future interest rates will be a complicating factor in the borrow-and-fund decision.

Finally, where the sponsor has fully funded the plan and implemented an LDI strategy, future interest rate decreases (or, for that matter, increases) will (theoretically at least) have no effect – the whole point of an LDI strategy is to take that risk off the board.

What sorts of plans are not at the VRP headcount cap?

As we said at the top, the foregoing analysis is only relevant for plans that are underfunded (on a market basis) and that are not at the VRP headcount cap. As more sponsors of underfunded DB plans have frozen their plans and “de-risked” small terminated vested liabilities, more of them have come under the headcount cap – for those sponsors, the only way to reduce VRPs is to reduce headcount. Funding doesn’t help.

The typical profile of an underfunded DB plan not at the headcount cap is one that covers a significant number of current lower paid employees with modest benefits. Sponsors of these sorts of plans will want to consider the analysis presented above.

Conclusion

Understanding the PBGC (per capita and variable) premium "overhead cost" on DB plans and the tradeoffs between paying VRPs and funding is an important element in DB plan finance.

With the “freezing” of the VRP rate in SECURE 2.0 at 5.2%, the math with respect to borrowing-and-funding vs. funding over time and paying VRPs has in some respects stabilized. Interest rate risk, however, in the near- and medium-term, does present a wild card.

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We will continue to follow this issue.