Plan funding strategy after ARPA

The recently enacted American Rescue Plan Act of 2021 (ARPA) significantly relaxes single-employer defined benefit plan minimum funding requirements, by extending and increasing the “floor” on valuation interest rates (aka interest rate stabilization) and extending the funding shortfall amortization period from 7 to 15 years.

The new rules change the incentives for sponsors of underfunded DB plans to fund/not fund. In this article we analyze some of the strategic funding decisions confronting those sponsors.

ARPA significantly reduces minimum funding requirements…

In our first article on ARPA we published a chart, showing how ARPA increases liability valuation interest rates for ERISA defined benefit plan minimum funding requirements. The following chart shows, for a typical (duration 12) plan, how these higher interest rates, together with 15-year amortization, reduce ERISA-required minimum contributions.

(Assumptions: Duration 12; $100 million in 2020 (pre-ARPA) liabilities, $80 million in assets; adopt ARPA interest rate rules and 15-year amortization in 2020.)

Thus, ARPA interest rate stabilization/funding relief significantly reduces minimum funding requirements and the demand an underfunded DB plan puts on sponsor cash.

…and makes it easier to avoid benefit restrictions

In addition, ARPA interest rate stabilization – by increasing valuation interest rates and thus reducing liability value – makes it easier for plans to meet the 80% funded percentage requirement, to avoid application of benefit restrictions (including restrictions on the payment of lump sums/distributions of annuities). For instance, our example plan under HATFA would be required to make an additional $800,000 contribution for 2021 to avoid application of benefit restrictions. Under ARPA this plan is over 80% funded without any additional contributions.

We estimate that plans with a funded status of 50-60% on a spot rate basis will be at or near 80% funded on an ARPA basis.

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Sidebar: PBGC variable-rate premium basics

PBGC variable-rate premiums are generally calculated as a percentage (4.6% for 2021) of the plan’s unfunded vested benefits (UVBs). UVBs are, generally, the plan’s liabilities for vested benefits minus the fair market value of plan assets. Liabilities for this purpose generally are determined using “spot” Pension Protection Act first, second, and third segment rates, without applying, e.g., ARPA interest rate stabilization. (Sponsors may use as an alternative 24-month average segment rates to value liabilities for purposes of determining UVBs.)

VRPs are also subject to a headcount cap — $582 per participant for 2021. If the total VRPs divided by the number of plan participants exceeds the VRP headcount cap, then the VRPs with respect to the plan are limited to the number of participants times the headcount cap. Thus, underfunded plans at the headcount cap typically have larger benefits per participant.

To illustrate:Plan 1 has, for the 2021 VRP calculation, $100 million in liabilities, $60 million in assets, and 5,000 participants. It’s VRP is $1,840,000 (UVBs of $40 million times 4.6%). It is not subject to the headcount cap (the cap would produce VRPs higher than the regular VRP rate — $582 times 5,000 = $2,910,000.) 

Plan 2 has the same liabilities and assets but has only 3,000 participants. It is subject to the headcount cap, and its VRPs are limited to $1,746,000 (3,000 times $582).

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Funding strategy

In the context of post-ARPA relaxed ERISA minimum funding standards, the primary incentive for plan funding is (even more than it had been) PBGC variable-rate premiums (VRPs). (For a discussion of the basics of PBGC variable-rate premium system and current rates, see the sidebar.)

The reduced minimum funding requirements present a set of short- and medium-term decisions for plan sponsors. What those decisions are depend, generally, on the sponsor’s financial position and current plan financials and demographics.

Types of sponsors

Let’s begin by identifying three different “types” of sponsors:

Maximum funders: These sponsors (e.g., sponsors seeking to maximize tax deductions via plan contributions) generally are unaffected by ARPA. We would include in this group any plan that is fully funded at current market rates.

Minimum funders: Some sponsors will have a nearly inelastic preference for cash, and any reduction in minimum funding requirements will result in reduced funding. The reduced funding requirements of ARPA will, for these plans, translate directly into reduced funding.

Strategic funders: Sponsors for whom the tradeoff between the cost of not funding vs. the need for cash is a consideration.

Decisions for strategic funders

The latter group of sponsors, in developing a funding strategy that maximizes the financial benefit to the company, will wish to consider the benefits of retaining cash vs. the increased costs (primarily, increased PBGC VRPs) resulting from reduced funding.

In this regard, we identify three types of plans: 

1. Plans at the VRP headcount cap: Sponsors of plans at the VRP headcount cap generally cannot reduce VRPs by making contributions. For these plans VRPs can only be reduced by reducing headcount. And those headcount reductions have a significant effect on VRPs: every participant taken off the books reduces VRPs by (for 2021) $582 annually. (We note that headcount reduction also reduces the PBGC “regular” per capita premium ($86 per participant for 2021). This reduction is available to all plans, regardless of funded status.)

The only limit on these annual VRP savings from headcount reduction is that, at some point, the sponsor will “fund the plan out of the cap” – that is, as plan funding increases, at some point, the cap will no longer apply. For sponsors of plans at the headcount cap that are pursuing a headcount reduction strategy, the relaxation of funding requirements in ARPA will generally permit the sponsor to (further) delay funding and will permit the plan to remain subject to the cap for a longer period.

For these plans, the only cost of not funding is interest on the “debt” – the unfunded portion of the participant’s benefit.

2. Plans not at the headcount cap: Plans not at the VRP headcount cap can reduce VRPs by making contributions over and above the ERISA minimum. These contributions will reduce annual VRPs by (for 2021) 4.6% of the amount contributed. Thus, for these plans, in effect, the cost of not funding is (1) interest on the “debt” + (2) (for 2021) 4.6% of the debt.

3. Plans facing a benefit restriction: Plans below 80% funded on an ARPA basis are subject to ERISA-imposed benefit restrictions, including a restriction on paying out lump sums (and on annuity settlements). If such a plan is also at the VRP headcount cap (or the sponsor has some other compelling reason for avoiding benefit restrictions), the sponsor may want to fund enough to get to 80% on an ARPA basis. 

As noted above, generally, and depending on duration, plans with a funded status of 50-60% on a spot rate basis will be at or near 80% funded on an ARPA basis.

Portfolio strategy

Thus far, our analysis has only considered sponsor strategy focused on contributions and headcount reduction. How does portfolio strategy affect this analysis?

LDI-ed plans: The foregoing analysis holds in a relatively simple manner for plans pursuing an LDI (liability driven investment) strategy. For these plans, generally (and not with respect to unfunded liabilities) changes in interest rates will not affect UVBs and there will be no “equity premium” returns.

Non-LDI-ed plans: For “non-LDI-ed plans” not at the headcount cap, (1) increases in interest rates (for instance) will reduce UVBs, and (2) “equity premium” returns will both reduce UVBs and increase the ARPA funded percentage. Increases in interest rates and/or “equity premium” returns may take a plan out of the headcount cap (in the same way that additional contributions would), but as long as the headcount cap applies the only way to reduce VRPs is (as we said) to reduce headcount.

We also note that if a sponsor pursues a strategy of increased funding of a non-LDI-ed plan (to reduce VRPs) there is a risk that, especially with respect to a frozen plan, because of unanticipated gains from asset returns or increases in interest rates, the plan may become overfunded. There are a number of strategies to deal with such a “stranded surplus.” It is nevertheless a risk that sponsors will want to consider.

Financial disclosure

Generally, all financial disclosure is done on a mark-to-market basis, with significant “buffering” of experience gains/losses. Headcount reduction will generally trigger recognition of those unrecognized experience gains/losses. We discuss the implications of this result in our article Liability settlement, mark-to-market accounting, and PBGC premium reduction: effects on corporate earnings.

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There are, obviously, a number of moving parts to the funding/derisking decisions confronting sponsors in light of the changes made by ARPA. Sponsors will want to discuss their options and the key variables with their consultants.

We will continue to follow these issues.