With the passage of tax reform in December 2017 corporate tax rates are going down, from a top marginal rate of 35% in 2017 to 21% in 2018. This means that deductions taken in 2017 are generally worth more – as much as 14 percentage points more – than deductions taken in 2018.
In this article we review the extent to which defined benefit plan sponsors may accelerate funding and increase their DB funding deduction for 2017, the possibility of a related reduction in PBGC variable-rate premiums, and strategies for managing the risk that such accelerated funding may generate a future plan surplus.
As a general matter, the contribution for 2017 must be made by the tax return due date, with extensions. For a calendar year plan/tax year, that would generally be September 15, 2018. Non-calendar year plan/ tax year taxpayers have longer to execute this strategy.
Key opportunity: 35% tax deduction
Why accelerate funding? Consider a very simple example: a corporation that pays taxes at the highest marginal rate sponsors a defined benefit plan with $100 million in unfunded benefits. The sponsor must, at some point, make a $100 million contribution to the plan. If the sponsor contributes that $100 million for the 2017 year, it reduces its 2017 taxes by $35 million; if it contributes that $100 million for a later year, it reduces its taxes for that later year by $21 million. Making that contribution for 2017 nets the sponsor $14 million in tax savings.
Effect on PBGC variable-rate premiums
DB plan sponsors must pay Pension Benefit Guaranty Corporation variable-rate premiums on the amount of their unfunded vested benefits (UVBs) for the prior plan year. UVBs are determined in the same way a plan’s funding shortfall is determined, except that only vested benefits are considered and interest rate stabilization (25-year smoothing) is disregarded. A rough (but simple and good-enough) way to think about the VRP rate is simply as (for 2018) a ‘tax’ equal to 3.8% of unfunded benefits (this number is expected to increase to 4.3% in 2019).
As a general matter, contributions ‘for’ 2017 will reduce VRPs for 2018, and fully funding plan liabilities will eliminate them.
For plans subject to the VRP headcount cap (which limits total VRPs for a plan to about $523 times the total number of plan participants), the analysis is more complicated. With regard to the VRP headcount cap, see our article Reducing pension plan headcount reduces risk and PBGC premiums.
For our example plan with $100 million in unfunded benefits, a $100 million contribution this year saves the company $3.8 million in premiums ($3.0 million net of taxes).
Tax savings plus premium savings
Combining the $14 million in savings from the ‘expiring’ 35% corporate tax rate and the reduction in 2018 PBGC premiums, this represents a straight-up $17 million value opportunity for pension sponsors.
A multi-year view uncovers additional sources of value. Recall that, absent funding acceleration, the plan would be required to make something like $100 million in contributions over the next several years. Making a large contribution now in lieu of these future requirements can:
- Eliminate the potentially volatile ‘cash calls’ from the pension plan that complicate future cash budgeting
- Accelerate tax deductions the company would otherwise take in future years (the NPV of accelerating a deduction five years is 10%-15%, or $2-$3 million for the $21 million deduction in our example.)
- Eliminate a whole string of future PBGC variable premiums (five years of savings could be worth $15 million net of taxes).
When you add it all up, a $100 million pension contribution this year could net $30 million or more to the company. For pension sponsors that are also taxpayers, this is an historic opportunity.
The value of the 35% deduction and accelerated deductions by themselves make a compelling case for a large contribution this year, beyond amounts sufficient to eliminate PBGC variable premiums.
Pension sponsors with significant taxable income for 2017 and access to cash or credit may benefit greatly from considering the huge tax deduction opportunities pension plans represent.
The Pension Protection Act significantly increased the defined benefit plan deduction limit. Oversimplifying a lot, a DB plan sponsor may for a plan year generally deduct (1) the funding target, plus (2) the target normal cost, plus (3) a ‘cushion amount’ equal to 50% of the funding target plus the cost of projected pay increases (or, for non-pay-based plans, certain other projected increases), minus (4) plan assets.
This limit will generally allow a lot of room for deductible contributions. Sponsors that want to maximize the 14 percentage point ‘gain’ from taking a deduction in 2017 vs. subsequent years will want to understand the exact extent of this available headroom.
Is surplus a risk?
One concern sponsors have about aggressively funding DB obligations is the possibility of a ‘stranded surplus.’ If, on plan termination, the plan has surplus assets that revert to the sponsor, the sponsor must, in addition to income taxes, pay an excise tax of up to 50%.
The possibility of a termination surplus depends on a number of moving parts. Let’s begin by noting that if the sponsor’s DB plan is ongoing – that is, participants are continuing to accrue benefits – excess funding can be used to pay future benefits. Thus, stranded surplus risk is much more significant for (fully) frozen plans than for ongoing ones.
Next, the surplus ‘challenge’ depends in part on the sponsor’s plan finance and long-run exit strategies. If the sponsor intends to go through a formal PBGC termination procedure and buy annuities, then the ‘real’ plan funding target is likely to be (much) higher than the one on the plan’s books. If the sponsor is pursuing a robust asset-liability matching strategy, then, unless the sponsor literally puts in more than total plan liabilities, there is little risk that assets will outrun liabilities.
The concern about stranded surplus is more acute where the sponsor’s benefit finance strategy anticipates assets that are, e.g., invested significantly in equities will outperform liabilities, the value of which is driven by interest rates.
Overall, pension surplus is much more accessible to pension sponsors than is generally appreciated. Few if any pension plan terminations generate any material excise or income taxes to employers. If other strategies (e.g. providing ancillary benefits or cash balance accruals, finding an underfunded plan with which to merge) fail to soak up surplus assets, the employer can always use surplus assets to fund a ‘qualified replacement plan’ (i.e. a defined contribution plan) over up to seven years following plan termination without paying any excise or income taxes.
In our view, the idea that DB sponsors must ‘thread the needle’ in order to terminate pension plans without incurring excise and income taxes is highly exaggerated. Employers can employ a wide range of strategies to make effective use of even large pension surpluses. And given the historic but time-sensitive opportunity related to the 35% corporate tax rate for 2017, many employers would benefit from understanding these ideas better.