We have previously posted articles on strategies for borrowing-and-funding and reducing headcount to reduce Pension Benefit Guaranty Corporation premiums. The increases in PBGC premiums in the Bipartisan Budget Act of 2015 (BBA2015) have made this strategy even more compelling. In this article we review the cost of borrowing-and-funding vs. continuing to pay the PBGC variable-rate premium in light of those premium increases.
Borrow-and-fund vs. the PBGC variable-rate premium
PBGC premiums function like a tax on a plan’s unfunded vested benefits (UVBs). Indeed, one reason they are so popular with Congress as a way to fix federal budget shortfalls is that they are counted as revenues just like taxes. So, at the highest level, the choice between paying the PBGC premium ‘tax’ and borrowing to ‘fund-up‘ a plan is a choice between the cost of the tax and the cost of borrowing.
Getting the cost of borrowing-and-funding vs. paying the PBGC variable-rate premium on an apples-to-apples basis requires two not entirely intuitive adjustments:
Adjusting for ERISA minimum funding. We don’t want to compare the cost of borrowing-and-funding to the cost of not funding and simply paying PBGC variable-rate premiums forever. ERISA generally requires funding over 7 years. While interest rate stabilization under Highway and Transportation Funding Act of 2014 (HATFA) may delay this somewhat, in the interest of keeping it simple we’re just going to stick with an assumption of 7-year funding. So our comparison will be between borrowing and funding now, and then repaying the loan over 7 years, to borrowing-and-funding over 7 years and paying PBGC premiums on the (declining) underfunded balance.
For purposes of our analysis, the key variables are:
premium (as a % of
UVBs and adjusted for
2% wage inflation)
Cost of borrowing. This rate will vary from sponsor to sponsor; and it is probably the most important variable in the analysis. In this article, the cost of borrowing will define the breakeven point – the point below which it is more efficient to borrow-and-fund immediately rather than fund over 7 years and pay PBGC premiums on the plan’s UVBs.
Rate of return on assets. Probably the fundamental difference between paying the PBGC variable-rate premium and borrowing-and-funding is that when you borrow you have assets (the loan principal) that, after they have been contributed to the plan, will be earning a return. Throughout this article we are going to assume a return on plan assets of 4%. (For purposes of their own analysis, sponsors will want to consider their own return assumption(s). A higher rate of return could increase the attractiveness of the strategy substantially.)
Plan valuation rate. Each year, the value of plan liabilities will ‘grow’ at the plan valuation rate. For purposes of this article we are going to assume that the plan valuation rate is the same as the rate of return on assets. Again, this simplifies our analysis a lot; a more robust analysis would use different liability valuation rates and return rates.
Contributions are assumed to go in at the beginning of the year; to preserve comparability the loan payment is also assumed to be made at the beginning of the year. The variable-rate premium is based on UVBs as of the end of the prior year; for instance, in year 1 UVBs = $20,000,000, and the 3% variable-rate premium is $600,000.
In our base case, we are going to assume that the two key variables – the cost of borrowing and rate of return on plan assets – are identical (4%). This simplifies the analysis.
UVB/funding shortfall = $20 million
Rate of return on assets = 4%
Cost of borrowing = 4%
|Year||Fund over 7 years +
|Contribution||PBGC Premium||Loan repayment|
|2016||$ 3,204,031||$ 600,000||$ 3,204,031|
This example illustrates the fundamental difference between funding over 7 years and paying PBGC premiums, on the one hand, and borrowing and funding immediately, on the other. This example is ‘easy’ because identical payments are made ($3,204,031), in one case to fund the plan, in the other to repay the loan. In both cases the plan is fully funded after 7 years. The only difference: when the sponsor funds over 7 years, it also must pay PBGC premiums.
We might add that, even though this example is simplified, it’s arguably conservative to assume that the return on plan assets equals the cost of borrowing. But, given that assumption, borrowing and funding saves all PBGC premiums at, in effect, no additional marginal cost.
The breakeven point
So, where the cost of borrowing equals the rate of return on plan assets, the answer is easy. It is significantly ‘cheaper’ to borrow and fund than to fund over 7 years and pay PBGC variable-rate premiums.
The next question is, then, how much higher does the cost of borrowing have to be in order to make funding over 7 years and paying the variable-rate premium cheaper than borrowing and funding immediately? To determine the answer to this question, we have to compare the relative cost of, on the one hand, PBGC variable-rate premiums and, on the other, what we are going to call ‘excess loan payments.’ By ‘excess loan payments’ we mean the additional cost of repaying the loan (relative to funding the plan over 7 years) because the cost of borrowing is higher than the rate of return on assets (which, as discussed above, is also our assumed plan valuation rate). Thus ‘excess loan payments’ represent the spread between the sponsor’s borrowing rate and the plan’s asset return rate.
To get these two numbers (PBGC variable-rate premiums vs. excess loan payments) on an apples-to-apples basis, we consider the future value, after 7 years, of each. Thus, we credit interest (at the rate of return on assets) on both the PBGC variable-rate premiums and the excess loan payments.
In the example we’re using, the breakeven point is a cost of borrowing of 9.21%. At that borrowing rate, the (annual) cost of repaying the loan is $3,664,741. That is $460,710 per year greater than the $3,204,031 (annual) amount it costs to fund the plan.
UVB/funding shortfall = $20 million
7 year shortfall amortization (at 4%) = $3,204,031
Loan repayment (at 9.21%) = $3,664,741
Excess loan payment = $460,710
|Year||Fund over 7 years + PBGC
|Borrow and fund
|1||$ 600,000||$ 600,000||$ 460,710||$ 460,710|
At a borrowing rate of 9.21%, the cost of the loan equals the cost of delaying funding and paying PBGC variable-rate premiums. If a sponsor’s borrowing rate is lower than 9.21%, it doesn’t just ‘break even.’ For instance, as our first illustration (Table 2) showed, where the borrowing rate is 4%, all PBGC variable-rate premiums are ‘saved money’ – the sponsor saves the full accumulated value of the PBGC variable-rate premiums – $3,638,822.
Obviously, this is a very stylized analysis. The point is that (1) there is a trade-off – at certain costs of borrowing/rates of return, borrowing and funding is cheaper (perhaps significantly cheaper) than paying the variable-rate premium, and (2) the increase in variable-rate premiums in BBA2015 makes borrowing and funding significantly more attractive for many sponsors.
We will continue to follow these issues.