Splitting pension plans can reduce PBGC variable-rate premiums
In this article we consider a strategy for reducing PBGC variable-rate premiums – the split-up of a plan (which we’re going to call the ‘combined plan’) into a plan that covers participants subject to the variable-rate premium headcount cap (the ‘HCC plan’) and a plan that covers all other participants (the ‘non-HCC plan’). Such a strategy may reduce PBGC variable-rate premiums in two ways. First, it can be used to maximize the effect of the headcount cap. And, second, it may allow the sponsor to make contributions that reduce variable-rate premiums where the headcount cap would otherwise prevent that result.
This material is dense, and as we’ll repeat at the end, the analysis requires involvement of the plan’s actuary and of counsel. But for some (many?) sponsors it may be worth considering – PBGC variable-rate premiums function as a sponsor-paid tax on plan funding, and strategies that reduce them go right to the sponsor’s bottom line.
We begin with a review of how PBGC’s variable-rate premiums are calculated.
Variable-rate premium basics
The PBGC variable-rate premium is the lesser of:
The VRP rate. For 2018, the VRP rate is $38 per $1,000 in unfunded vested benefits (UVBs). 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) and asset smoothing are disregarded. A rough (but simple and good-enough) way to think about the VRP rate is simply as (for 2018) 3.8% of unfunded benefits, and that is how we treat it in this article. In 2019, the VRP rate will be $42-$44 per $1,000 in UVBs (depending on average wage growth during 2017). After 2019, the rate will continue to increase based on average wage growth.
The Headcount Cap (HCC). For 2018, the HCC is $523 times the total number of participants in the plan. After 2018, the HCC will continue to increase based on average wage growth.
Interaction of the VRP rate and the HCC in a one participant plan
These two rules – the variable-premium rate and the cap – trade off against each other. The easiest way to understand this is to walk through some examples.
Let’s begin by considering a plan with only one participant. If the funding shortfall for that participant is greater than $13,763 ($523 divided by 3.8%), the HCC will apply. If the shortfall is $13,763 or less, it won’t apply.
If the HCC doesn’t apply, then the VRP will be (for 2018) 3.8% of the plan’s UVBs. If it does apply, the VRP will be $523, regardless of how big the plan’s UVBs are. A corollary of the latter rule is that, if the HCC applies, contributions by the sponsor, even though they reduce UVBs, will not reduce the VRP unless the contributions push funding so high that the HCC no longer applies.
A two participant plan
If we add another participant, then it is the average of the underfunding of the two participants’ benefits that matters – if the average shortfall for the plan is greater than $13,763, then the HCC applies. The ‘average’ matters here simply because the HCC is a per capita limit on the VRP.
If we add another participant whose benefit is ‘better funded,’ then it’s possible that the average underfunding will be below $13,763, and the plan won’t be subject to the HCC, regardless of the fact that if the plan only covered the first participant it would be subject to the HCC.
On the other hand, if the average underfunding for the two participants (in this 2-participant plan) is over $13,763, then the HCC would apply, regardless of the fact that if the plan only covered the second participant it would not be subject to the HCC.
Consequences for premiums
To connect the dots here, consider the table below, which compares the premium calculations for two distinct one person plans with the same calculations assuming both participants are covered by a single plan:
|Count||Liability||Assets||UVB, (2) – (3)||VRP Before Cap, (4) x 3.8%||VRP Cap, (1) x $523||VRP min [(5), (6)]|
|2 Plan Total||2||150,000||100,000||50,000||1,900||1,046||$713|
The single plan is $50,000 underfunded ($25,000 per participant), so the HCC applies and the variable premium is $523 x 2 = $1,046.
Note also that in the single plan a $20,000 voluntary contribution does not reduce the premium at all, since it leaves the plan $30,000 underfunded ($15,000 per participant).
Under separate plans, the variable premium under Plan A is reduced to $190, since that plan is only $5,000 underfunded, while the premium for the Plan B participant remains at $523.
On top of this, the sponsor ‘gets credit’ for voluntary contributions to Plan A, so that a $5,000 contribution ‘earns’ an immediate 3.8% return in the form of a lower premium, an opportunity that does not exist under the single plan.
Obviously, this a stylized example, and some scale is needed to overcome costs involved in splitting plans, but sponsors suffering from exorbitant increase in PBGC premiums in recent years can significantly reduce this expense going forward by adopting a split plan strategy.
In addition, the strategy provides an incentive for sponsors to make voluntary contributions to reduce pension underfunding, in contrast with the single plan strategy, under which sponsors are more inclined to only make minimum required contributions.
The point of all this is, by now, pretty obvious. In a perfect world, if a sponsor could put all participants with a funding shortfall (in 2018) greater than $13,763 in one plan, and all the others in another, it could minimize VRPs and maximize the effect of contributions in reducing PBGC premiums.
Is that possible – can a sponsor do that? The answer is yes, but there are a few complications worth understanding.
Complications and issues
One complication is the assigning of plan assets to participants in connection with splitting a plan. Assets are allocated to participants based on ordering rules applicable to plan terminations. (Note, simplified rules apply in the case of de minimis spin-offs of <3% of plan liabilities.) These calculations require a separate actuarial valuation using assumptions dictated by PBGC, and the ordering rules generally favor current retirees. Once assets are assigned to participants, the calculation of each participant’s unfunded liability is straightforward.
Another complication is that the ‘threshold’ for identifying ‘HCC participants’ will decrease to about $12,500 in 2019 and stabilize around that number thereafter.
Also, over time, individual underfunding can increase or decrease due to fluctuations in market interest rates and plan asset values, but we expect these amounts to shrink as required contributions reduce the plan’s funding shortfall.
In general, the greater the number of participants moved into the ‘non-HCC plan’, the more significant the impact on PBGC premiums. But also, the greater the appetite the sponsor has for making voluntary contributions (provided they get ‘credit’ for these contributions in terms of lower premiums), the greater the number of participants that can be moved to the ‘non-HCC plan’. So, in practice, the process of determining the appropriate split can be iterative.
Finally, it is quite possible that splitting plans increases total required contributions in the near-term compared to a single plan, and it also creates a ‘HCC plan’ that is less funded than the original plan and so more likely to run afoul of underfunding penalties such as benefit restrictions or ‘at-risk’ status. Sponsors should be aware of these issues and strategies for dealing with them before embarking on this strategy.
In this regard, however, we note that PBGC premiums function like a tax: once paid the sponsor gets no benefit from them (other than PBGC benefit insurance). So premium ‘overpayments’ are, in effect, lost money. Contributions, on the other hand, will ultimately be used to pay off real liabilities under the sponsor’s plan. So the sponsor generally will (ultimately) get the benefit of any one year’s ‘over-contribution.’
The analysis involved is, however, very technical and, as discussed, is not risk-free. A sponsor will not want to undertake a project like this without an actuary and without consulting counsel.