The U.S. Senate approved a bill Wednesday that will allow many companies to lower their contributions to their employee defined-benefit pension plans this year. But the proposal may increase companies’ tax liabilities, and some say it could also lead to a drop in plan funding.
The provision in the Senate highway bill requires companies to calculate their defined-benefit pension plan contributions using a rate within a range of a long-term average of interest rates, rather than the short-term, two-year average they currently use.
The Employee Retirement Income Security Act Industry Committee (ERIC), a group of corporate pension-plan sponsors, says the provision would provide relief for companies. “The current interest-rate environment is severely burdening companies and threatening the viability of defined-benefit plans, many of which must choose between funding their plans and hiring and capital investments or even further cutting back on jobs,” ERIC wrote in a statement.
Indeed, with the Federal Reserve holding interest rates down over the last several years in an effort to stimulate the economy, the two-year average interest rate that companies use to calculate their pension contributions has plummeted. Companies determine their contributions by discounting future benefits by these interest rates, so that when interest rates are lower, the required contributions skyrocket.
As a result, companies have had to increase their contributions to keep their plans funded to levels required by the Pension Protection Act of 2006. These employers say they are having trouble keeping up with the size of required contributions and could be using the cash more strategically.
Under this provision, companies could use the long-term average rate, currently higher than the two-year average, to determine their contributions, says Alan Glickstein, senior retirement consultant at Towers Watson.
This provision, if it becomes law, could provide much-needed support for employers over the next few years, says Glickstein. But the effect of the provision will change every year, because it is designed to gradually offer less variation from the current interest rate as years pass, and “there is no guarantee that current rates will be much lower than longer-term averages in future years,” Glickstein says.
Because short-term rates will fluctuate over time, this provision could provide balance to the system, he says. If those rates were higher than the long-term average, companies would still have to use the long-term rate.
Currently, “artificially low rates are making pension plans look less well-funded than they really are,” he says. Ultimately, the provision could provide long-term stabilization, because it would require companies to pay more into their plans if the long-term interest rate average were lower than two-year interest rates, he adds.
The Tax Effect
Since companies can generally take tax deductions for their pension contributions, the bill could have some tax implications, says Mark Spittell, Senior Director at Alvarez & Marsal Taxand, a tax advisory firm. If companies make smaller contributions, they may have to pay more in taxes. But the lower tax deduction and potentially higher liability will not cancel out all the savings from decreased contributions, Spittell says.
A company does not have to pay taxes on its contributions. In turn, if its contributions are higher, it will save more on taxes. If a company taxed at the top corporate rate contributed $100 to a pension plan, for instance, it would save $35 in taxes. If that company instead made an $80 contribution, it would save $28 in taxes. But it would also save $20 on its contributions.
While the tax savings at the lower contribution rate are lower, the net effect of the $20 contribution, minus the $7 in additional taxes, would be a $13 advantage over the higher contributor. Companies that are currently losing money, and hence not paying taxes, would simply benefit from a lower contribution requirement.
Some say the pension provision offers a reprieve for companies. “A well-funded pension plan is a good thing, but if it causes the company to falter or fail, maybe you would be better off allowing companies to fund those liabilities over a longer period of time,” Spittell says.
Others argue that letting companies decrease their contributions is irresponsible because the change could lead them to underfund their plans and eventually require help from the Pension Benefit Guaranty Corporation, the federal organization that insures private-sector defined-benefit pension plans.(PBGC is funded by contributions of corporate pension plan sponsors, not taxpayer dollars.)
To that point, pension plan funding has dropped over the last few years. The aggregate funding ratio for plans sponsored by companies in the S&P 1500 fell from 81% to 75% funded from 2010 to 2011. But funding seems to be on the rise: at the end of February this year, that ratio was 79%.
The Senate highway bill has been referred to the House.