Workplace Issues

Tax Law Drives Pension De-Risking Opportunity

The lower corporate tax rate is leading CFOs to finally address the problems of underfunding, rising costs, and mounting liabilities.
June 25, 2018
Tax Law Drives Pension De-Risking Opportunity

Among the many effects on corporate finance from the Tax Cuts and Jobs Act is a greater motivation to address problems with defined-benefit (DB) employee pension plans. Thanks also to the savings from a lower corporate tax rate for 2018, senior finance executives think that this year may be an opportune time to reduce the liability risks associated with their companies’ DB pensions.

Those were among the important findings of a recent CFO Research study on how the new tax law is influencing a range of pension-related decisions.

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The online survey, conducted in collaboration with Prudential Financial, drew 127 responses from finance executives whose companies have DB plans for current or former employees. This is the eighth consecutive year Prudential has surveyed CFOs on pension issues.

Respondents came from a variety of industries, led by financial services/real estate, health care, and auto/industrial/manufacturing. They consisted mostly of chief financial officers, directors of finance, and vice presidents of finance. A majority of respondents came from companies with $250 million to more than $5 billion in annual revenue.

Among the top conclusions of the research: Senior finance executives are using the new tax law’s benefits to ramp up DB plan funding. Under the new tax rules, businesses have until mid-September 2018 to deduct pension-plan contributions at the 2017 corporate tax rate of 35%. After that, the new 21% rate kicks in.

Not surprisingly, about three-quarters (74%) of survey respondents said their organization was “very likely to make a substantial DB plan contribution” in time to take advantage of the larger deduction.

Increased Funding

The survey results match what Rohit Mathur, head of global product and market solutions for Prudential’s pension risk transfer business, is observing in the market.

“A number of companies are accelerating pension contributions,” he says. “We are also noticing an increasing interest in pension risk transfers among plan sponsors.”

Even after the September deadline, companies can use savings from the significantly reduced corporate tax rate to fund their pensions at higher levels.

In the survey, 64% of respondents said they were “very likely to use the tax savings from the new law to increase funding of our DB pension plan(s).” (See Figure 1, at right.)

The new law also includes a provision allowing U.S.-based multinationals to repatriate foreign earnings at tax rates far lower than the 35% that applied in the past. Companies can take advantage of a one-time repatriation at the rates of 15.5% for cash holdings and 8% for non-liquid assets.

About a quarter (24%) of survey respondents said they planned to use repatriated capital to bolster their DB funding levels.

Among survey respondents at the companies that expect the TCJA to generate excess income, 29% said they expected to use the funds to minimize liability risk, through such efforts as boosting retiree health-care funding.

The study also found that plan sponsors were considering whether to alter their asset management strategies, as well as whether to transfer pension obligations to an insurance company.

Cost Pressures

The decision to improve the funding levels of DB plans isn’t solely an outgrowth of the new tax policy. Plan sponsors have long struggled to generate sufficient returns to offset increasing liabilities from persistently low interest rates and increasing lifespans. But the sponsors are now contending with rapidly changing conditions, including rising costs and bond yields.

For example, the premium levied by the Pension Benefit Guaranty Corp. (PBGC) is on the upswing. The variable-rate component of the premium, calculated using a DB plan’s unfunded obligations, will increase from this year’s $38 per $1,000 of unfunded vested benefits to $42 per $1,000 in 2019.

The variable-rate increase has been an annual ritual since 2013, when the rate stood at $9 (where it had been since 2007). Over the past six years the per-participant component of the premium has increased by almost 115%.

DB plan sponsors are also under pressure to grow plans’ investment returns, thanks to the life-expectancy increases as reflected in Internal Revenue Service mortality tables.

In the Prudential survey, 70% of respondents agreed that “the recent changes in actuarial mortality assumptions, and the prospect of further changes, are creating ‘longevity risk’ for my organization that places additional pressure on our DB funding levels.”

Shifting the Risk

Overall, the growing expense of maintaining DB plans along with the potential risks from underfunding are driving senior finance executives to consider pension risk transfers.

Companies with well-funded plans can offload some or all of their pension obligations to an insurance company as a way to reduce risks and administrative expenses, including PBGC premiums. In return, sponsors purchase a group annuity contract for plan participants.

In the survey, 62% of respondents agreed that once their “DB pension plan becomes well-funded,” their organization will be “very likely to execute a full or partial pension risk transfer to an insurance company.”

In sum, by skillfully taking advantage of the TCJA, plan sponsors can accelerate DB plan funding and, in the short term, claim deductions on their contributions at a higher rate. By controlling their risks and costs, senior finance executives can stabilize and strengthen their companies’ DB pension plans. That shelters the plans from sources of volatility and prepares them to be delivered into the hands of a third party that can reliably serve participants in the long run.

Finally, while DB plan funding and liability management was a core concern of the surveyed CFOs, other financial priorities will also receive a boost from the TCJA.

For example, many finance chiefs said they were likely to utilize newly accessible capital for the benefit of the enterprise, including accelerating capital expenditures and returning capital to shareholders. (See Figure 2,  above.)

For CFOs, figuring out which investment strategies will have the most long-term benefit for their companies is indeed a good problem to have.