It’s well known that corporate pension plan sponsors have until mid-September to make tax-deductible contributions under the more favorable 35% corporate tax rate, rather than the 21% rate established by the Tax Cuts and Jobs Act.
This is an attractive proposition that many corporations are looking to leverage, if they haven’t already.
But, given the boost in funded status from these voluntary contributions, perhaps less obvious is that minimum required contributions may rise over the next several years. Addressing this issue should be a key focus for most plan sponsors so that unexpected pension contributions don’t disrupt strategic company initiatives.
The End of the Vacation?
Why would plan sponsors, even those that make voluntary contributions by mid-September of this year, be subject to higher minimum required contributions in the coming years?
First, updated mortality tables, which have become effective for 2018 plan years, will cause the liabilities used in determining minimum required contributions to increase by approximately 4% to 5%, on average.
It should be noted that plan sponsors have the ability to defer these mortality updates until 2019 if using them this year is “administratively impracticable” or if the update would result in “an adverse business impact that is greater than de minimis.”
While it appears many plan sponsors will likely elect a deferral due to an “adverse business impact,” they will still feel the consequences of higher liabilities in the coming years.
Second, the multiple iterations of funding relief that have occurred since the 2008 financial crisis are gradually dissipating as artificially high funding discount rates begin to converge with recent market yields. This results in a lower discount rate and a higher liability for contribution purposes — and, consequently, likely higher required pension contributions going forward.
Furthermore, many plan sponsors have used credit balances to satisfy minimum required contributions in recent years. This mechanism, which relies on employing excess contribution money from prior years, may not be as helpful going forward, as these balances have gradually been depleted.
The dynamics that have resulted in muted pension contributions in recent years have been largely beneficial to plan sponsors by allowing cash to be allocated to other company uses. But this has also created a bit of complacency and unrealistic estimates of expected future contributions.
Challenging investment returns and extremely low discount rates — despite year-to-date increases — present further hurdles for sponsors as they contemplate options for infusing money into their plans. For many plan sponsors, the contribution vacation is slowly coming to an end.
Employing the Contributions Lever
Some effective actions can be taken to address this potentially mounting financial burden.
Plan sponsors have four levers to help manage their defined benefit plans: asset returns, liability hedging, benefit management, and contributions policy. The use of each lever should be appropriately balanced and coordinated to each plan’s optimal effect.
With regard to contributions, plan sponsors should consider several actions, as discussed below.
Capture a Realistic Forward Picture: As a first step, each plan sponsor should ensure that its key stakeholders have a full understanding of their plan’s projected minimum required contributions over the next five to ten years.
This analysis should capture the updated mortality assumption, as well as the wear-away of the discount-rate smoothing and credit-balance depletion mentioned above.
Also critical is assessing the impact of various asset returns and discount-rate changes, to get a full picture of the magnitude of required contributions under different market environments. This can be done via a combination of specific deterministic scenarios, supplemented by stochastic simulations of future economic environments.
Plan sponsors would benefit from viewing the minimum required contribution forecast as just that — the minimum. Although funding minimums are governed by regulations, a sponsor has leeway in the timing and amount of contributions beyond the required minimum.
Contribution policy represents the most direct link between a company’s balance sheet and its defined benefit pension plan, even if the intra-balance sheet flow is initially a zero-sum game.
A thorough analysis must be done to compare the return on investment of a pension contribution vs. either paying down existing company debt or reinvesting in the broader business. The decision on when to fund the pension and how much to contribute can substantially affect funded status in future years.
Therefore, a detailed analysis should focus on the contributions needed to meet the plan’s objectives.
Is the objective to stay above 80% funded, as defined by the Pension Protection Act of 2006, in order to avoid certain restrictions? To achieve fully funded status in three years? To terminate the plan in five years?
Minimum required contributions are unlikely to achieve those goals on their own and therefore should be treated as merely a lower boundary.
Quantify Balance Sheet Trade-offs: In many cases, the return on investment for contributions to the company pension plan may not be immediately clear.
To properly assess the trade-off between pension contributions and other uses of capital, it is helpful to view the pension underfunding as analogous to standard balance sheet debt, with a potentially high interest cost.
Often, when the impacts of PBGC premiums are included in this analysis, plan sponsors find that paying down the pension debt (i.e., the underfunding amount) is a more efficient use of capital as compared to paying down other debt on the balance sheet. This has also been a significant driver of corporations taking out debt to fund pension plans.
Establish a Dynamic Investment Strategy: It’s important to have a clearly defined investment strategy roadmap in place before contributions are made, so as to achieve efficient implementation and preserve funded status gains.
Once contributions are made —through existing company cash, debt proceeds, or company stock — the key is to protect the improvement in funded status. Many plan sponsors would like to forget that S&P 500 companies have poured nearly $500 billion into their pension plans in the last eight years and seen only a 3% increase in funded status.
To ensure pension contributions are most impactful to the plan’s health, it is crucial to reassess asset allocation and portfolio construction as contributions are made.
How best to allocate the new capital into the plan’s investment portfolio depends on several factors.
For plans that have significantly reduced their underfunding, a material portion of the contributions should be invested in liability-hedging fixed income in order to reduce funded status volatility and help lock in the plan’s funded status gains.
Plans that are closed to new participants or completely frozen should also lean heavily toward de-risking assets, perhaps following a funded status glide path.
On the other hand, plans that are either open to new participants or digging out of large underfunded gaps need to be thoughtful about allocating the new money to return-seeking assets, especially given the currently elevated equity valuations.
For plans that have the resources and can take on some illiquidity, adding to low-beta diversifiers and/or private investments may be an effective way to avoid contribution regret.
Unfortunately, a company’s ability to contribute to its pension plan does not remain constant. Periods in which markets perform poorly (creating a need for higher contributions) may coincide with periods during which the company itself faces financial adversity and has less free cash flow to set aside for pension infusions.
Therefore, the risk profile of pension assets may be intertwined with the risk profile of the company’s core operations.
Another aspect to consider in terms of the “cyclicality” of contribution policy is that when times are good and a company has more cash to invest in its pension, market valuations may be elevated.
Finance executives must monitor the competing forces of their ability to fund their pensions and the attractiveness of deploying cash into higher-priced investments.
While the focus on making pension contributions prior to the mid-September tax deadline is important, it should be the first step in establishing a dynamic contribution roadmap.
Especially given mounting contribution requirements ahead, plan sponsors should take this opportunity to view their contribution policy as one available lever—along with asset returns, liability hedges, and benefit management—in navigating the pension plan to a strong financial position.
Adopting a comprehensive strategic plan for the pension that aligns with broader organizational objectives is also critical to success.
Contribution strategy should be actively managed in the same way that asset allocation, portfolio construction, and manager selection are reviewed regularly. To be effective, it requires ongoing oversight and should allow for adjustments as markets and company capital needs change over time.
Ultimately, a well-executed contribution strategy can shift the focus away from underfunded pension plans and toward the core strategic initiatives that will help drive the company forward.
Justin Teman is senior investment director at Cambridge Associates, a global investment firm that works with endowments, foundations, pension plans, private clients, governments, and insurance companies.