It’s time to consider a deliberate pension plan funding policy
Companies are obligated to contribute at least the minimum required contribution as required by law, and for some companies that is all that they can afford to contribute. However, depending on the ultimate goals and objectives of a pension plan sponsor, there are reasons to create a contribution policy to guide budgeting and decision making to better manage funded status risk within a plan. In many cases, plan sponsors may find that the minimum required contribution isn’t the best funding policy. This article looks at where contribution requirements are headed and the considerations pension plan sponsors should have in determining how much to contribute to their pension plan trust.
Since the Pension Protection Act of 2006, minimum required contributions have been determined based on the value of benefits accruing over the year (and potentially administrative expenses) plus a seven-year amortization of any unfunded liabilities. The liability basis for these calculations is based on benefits accrued as of the valuation date and initially a 24-month smoothed interest rate based on a high quality corporate bond yield curve (segmented for simplicity into three rates, one for the first five years, one for the next 15 years, and one for years beyond 20).
With the great financial crisis, we saw the introduction of various funding relief measures that gave plan sponsors options for minimizing the unfunded liability to be used for minimum contribution requirements. Most notably the Moving Ahead for Progress in the 21st Century Act (MAP-21) constrained the interest rate assumption to a corridor around the 25-year historical average of the corporate bond rates. This had the effect of increasing the interest rates used to value pension liabilities, which reduced minimum required contributions. While this corridor was set to widen to the point of irrelevance after a few years, additional rounds of legislation (the Highway and Transportation Funding Act of 2014 and the Bipartisan Budget Act of 2015) pushed the date that the initial corridor would widen out to 2021.
In 2020, additional legislation was proposed via the HEROES Act that would have narrowed the interest rate corridor even more and pushed out even further the date for when it would phase out. This legislation went even further by proposing to eliminate existing amortization bases from previously unfunded liabilities and to extend the amortization period for future bases out to 15 years. While these provisions didn’t make it through Congress last year, with a new administration in 2021 this legislation is now back in play.
If pension relief is passed in 2021, it will bring additional and potentially substantial relief to plan sponsors that are only able to pay the minimum required contribution. If no new relief materializes into law, plan sponsors can expect contribution increases beginning as early as 2022. If the relief measure passes, plan sponsors that are concerned with contribution risk can re-examine their investment strategy as well as whether the change in contribution requirements will have a material effect on their future cash flow needs.
What will happen to required contributions without further relief?
If no additional relief comes through Congress, plan sponsors can expect to see their funding target liabilities that are used in calculating their minimum required contributions increase anywhere from 15% - 25% over the next few years. Depending on how well funded a plan is, that could translate into contributions that are upwards of 50% higher than the levels from the last few years.
Considerations for a funding policy
Legislated minimum required contribution levels (both now and in the future) are important, but they are only one piece of the puzzle. In thinking through what makes sense for a specific plan sponsor, their ultimate goals and objectives need to be defined. For frozen pension plans, that could mean a target timeline to financially prepare for plan termination. For non-frozen plans, targeting a certain funded status level could be the key. These considerations cannot be made in isolation. The plan sponsor’s risk tolerance, investment objectives, and ability to weather future contribution volatility need to be factored in as well. Below are a few sample scenarios to illustrate the point:
A frozen plan that is nearing termination and is 100% funded on a minimum required contribution basis but underfunded on a plan termination basis.
This plan will want to look at their time horizon to an eventual termination and determine how much of their plan termination underfunding they want to resolve with contributions versus investment returns. That will influence how much they contribute each year as well as how much investment risk to take on. Depending on how aggressive the time horizon is, this will certainly require contributions even though their minimum required contributions could be $0.
An open plan with ongoing accruals that is well-funded on a minimum required contribution basis but is underfunded on a PBGC liability basis.
Similar to Sample 1, in this case the plan sponsor may have a $0 minimum required contribution but may be paying PBGC variable rate premiums. In this case, the plan sponsor will want to consider a funding policy that gets them to at least 100% funded on a PBGC liability basis to eliminate the additional PBGC premium they are paying.
A plan that has historically maintained a funded status just over 80% on a minimum funding basis using as little cash as possible so that they can continue to pay lump sum distributions.
Without additional funding relief, this plan sponsor may quickly find that they have large cash contribution requirements over the next 2-3 years to maintain the 80% funded status level. By looking at what those contribution requirements are expected to be, they can smooth out those contributions beginning in 2021 to have less volatility in the overall cash they deposit into the plan.
In order to effectively plan, plan sponsors will want to understand their projected cash contributions based on conditions today. Coupled with their overall goals and objectives, constraints, and risk tolerances, putting all the pieces together will create clarity on what the company’s optimal contribution policy should be. If ignored, plan sponsors stand to risk some unpleasant surprises in their cash contribution requirements in the years to come. It is imperative for plan sponsors that want to effectively manage their pension plans and the risk they bear to the organization to articulate a contribution policy.
R&M pension plan services
Through a variety of strategies, we can help defined benefit plan sponsors solve some of their most acute challenges.