Michael Moran, CFA, Senior Pension Strategist at Goldman Sachs Asset Management, provides observations on recent tax reform measures and outlines key implications for pension plans.
Q: Under tax reform the corporate tax rate will be lower in the future than what had previously been in effect. Has that influenced behavior of plan sponsors with respect to making contributions to their plans?
A: Yes. Contributions to corporate defined benefit (“DB”) plans are generally tax deductible up to certain limits. For plan sponsors that were contemplating making a contribution in future years, some decided to accelerate that contribution into 2017 in order to reap the benefits of getting the tax deduction at a higher rate.1 Kroger and Valvoline are two examples of companies that explicitly cited potential corporate tax reform as one of the reasons for making a voluntary contribution earlier in 2017. Since plan sponsors can under certain circumstances make a contribution up to 8 and a half months after the end of the year and still have it count as a deduction for the previous tax year, we expect voluntary contribution activity to continue into 2018 where sponsors claim a deduction at their former, higher tax rate.
Q: Has the potential to reap a larger tax deduction today been the only factor driving plans to make voluntary contributions in 2017?
A: No. There have been several other factors which have also provided plan sponsors with an incentive to put more money into their plans sooner rather than later.1 We have observed significant voluntary contribution activity in 2017 including Boeing ($3.5bn), Verizon ($3.4bn) and Delta (> $3.0bn).
First, PBGC variable-rate premiums have been rising at a rapid rate. Plan sponsors were (generally) paying 3.4% on any deficit in 2017, and that will rise to 3.8% in 2018 and over 4% by the end of the decade.2 Accelerating contributions may help reduce and, in some cases, may eliminate those premiums.
Second, the IRS has updated mortality tables for funding purposes to better align with updates made for GAAP accounting purposes in 2014. Some sponsors recognize that they may see higher contribution requirements and PBGC variable-rate premiums in the future given these upward changes to liabilities and, therefore, making a voluntary contribution today may make sense.1
Third, funding relief that had been enacted and updated several times by Congress over the past few years is scheduled to run off over the next few years. Consequently, as with the aforementioned mortality issue, for some plans, ERISA liabilities and funding requirements may rise in the next few years. Making a voluntary contribution may help mitigate some of those higher deficits in future years.
Q: Changes to repatriation rules under tax reform may make foreign cash more accessible for US multi-nationals. How might that impact sponsors of corporate DB plans?
A: It could have multiple impacts. First, repatriation of foreign cash may provide sponsors with increased capital flexibility which may enable them to continue to make voluntary contributions in the future for all of the reasons detailed above. Estimates of overseas cash for US companies have been in the range of $1-$2.5tn, which is in stark contrast to the aggregate underfunding of S&P 500 US Defined Benefit Plans, which is estimated at approximately $300bn.1
Second, increased flexibility around cash may mean that some US multi-nationals may not need to issue as many bonds going forward to fund buybacks, dividend increases, capital expenditures, etc. Coupled with limitations around future interest deductibility, this could lead to a supply/demand imbalance. Just as more corporate DB plans are looking to add long duration fixed income to their portfolios as funded ratios move higher from contribution activity,1 the new supply of long duration fixed income securities may decline.
Finally, given the aforementioned new interest deductibility limitation applicable to certain companies, some sponsors may not find a borrow-to-fund strategy as compelling as before the enactment of tax reform. In particular, for certain companies, interest deductions are generally limited to 30% of EBITDA for tax years beginning before 1/1/2022, and to 30% of EBIT for subsequent tax years. Given this, the ability to use existing corporate cash for pension funding may become more critical.
Q: What does all of this mean from a corporate DB plan management perspective?
A: Increased contribution activity leads to higher funded ratios which may be a catalyst for more de-risking activities. This may take the form of increased allocations to long duration fixed income, to better match plan liabilities, as well as more risk transfer activities since better funded plans make it easier for the sponsor to transfer liabilities to a third party insurance company. Potential supply/demand imbalances for long duration corporate bonds may lead sponsors with interest rate triggers in their glide paths to move forward with de-risking despite persistently low bond yields due to continued downward pressure on the long-end of the yield curve. In addition, while the return generating portion of some plan portfolios may likely shrink, some plans may seek to de-risk that portion of their allocation as well through increased allocations to alternatives/lower equity beta strategies, in order to reduce overall plan asset volatility.
1 Based on GSAM observations.
2 Pension Benefit Guaranty Corporation.
The economic and market forecasts presented herein are for informational purposes as of the date of this presentation. There can be no assurance that the forecasts will be achieved. Please see additional disclosures at the end of this presentation.