When will PBGC premiums force a change in contributions?

Editorial Note: This post originally appeared on our companion blog, Fiduciary Matters, on September 20, 2016.

Some wit once observed that “despite the regular and well-documented occurrence of Fridays, they always seem to catch the British railway system by surprise.”1 And just as Friday is surely coming, so too is the day when U.S. defined benefit (DB) pension plan sponsors cannot afford to pay only the minimum required contribution into their plans. There’s no excuse for being surprised by the inevitable.

Four big questions for DB plans for 2017

There are four big questions hanging over DB plans as we approach 2017. I looked at the first a couple of weeks ago (“Is there a point where interest rates are too low for LDI to make sense?”) In this post, I’ll address the second: at what point will PBGC (Pension Benefit Guaranty Corporation)2 premiums force a change in contribution policy? We’ll turn to the other two (which concern annuity buyouts and outsourcing) in later blogs.

For many years, contribution policy was not a particularly complex issue. Few plan sponsors saw much incentive to pay more than the minimum required contribution; most simply paid what they were told to pay by the IRS.

A tax on contributions not made to the plan

Two things changed since then, though: funding relief and PBGC premiums.

Funding relief – which has been granted on five separate occasions since the Pension Protection Act of 2006 – means that minimum requirements are low. 15 of the then-19 members of the $20 billion club (our name for the publicly-listed U.S. corporations with the largest pension liabilities) were not required to make any contribution at all to their primary U.S. plans in 2015, even though SEC filings showed their combined pension liabilities to be on average only 80% funded at the start of the year.

And PBGC premiums are, in effect, a tax on not making contributions, a tax that gets larger every year. From $1 per participant when the PBGC was created, these premiums had drifted up to $35 per participant plus 0.9% of the liability shortfall by 2012, when a sharp-eyed member of Congress spotted that these premiums counted as revenue for the purpose of balancing the budget. In short order, the 35-and-0.9 became (for 2016) 64-and-3.0, rising to at least 80-and-4.1 by 2019. And even if no new increases are passed by Congress, indexation means that both of those numbers will continue to increase in line with national average earnings. That formula could even mean that given enough time, the PBGC premium to be paid each year on an unfunded liability would eventually be larger than the liability itself. Admittedly, that point is several decades away (and the existence of a per-participant cap, currently $564 in total, would act as a brake), but as current legislation stands the premiums are going to just keep rising.

The absurdity of this situation was nicely captured by Justin Owens in a previous post which described an imaginary conversation in which a creditor father proposes a PBGC-like arrangement to their indebted child and gets a predictably stunned response:

“So you’re telling me that to pay back a $100,000 loan I need to pay you over 25% on top of payments we’ve already agreed to, just so you can have a fund I probably won’t ever need?”

“Yeah, sorry about that, but keep in mind I am giving you a few extra years to pay me back.”

And that 25% number may be on the low side. Justin explains: “We run these numbers for plans regularly. We generally find that if the sponsor funds based on simply the minimum requirement, then as much as 30% – in some cases even 40% – of their contributions will in effect be paid to the PBGC rather than to their plan participants. This is a grossly inefficient use of cash. And with every passing year and every increase in the premiums, that number gets bigger.”

So nobody should be surprised that GM is borrowing $2 billion in order to make discretionary contributions to their U.S plan even though the minimum required contribution is zero, nor should they be surprised if we see others making similar moves . Not every plan sponsor is going to decide that 2017 is the year where the minimum contribution policy is finally unsustainable, but every sponsor should be asking the question.

1 I’ve tried hard, but without success, to locate a source, however apocryphal, for this quote. I must have got it from somewhere.

2 The Pension Benefit Guaranty Corporation (PBGC) is an independent agency of the United States government that was created by the Employee Retirement Income Security Act of 1974 (ERISA) to encourage the continuation and maintenance of voluntary private defined benefit pension plans, provide timely and uninterrupted payment of pension benefits, and keep pension insurance premiums at the lowest level necessary to carry out its operations.