The House Ways and Means Committee's proposed tax bill to allow companies to revert pension assets in excess of 125% of their plan's current liability raises two important issues. First, does 125% of current liability provide enough of a cushion? Second, how much surplus should a company revert?
Despite these issues, the surplus reversion proposal is a welcome break for corporate plan sponsors without harming beneficiaries. There is a perception that sponsors and participants are at cross purposes when it comes to benefit security, but this is usually not true.
Even if a plan has negative surplus (that is, a deficit), participants' accrued benefits are largely protected by the Pension Benefit Guaranty Corp. The major benefit at risk is future accruals (including pay increases). Surplus pension assets will not ensure these future benefit accruals, because they will not be earned unless the company is profitable enough to stay in business, which means it is profitable enough to pay its future required pension contributions.
Surplus reversions will not significantly impair the participant's security, and freeing up the capital may even make the company stronger and more able to pay future accruals.
On the first issue, the tax bill's proposed 125% cushion of pension liability is less than it may appear. Under the proposal, the liability is computed using an existing formula in the tax code the Internal Revenue Service uses for pension calculations - a four-year weighted average of 30-year Treasury bond rates. Unfortunately, the liability, based on the weighted average of rates, differs substantially from calculating the liability using current market rates.
The most recent highest four-year average rate allowed by the IRS (now about 7.71%) is much higher than the current market rate for the 30-year Treasury bond (6.61%). So a typical plan with a pension liability of 11-year duration has an accrued liability under the tax bill proposal that is 89% of the marked-to-market liability. This means that the 125% cushion under the tax bill would translate into a 112% cushion using the current market rate.
For plans with longer duration liabilities (typically those plans with a high proportion of active employees vs. retirees), the 125% tax-bill cushion basis translates into even less cushion on a marked-to-market basis. For example, take a plan whose liability has a 14-year duration. Under the tax bill calculation, a liability of $100 million would need a cushion of $25 million before it could begin a reversion. But on a market-to-market basis, its liability would be $115 million, leaving only a cushion of $10 million before it could begin reversion.
The supposedly safe 125% cushion is not safe as far as the PBGC is concerned. Many plans will have to pay a higher PBGC premium immediately if they reverted all the surplus they can under the proposal, because the rate used to calculate the threshold liability for PBGC premiums is much lower than the IRS liability rate. The PBGC premium calculation uses 80% of the current market rate on the 30-year Treasury bond. With the market rate at about 6.61%, that means the PBGC rate is 5.29%, while the rate used in the reversion proposal would be 7.71%.
Take a sponsor whose pension liability has a 14-year duration. If the accrued liability is $100 million, then the proposed tax bill would allow the sponsor to revert surplus as long as they leave at least $125 million in the plan. Its PBGC liability, however, would be $137 million, based on the PBGC assumed interest rate.
Thus, plans that revert assets may wind up paying higher PBGC premiums, because their assets, despite meeting the 125% cushion in the tax bill, drop below the PBGC calculated liability threshold.
Despite these problems, surplus reversion gives a welcome flexibility to corporate plan sponsors. But it raises two questions: Is there a right amount of surplus to revert? And how should the plan's asset allocation be adjusted following the reversion?
In a nutshell, companies with mature plans or companies that downsized a lot (i.e., a high portion of retiree liabilities) should revert as much surplus as possible and manage future costs by matching assets to liabilities with a relatively low equity exposure. Companies with plans which have a high proportion of active employees should leave more surplus than the minimum permitted.
Finally, it will pay for companies with very high borrowing costs (or those that cannot borrow at any price) to revert more surplus than companies with investment-grade borrowing capabilities.
From a corporate finance perspective, reversions change assets and liabilities asymmetrically. Each dollar of reverted surplus increases the company's assets by the same amount, but the same is not true for the liabilities. The value of a corporation's liability is the present value of the after-tax future required contributions; these contributions will increase when the surplus is reverted. In general, the marginal liability is larger for each additional dollar of surplus reverted. Basically, the tradeoff is between the tax advantage of funding the plan (the assets build up tax free) vs. the cost of overfunding the plan (surplus may not be obtainable in the future at fair economic value).
For example, if a plan is so well funded that the sponsor probably will never have to make another contribution, removing some surplus will increase the future contributions only slightly.
However, reverting surplus from a less well-funded plan can increase future contributions more than it increases assets because the surplus will not be available to reduce future contributions, nor will the tax-free buildup that the surplus would have earned. In addition, the sponsor may have to pay higher PBGC premiums.
The point where surplus reversions are no longer worthwhile will differ from plan to plan. If a sponsor has a very high borrowing cost, then it will generally be able to revert more surplus because the resulting increased future contributions are discounted at the sponsor's high rate, which results in a lower increase in liability than a sponsor with a low borrowing cost would experience.
Also, a plan with an increasing population knows its contributions will increase, so the tax benefits are likely to outweigh the cost of overfunding. There are several factors that will affect the optimal surplus reversion, but current liability is only peripherally involved.
Once a company decides how much surplus to revert, it must then decide how to invest the remaining assets. Because of the asymmetry, less surplus means the downside is more expensive. The higher expected returns of risky assets may no longer compensate the pension plan sponsor adequately for the increased probability of large PBGC premiums and other underfunding consequences. This means that the sponsor will need to invest more conservatively or use derivatives or dynamic rebalancing to avoid shortfalls.
Michael Peskin and Charlene Barnes are, respectively, president and vice president at Michael Peskin Associates Inc. in Weston, Conn.
