The dramatic decline in interest rates since the 2008 financial crisis has played havoc with the funding levels of corporate defined benefit plans, raising required minimum contributions and forcing difficult decisions. The passage of the Moving Ahead for Progress in the 21st Century Act of 2012, known as MAP-21, brought much needed relief through a revised method for setting liability discount rates. These new discount rates greatly reduce required minimum contributions, but they lead to an interesting question: Are plan sponsors better off under the new contribution rules?
Sponsors that follow MAP-21 will have reduced minimum contributions for a period of time — typically four to six years. However, relief comes at a price: MAP-21 raises Pension Benefit Guaranty Corp. premiums for the 2013 plan year and beyond. Sponsors that contribute at the lower levels of MAP-21 might incur higher costs in the long run.
Prior to MAP-21, the present value of liabilities was calculated using segment rates aligned with a plan's liability cash flows. These covered years 1 to 5, 6 to 20, and 21 and above, and were based on trailing 24-month averages of yields on high-quality corporate bonds. Under MAP-21, however, the applicable rates are based on 25-year averages — with floors and ceilings that will gradually widen over the next four years. By the time permanent floors and ceilings are in place in 2016, we expect that 24-month rate averages will have moved inside the floors, eliminating MAP-21 relief.
MAP-21 also included a significant rise in PBGC premiums. The flat-rate premium rose by $7 per participant in the 2013 plan year and will rise by the same amount next year. Increases thereafter will be based on inflation. The variable-rate premium, applied to unfunded vested benefits, will more than double by 2015. While MAP-21 caps the variable premium at $400 per plan participant (indexed for inflation), the combined increases will be substantial for many plans.
The PBGC variable-rate premium will be based on funding values calculated using the old discount rates, not the higher MAP-21 rates. So lowering contributions to the MAP-21 minimums will result in higher premiums going forward.
We used scenario analysis to project the impact of different contribution levels under varying interest rate and return on assets assumptions, taking into account both MAP-21 rate stabilization and the higher PBGC premiums. The sample plan used in our scenario analysis had a funded status of 92% at the start of 2012, with typical liability and cash flow characteristics; we did not assume any actuarial smoothing or carryover/prefunding balances.
We calculated cash costs over a 10-year horizon with and without MAP-21. These costs had three components: minimum annual contributions, the new PBGC premiums and full recognition of accrued benefits at the end of the period using a projected Internal Revenue Service yield curve.
We then formulated three simple interest rate scenarios to measure the potential impact of changing bond market conditions:
- no change in rates over the 10-year horizon;
- “bear flattening” — curve flattening with an overall rise in yields; and
- “bull flattening” — curve flattening marked by declining yields.
Asset returns are obviously critical to plan funding. So we re-ran our analysis using ROAs ranging from 5.5% to 9.5%. These assumptions were held constant over the study horizon.
Our assumptions also included our sample plan sponsor's cost of capital (8%) and effective tax rate (35%), which we used to calculate the net present value of all three cost components using both pre-MAP-21 and post-MAP-21 valuations. This enabled us to identify situations where it was beneficial for the sponsor to maintain pre-MAP-21 contribution levels. These included every scenario where ROA equaled or exceeded 7.5%. In the bear flattening case, maintaining a pre-MAP-21 contribution policy was beneficial even with a 7% ROA.
The explanation for these results is simple: MAP-21 contribution levels resulted in higher unfunded liabilities, triggering higher PBGC premiums. These higher premiums offset the benefits of delayed MAP-21 funding, even in some cases where the ROA was below cost of capital.
Our analysis applied deterministic ROA and capital cost assumptions to a single plan with a particular liability and corporate profile. Changing the sponsor's circumstances could have produced different outcomes, some of which might not have supported maintaining pre-MAP-21 contribution levels.
Reducing the funded status of the plan, however, does not change the outcome if other assumptions are held constant. While a lower funded status results in higher contributions under both contribution policies, lower PBGC premiums still favor a pre-MAP-21 funding strategy.
MAP-21 offers welcome relief to plan sponsors. However, while the lower short-run contributions it requires might be tempting, we believe plan sponsors that can make contributions based on pre-MAP-21 valuations should give that option serious consideration.
Peter S. Austin is head of fixed-income solutions, T. Rowe Price Associates Inc., Baltimore.