The BCG Pension Insider
November 2020 – Volume 109, Edition 1
Borrowing to Fund Pension De-risking
Many plan sponsors believe rising interest rates will rescue them from their pension liability. But with interest rates at historically low levels that belief does not appear to be coming to fruition any time soon. The Federal Reserve cut interest rates twice in 2019, cut interest rates even further in March 2020 to near 0% in response to the COVID-19 pandemic, and on September 16, 2020 issued a statement that the Federal Open Market Committee (“FOMC”) “decided to keep the target range for the federal funds rate at 0 to 1/4 percent and expects it will be appropriate to maintain this target range until labor market conditions have reached levels consistent with the Committee's assessments of maximum employment and inflation has risen to 2% and is on track to moderately exceed 2% for some time.” Translation: low interest rates are going to be with us for quite some time.
If there is a silver lining to the low interest rate environment, it is that the cost of borrowing money also remains low. Under a de-risking strategy known as “borrow-to-fund”, plan sponsors can borrow money at current low rates, make a tax deductible contribution to fully fund their plan’s PBGC liability¹, and eliminate their plan’s PBGC variable rate premium cost. From there, additional de-risking options can be considered to further reduce plan cost and risk, such as lump sum windows or purchasing annuities for a tranche of retirees. Closing a plan’s funding gap also brings the sponsor closer to endgame strategies such as plan hibernation or plan termination (see definitions below).
- Plan hibernation (or self-sufficiency) — to achieve a plan funded status sufficient to cover the liabilities without any need for further contributions from the plan sponsor. Under a hibernation strategy, the plan would remain on the company balance sheet.
- Plan termination — to remove plan from company balance sheet through combination of lump sums and annuity purchase.
Where a borrow-to-fund strategy is employed to fund up a pension plan, a company’s total level of debt does not change. What does change is the variable and volatile pension liability is replaced with a fixed liability. Through the issuance of new bonds, plan sponsors effectively hedge the possibility of rising interest rates that would otherwise reduce their pension liability, as they can later buy back the new bonds issued at a discount when rates rise. Borrowing to fund through a loan provides a known and stable interest rate. Regardless of how the borrowing is structured, the replacement of an expensive and risky pension liability with a fixed liability (whose only carrying cost is interest) strengthens the balance sheet, is considered a net positive by shareholders, and is often seen as credit neutral or positive by the credit rating agencies.
As an example of how borrowing-to-fund compares to funding over time, consider a plan with a liability of $25 million for PBGC premium purposes, and assets of $22 million. With a current (2021) Variable Rate Premium of $46 for each $1,000 of Unfunded Vested Benefit (UVB), the plan would owe a PBGC Variable Rate Premium of $138,000 in 2021. By assuming a $3 million loan at 3%, the fixed liability interest payments would be very close to the interest cost that would otherwise be borne by that $3 million of pension liability (using a FTSE Pension Liability Index discount rate for October 2020 of 2.78%), but the sponsor would realize savings of $138,000 for 2021, and each year thereafter (assuming the plan’s funded status was maintained). Additionally, the plan sponsor can claim a 2021 tax deduction for the $3 million contribution.
¹ A plan’s PBGC liability represents the benefit obligation of a plan sponsor that determines the size of the Variable Rate Premium (VRP) that the sponsor must pay to the Pension Benefit Guaranty Corporation each year. Assumed interest rates are based on either a single corporate bond yield curve derived from a blending of corporate bonds rated AAA, AA and A; or from a trailing 24-month average of such yield curves.
Most Plan Sponsors Not Expecting Delays in Future Pension Buy Out Activity Due to COVID-19, MetLife Poll FindsPosted: Monday, November 9, 2020 9:33 am
Associated Press | NEW YORK--(BUSINESS WIRE)--Nov 9, 2020
Just 19% of plan sponsors interested in an annuity buyout with a specific timeframe in mind reported that the pandemic has decreased or delayed the likelihood of transacting, according to MetLife’s 2020 Pension Risk Transfer Poll, released today. A vast majority (81%) said there had either been no change in plans due to COVID-19 (27%), or that the pandemic has actually increased or accelerated the likelihood they would transact (55%).
“Despite a slowdown at the beginning of 2020 due to COVID-19, we have seen the pension risk transfer (PRT) pipeline build momentum in the third and fourth quarters,” said Melissa Moore, senior vice president and head of U.S. Pensions at MetLife. “This is consistent with the Poll findings, which show plan sponsors do not expect buyout activity to be delayed by either the pandemic or a protracted economic recovery.”
In fact, the Poll found that the primary catalysts driving interest in PRT transactions include market volatility (51%) and mortality changes due to COVID (36%). The Poll also found that plan sponsors are looking to transact sooner rather than later—among defined benefit (DB) plan sponsors interested in a buyout, the majority (81%) say they would transact within five years, including 24% who said they would secure a buyout within two years.
Impact of COVID-19 on plan management
While buyout activity is resuming, the pandemic has had an impact on how plan sponsors manage their DB plans. Forty percent of plan sponsors report they have borrowed money to fund pension deficits, and 35% restricted benefit payment options (e.g., lump sums) because of the impact on funded status. About one in five (22%) decreased or called back planned contributions, 15% triggered a partial plan termination due to layoffs, and 6% have frozen or closed their plans.
“The Poll also shows that in the current environment plan sponsors appear to be most concerned about maintaining and funding their DB plans to meet their required benefit obligations,” said Moore. “The volatile market environment is also a concern—plan sponsors said they were focused on the performance of their plan investments, including minimizing asset volatility and the impact of the low interest rate environment.”
Public policy relief
In addition to looking at how they manage their plans, DB plan sponsors have also taken advantage of the relief measures available through the Coronavirus Aid, Relief, and Economic Security (CARES) Act. Nearly nine in ten plan sponsors (89%) say they have taken, or will take, advantage of the CARES Act provision that extends the deadline to make DB plan contributions until January 1, 2021; only 10% say that is not part of their plans and 2% are unsure.
About the Poll
The MetLife 2020 Pension Risk Transfer Poll was fielded between August 6, 2020 and August 27, 2020. MetLife commissioned MMR Research Associates, Inc. 1 to conduct the online survey. Survey responses were received from 200 defined benefit (DB) plan sponsors with $100 million or more in plan assets who have de-risking goals. This included 55% of plan sponsors who reported DB plan assets of $500 million or more. To read the full MetLife 2020 Pension Risk Transfer Poll report, visit www.metlife.com/prtpoll2020.
MetLife, Inc. (NYSE: MET), through its subsidiaries and affiliates (“MetLife”), is one of the world’s leading financial services companies, providing insurance, annuities, employee benefits and asset management to help its individual and institutional customers navigate their changing world. Founded in 1868, MetLife has operations in more than 40 markets globally and holds leading positions in the United States, Japan, Latin America, Asia, Europe and the Middle East. For more information, visit www.metlife.com.
1 MMR Research Associates, Inc. is not affiliated with MetLife.
SOURCE: MetLife, Inc.
Copyright Business Wire 2020.
ANNUITY PURCHASE RATES
Sample Interest Rates for a Pension Annuity Buyout
(Assumes no lump sums, disability, or unusual provisions)
Retirees (duration of 7) – 1.52%
Term Vesteds (duration of 10) – 1.76%
Actives (duration of 15) – 1.86%
Annuity Purchase Rates as of November 1, 2020