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Tax reform creates opportunities for defined benefit plans

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Human Capital BulletinRecently enacted tax reform in the United States presents a unique opportunity for organizations sponsoring IRS-qualified, single-employer Defined Benefit (DB) pension plans. Plan sponsors looking to take advantage of the tax arbitrage opportunity have several items to consider, regardless of the plan’s current funded position.

The IRS provides organizations the ability to deduct DB plan contributions made after Dec. 31, 2017, on 2017 tax returns. For DB plans with plan years beginning Jan. 1, 2017, the deadline is effectively Sept. 15, 2018. The same contribution amount could provide a higher tax benefit in 2017 (if entity taxed at 35%) than 2018 or later (if entity taxed at new 21% corporate tax rate).

Positive implications Organizations making additional or accelerated contributions to take advantage of this opportunity not only gain from a higher 2017 tax benefit and greater security for plan participants. These contributions have other advantages in the near term.

From a Pension Benefit Guaranty Corporation (PBGC) and minimum required contribution perspective, increasing contributions could have the following positive implications:

  • Lower PBGC variable rate premiums
  • Reducing risk of a PBGC 4010 filing
  • Mitigation of adverse consequences due to new IRS prescribed mortality tables as well as contribution spikes if interest rates become more volatile as funding relief phases out

In addition, from an accounting perspective, additional or accelerated contributions may be included in the calculation of the fiscal year 2018 net periodic benefit cost (NPBC), subject to auditor approval. Inclusion of the contributions could lower the NPBC (or higher income item) from what it otherwise would have been. There may be other financial statement benefits realized from making additional contributions before the deadline as well.

Lastly, organizations may be able to take timely actions towards de-risking their DB plans, including:

  • Reallocating plan assets through reductions of risk-seeking assets
  • Targeting obligation settlements, including terminated vested lump sum windows or retiree annuity purchases
  • Full plan termination

Factors to consider As 2017 financial results become available, organizations should assess whether changing their near-term funding strategy is appropriate. The decision to contribute more than required by the IRS has many positives, but the decision needs to consider other corporate needs. Plan sponsors should note, once cash is contributed to a DB plan, the cash is no longer available for general corporate use.

If a plan sponsor is financially able to make additional contributions or accelerate future contributions, a complete review of the organization’s objectives for the DB plan should be performed. This review would include consideration of the following:

  • Purpose of the plan (e.g. talent attraction and retention)
  • Integration with other employer benefits
  • Implications on organization financial objectives, including performance management metrics
  • Return on investment for use of cash within the DB plan
  • Fixed-interest debt to fully fund the DB plan

In almost all instances, plan sponsors should forecast the potential NPBC and required cash contributions expected over the next five to seven years under the current funding policy and compare that to a forecast using alternate funding policies. These forecasts could consider multiple economic scenarios as well as alternate plan asset allocations.

For organizations interested in settling plan obligations within the next five to seven years, increased contributions may allow plan sponsors to take actions earlier than anticipated. A review of available options should be completed under scenarios with an increased funded status. If interest rates continue to rise, a higher funded status provides plan sponsors a greater ability to take advantage of opportunities if they present themselves.

Also note that if an organization intends to use debt to make the additional contribution, they should consider whether the resulting interest expense could be subject to limitation under new tax rules effective in 2018.

Conclusion While tax reform creates a unique opportunity for organizations sponsoring a DB plan, there are many issues sponsors should consider before making additional or accelerating contributions to their plan.

Besides increased benefit security for plan participants, increased funding could be offset by other near-term cash savings (reduced PBGC variable-rate premiums) as well as provide opportunities for long-term economic savings through timely plan settlement actions. These outcomes should be compared to other corporate objectives, which may provide higher returns on the invested capital. There is still time to take action because the deadline is effectively Sept. 15, 2018, for DB plans with plan years beginning Jan. 1, 2017. Each organization has unique tax situations and retirement program objectives, and all DB plan sponsors should complete an assessment to ensure an opportunity is not missed.


Contact
Andrew Etheridge
Experienced Manager
Human Capital Services
T +1 312 602 8262

Ray Berry
Experienced Manager
Human Capital Services
T +1 312 602 8333

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