Keeping Ahead of Tax Reform

A change in the corporate tax rate will have a ripple effect on LDI. CIOs need to move fast.

“Some people say it differently, and they will say we are the highest developed nation taxed in the world. … A lot of people know exactly what I am talking about, and in many cases, they think I am right when I say the highest,” President Donald Trump said in a television interview on October 17, referring to taxation in the United States. “As far as I am concerned, we are really essentially the highest. But if you’d like to add the ‘developed nation,’ you can say that, too.”

In pressing for sweeping tax reform, Trump has claimed the United States is the highest-taxed developed nation at least 20 times, according to reports. Each of those 20 times has sounded the alarm bells for fact checkers. The oft-repeated claim is false. The US collected 26.4% of its gross domestic product in total revenue, according to data by the Organisation for Economic Co-­operation and Development (OECD), well below the 34.3% OECD average. The US trails a long list of major developed economies—France, Germany, and the United Kingdom, for example—by this crucial measure.

When it comes to the corporate tax rate, however, the United States does, in fact, top the charts. At a stated 35% federal rate—and close to 40% including state and local taxes, according to estimates by KPMG—the United States breezes by other major economy rivals. And it’s here that chief investment officers need to keep a close eye on ongoing efforts by the administration and congressional Republicans to bring the federal rate down to 15%, in the case of the former’s proposals, and 20% in the case of the latter.

A reduction in the corporate tax rate would have a seismic effect on the value of funding LDI ahead of a change. For starters, the funding amount itself is deductible by the corporate tax rate and provides a direct benefit to funding when the rates are higher. For those issuing debt to fund, the interest payments on the debt are also deductible by the corporate tax rate, further compounding the benefit of funding when rates are higher. Moreover, a change to the rate that interest payments can be deducted could cause a sea change in how much debt companies issue and the availability of high-quality corporate credit. The sum of these factors is a major reason why a spate of companies borrowed to fund their plans this year. It’s also why those sitting on the fence need to take a hard look at the facts when deciding when and how much to fund.

Companies need to realize they will have to fund plans and that banking on the performance of the portfolios alone won’t be enough as a first step, said Scott Kaplan, head of pension risk transfer at Prudential. “It really starts with the realization that funding contributions are going to be required over time as opposed to perhaps some hope in the past that I’m going to be able to close my funding gap through portfolio allocations and with superior performance with an asset allocation strategy, or interest rates will bail me out of the hole,” Kaplan said. “A lot of folks sort of sat on the fence with the hope that interest rates would rise, and I think what we’re seeing is more and more indications that we are in a lower-for-longer environment, which means that interest rates won’t be the panacea.”

That understanding is setting in, given recent market performance. “It’s a very high probability that a combination of interest rates or very good equity performance, which we’ve obviously already seen, is not going bail you out,” said Kaplan. “You quickly generally will come to the realization that contributions are going to have to be made.”

Once companies have decided to fund further and not bank on financial returns, the prospect of tax reforms makes the funding before a legislative change a matter of simple math. Since the fundings are tax deductible, a higher corporate tax rate leads to greater savings.

United Technologies’ decision to fund its plan by $2 billion this year illustrates this decision-making. The decision to fund resulted in savings that have a net present value (NPV) calculated to be $350 million, said Robin Diamonte, United Technologies’ CIO. If there is a reduction in the corporate tax rate to 20%, however, Diamonte calculates that the NPV of the savings will actually jump to $500 million given the differences in the tax deductability.

“The tax piece was just an added benefit. Because we weren't sure if it was going to happen at all, so when we did our scenario analysis, we said, ‘OK, this makes sense regardless if there’s any kind of tax relief at all,’” said Diamonte. “It still had a really strong NPV to it. Then we did the analysis, and by the way, if there is some kind of tax or corporate change in taxes, then that just increases the benefit to NPV by that much more.”

The benefits are two-fold for companies that are issuing debt to fund plans, as a spate of bold-face names have done so far this year. Since interest payments on debt are also deductible at the current corporate tax rate, companies can save twice as much under a higher-tax regime. “The ability to borrow and maintain a higher deduction on your debt is also a function of tax reform,” said Kaplan. “If the current deductions are grandfathered, you're going to want to issue debt when you can get a higher deduction on the interest on that debt than in the future.”

The consequences of being able to deduct interest payments from the corporate tax rate, meanwhile, could have sweeping consequences for how companies fund themselves—and for CIOs who move to de-risk their plans in the future. De-risking requires buying high-quality corporate bonds so that a plan’s assets more closely meet its liabilities.

But a lower tax deduction on debt could increase the after-tax cost of debt, and cause companies to issue less credit. And this, in turn, could make it more onerous and costly for plans that seek to de-risk after tax reforms.

“Another aspect is what does tax reform do as it relates to potentially the availability of quality, long-duration fixed-income,” said Kaplan.

Kaplan said this issue has surfaced in forward-looking discussions with investment banks and other market participants.

Tax reform and the higher after-tax cost of debt, though, could impact the supply of fixed-income “to the extent that there's a broad-reaching implication for how many companies, how much debt they use in their capital structure in the future,” said Kaplan. Lower issuance could lead to a scramble for outstanding bonds. “There becomes a technical issue in the market where the supply does not equal the demand for fixed-income, further pressuring the returns on fixed-income in the future, potentially.”

Kaplan noted that availability is not an immediate concern. But he points out that there is an increasing demand for fixed-income as pension plans move further into their LDI strategies as they swap equities for fixed-income, and for pension plans that have transferred their obligations to insurance companies, which again boosts the demand for fixed-income. “The demand for fixed-income is rising more quickly than the supply,” Kaplan said. The availability of fixed-income—already something CIOs should have been thinking about—may further be exacerbated by tax reform. Moving sooner rather than later would be advisable.

The Trump administration’s loud and repeated promises of tax reform were central to the market dynamics of the year and the massive run up in stocks. Despite repeated derailments of the agenda—with everything from healthcare to immigration seeming to take priority—tax reform now again seems to take center stage for the administration and the Republican-controlled Congress heading into year-end.

For CIOs thinking about what to do with their LDI plans, now would be a good time to take a close look at the facts and benefits of moving before tax reform. And the first step might be to abandon the fantasy that strong portfolio performance alone will be enough to meet obligations.