Home ListingJanuary 13, 2016

Russell: Borrowing Is Cheaper Than PBGC Premiums

Fully funding pensions now allows plan sponsors to avoid costly premiums and take advantage of tax arbitrage, according to Russell Investments.<br />

Reported by Featured Author

As Pension Benefit Guaranty Corporation (PBGC) premiums skyrocket, underfunded plan sponsors might be better off borrowing to fully meet their liabilities, according to Russell Investments.

In a research note, Managing Director James Gannon argued that borrowing to fund the pension plan eliminates the need to pay increasingly expensive PBGC variable-rate premiums.

Unlike flat-rate premiums, which plan sponsors pay per participant, the variable-rate premium is based on a plan’s unfunded liabilities. The recently passed budget bill has pushed the variable-rate premium to $34 per $1000 in underfunded liabilities in 2017, 7, followed by hikes to $39 in 2018 and $44 in 2019, once inflation is taken into account.

These ever-increasing premiums, Gannon wrote, mean that is “generally cheaper for sponsors to fully fund their pension plan—even if they needed to borrow money to do so—than to maintain the underfunded position.”

For his analysis, Gannon compared two options plan sponsors have for meeting liabilities: contributing to reduce the unfunded amount over seven years—and paying variable-rate premiums until the pension is funded—or borrowing money to fund the full amount now through issuing bonds.

“PBGC premiums… will make it more favorable for sponsors to borrow and fund their pension plans, and will even allow them to borrow at higher rates,” wrote Gannon.

Assuming a plan is $20 million underfunded and uses a 5% discount rate, a plan sponsor opting for the seven-year amortization would pay nearly $3.5 million per year, plus a total of $3.2 million in PBGC variable-rate premiums over that period.

In contrast, the same plan would need to issue a 10-year bond at an interest rate as high as 6.77% to fund the plan at once for the same expense.

Additionally, Gannon said funds that borrow to meet their liabilities can “take advantage of a tax arbitrage, especially if contributions and loan interest payments are tax-deductible.”

“The higher the [tax] rate, the more a sponsor would be willing to borrow, because the breakeven interest rate will increase with higher tax rates,” Gannon wrote. “Borrowing allows for the double impact of not paying PBGC premiums and being able to take advantage of a tax arbitrage.”