- Reducing Uncertainty
- Accessing Fixed Rate Debt Markets
- Tax Considerations
In the first half of 2020, a sharp decline in equity markets coupled with falling discount rates have led to potential double digit declines in funded ratios for plans with sizeable equity allocations. Further adding to the equation, PBGC premium rates have reached all-time highs in 2020 (expecting to trend higher with inflation) and contribution requirements could increase in future years if Congress does not introduce new longer-term funding relief. For many plan sponsors, the current financial market environment has left them searching for ideas to reduce uncertainty around future plan expenses.
Considerations for Reducing Pension Plan Volatility
There are a number of strategies healthcare pension plan sponsors can employ to reduce uncertainty related to plan costs and the overall impact of the plan on the balance sheet. For ongoing plans, this can include evaluating other retirement plan offerings and assessing the impact of freezing pension benefit accruals. Frozen or ongoing plans can explore implementing a glidepath strategy, incorporating a customized Liability-Driven Investing (LDI) fixed income allocation, and pension risk transfers like lump sum offerings or partial annuity buyouts. One of the more significant opportunities, and one that offers a meaningful decrease in balance sheet volatility and increase in future cost certainty, is fully funding the plan by issuing fixed rate debt.
Accessing fixed rate debt markets to fully fund a pension plan, which we will refer to as a “borrow-to-fund strategy”, offers some attractive characteristics. From a cash expense perspective, highly variable costs associated with an underfunded pension plan (namely PBGC premiums and contributions, whether required or voluntary) are primarily replaced with fixed annual debt service. From a liability perspective, a highly variable liability (driven by equity market performance, treasury rates, and credit spreads) can be generally replaced with a fixed liability with a set maturity and amortization schedule.
Although a borrow-to-fund strategy can be employed for ongoing or frozen plans, once fully funded, a frozen plan is able to eliminate most of the equity and interest rate risk by investing the majority of plan assets in a customized LDI fixed income strategy. This helps to greatly minimize changes in funded status and preserve the funded position of the plan. With this structure in place, plan sponsors can consider either a hibernation or termination strategy:
- Hibernation Strategy – The pension plan sponsor can continue to carry the pension plan on their books. Cash costs are minimized (though fixed rate PBGC premiums will still be an annual cost) and a properly implemented LDI strategy can leave little volatility in the plan. There may still be costs associated with on-going administration and management of the plan.
- Termination Strategy – The pension plan sponsor can move to terminate the plan through a combination of lump sum payments and an annuity purchase from an insurance company. A termination results in the plan ultimately being removed from the sponsor’s books and associated costs are eliminated. While this can initially seem like an optimal solution, there are up-front costs and additional time commitments associated with executing a plan termination.
Ultimately, a borrow-to-fund strategy can shift power to the plan sponsor – most of the plan’s future costs and the decision to maintain vs. terminate are dictated by the sponsor, not financial markets.
Considerations for Borrowing
According to federal tax law, proceeds from a borrowing, by way of the capital markets or bank financing, used for pension funding must be obtained through an issuance of taxable obligations. 501(c)(3) entities have the ability to issue taxable debt directly, without a conduit authority, under a corporate CUSIP. While taxable debt is generally more expensive than traditional tax-exempt debt, taxable borrowing rates continue to be relatively low for strong investment grade borrowers. Furthermore, in the current market environment, U.S. Treasury rates have been lower than the AAA MMD tax-exempt yield curve, which has removed some of the interest cost benefits associated with issuing tax-exempt obligations. Finally, with negative yielding debt over $10 trillion across the globe, investor demand for taxable debt continues to be robust.
In lieu of issuing taxable debt, healthcare pension plan sponsors can consider shifting cash reserved for qualified tax-exempt capital expenditures to the pension. Subsequently, the organization can borrow for those qualified projects with a tax-exempt issuance, which could result in lower debt service costs if the relationship between tax-exempt and taxable debt reverts back to a historical level.
Overall, a borrow-to-fund strategy carries negligible balance sheet impact, as one liability is replaced with another. Replacing a liability highly susceptible to movements in asset prices with a fixed instrument reduces risk to the balance sheet. However, debt service coverage and debt to capitalization ratios should be considered, as long-term debt is included in those ratios while the net pension liability is not typically taken into account.
Mapping the Road Ahead
We encourage healthcare pension plan sponsors to revisit their pension management strategy in light of recent events and additional anticipated headwinds. For organizations with frozen plans and access to additional borrowing, a borrow-to-fund strategy should be analyzed as one approach to reducing overall cash expense and balance sheet volatility. Finally, if an organization proceeds with the borrow-to-fund strategy with the information outlined above, the rating agencies, stakeholders, and investors should be comfortable with a clear and well-constructed strategy.
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