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Aon Retirement and Investment Blog

Is It Time to Reconsider the Funding Strategy for U.S. Private Sector Pension Plans?

Seven years after the U.S. stock market hit bottom in the global financial crisis, defined benefit (DB) pension plans continue to run significant deficits. At year-end 2015, Aon Hewitt estimates the aggregate pension deficit for S&P 500 companies to be $445 billion. One might expect that the prolonged underfunded position would result in significant required contributions on the horizon. However, two key themes have emerged from regulatory activity over this period:

  • Required contributions have been deferred by Congress; and
  • The annual penalty for maintaining an underfunded plan has increased significantly. The Pension Benefit Guaranty Corporation (PBGC) premium assessed on pension deficits will rise five-fold, from 0.90% in 2013 to 4.50% by 2020.
This mixed bag of regulatory changes has given U.S. plan sponsors the flexibility to reduce contributions to DB pension plans, while at the same time increasing the financial penalties for doing so. These conflicting factors have prompted many plan sponsors to review their approach to pension plan funding. In an effort to assist plan sponsors with such a review, Aon Hewitt has recently published a report laying out the considerations for prefunding an underfunded pension plan. Some of the key highlights of the report include:                
  • The decision to make discretionary pension contributions (i.e., prefund) should be considered as part of an organization’s overall capital budgeting strategy. Like other capital budgeting decisions, pension funding should be evaluated both relative to the organization’s cost of capital and other uses of capital.
  • Many plan sponsors will find significant advantages to prefunding to avoid PBGC premiums. Organizations without sufficient cash reserves may find it attractive to borrow to fund the plan.
  • Borrowing to fund effectively exchanges soft debt for hard debt. While most rating agencies and lenders consider pension deficits to represent long-term liabilities similar to long-term debt, there are differences in the impact on other financial risk measures such as interest coverage ratios that should be considered.
  • The attractiveness of such a strategy depends on the pension discount rate (typically investment grade corporates), the tax status, and borrowing costs and capacity of the sponsor.
  • If the after-tax borrowing cost is less than the sum of the pension discount rate and PBGC variable premium rate, the math is likely favorable to borrow to fund the plan.
Please click here to obtain a copy of the complete report.

Vlad Sachelarie is an Associate Partner in Aon Hewitt’s Core Retirement group based in Cleveland.

Content prepared for U.S. subscribers, but available to interested subscribers of other regions.

The information contained above should be regarded as general information only. That is, your personal objectives, needs or financial situation were not taken into account when preparing this information. Accordingly, you should consider the appropriateness of acting on this information, particularly in the context of your own objectives, financial situation and needs. Nothing in this document should be treated as an authoritative statement of the law on any particular issue or specific case, nor should it be treated as investment advice. Use of, or reliance upon any information in this post is at your sole discretion. It should not be construed as legal or investment advice. Please consult with your independent professional for any such advice. The blog content is intended for professional investors only.

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