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Aon Retirement and Investment Blog

Game Changer: Pension Funding and Tax Reform

On September 28, 2017, the “Big Six”* Republican tax negotiators outlined their tax reform goals in the “Unified Framework for Fixing our Broken Tax Code.” While not definitive, the document puts some important parameters around what the Trump administration and congressional Republicans hope to achieve by overhauling the US tax code.

The Unified Framework has important implications for corporate sponsors considering how to finance their pension deficits. If corporate pension plan sponsors think the framework is likely to survive largely intact through future negotiations, now is a critical time to consider discretionary contributions and funding alternatives.

Key aspects of the framework as they pertain to corporate defined benefit pensions include the following:

  • The framework reduces the corporate tax rate to 20%, from the current 35%.
  • The framework also indicates that net interest expense paid by C corporations (i.e. most public companies) will be “partially limited.”
What might these changes imply for corporate DB sponsors?
  • The potential drop in the corporate income tax rate is a big deal, and DB pension sponsors that are in a taxpaying position in 2017 should consider accelerated funding (whether cash or debt financing) to pick up the additional 15% deduction. We presume that any changes to the tax code would go into effect in 2018 at the earliest, but we cannot rule out the possibility that some changes would be made retroactive.
  • As we expected, debt-financed pension contributions have surged this year, largely driven by rising PBGC premiums and sponsors taking advantage of low credit spreads to finance contributions. Aon Hewitt Retirement and Investment’s blog post and white paper from 2016 foretold this trend. Reducing or eliminating the interest deduction would make debt financing less attractive.
  • Would limiting the deduction for interest payments, when combined with a drop in the tax rate make borrowing to fund less attractive? Over the near term, we think the answer for most sponsors is “no”. In fact, our modeling finds that taking advantage of the 35% deduction currently available will likely more than outweigh any limitation of interest deductions on any debt used to finance that contribution. Once the lower tax rate goes into effect, however, we expect corporate pension contributions will drop significantly.
  • Is there a chance that limiting the interest deduction could alter how companies finance themselves, with implications for bond yields that are used to value pension obligations? One plausible scenario could be a sharp drop in bond issuance, resulting in lower bond yields, and much higher values for the pension obligations that are priced in reference to those yields. Pension sponsors may want to consider this possibility when determining their risk posture. Sponsors that already have glide paths in place can view accelerated funding as both a tax and risk reduction strategy.
Sponsors in the middle of analyzing pension funding and investment strategies may want to consider more refined modeling to capture:
  • alternative corporate tax rates
  • alternative tax treatments of interest payments
  • appropriate liability measures (PBGC, plan termination, or other) to fund to, bearing in mind future mortality improvements
  • possible implications of a declining supply of corporate bonds as companies shift towards equity financing
These topics can be complex, but there is a real opportunity to act now. Plan sponsors should be working with their actuaries, investment consultants, and tax advisors to model scenarios and compare the return on investment of pension contributions to other opportunities across their business. 

* Big Six include:
  • House Speaker Paul Ryan;
  • Representative Kevin Brady of Texas, the House Ways and Means Committee chairman;
  • Senator Mitch McConnell of Kentucky, the majority leader;
  • Senator Orrin G. Hatch of Utah, the Senate Finance Committee chairman;
  • Steven Mnuchin, the Treasury secretary; and
  • Gary D. Cohn, the National Economic Council director
Alan Parikh and Kristen Cook are part of Aon Hewitt’s core retirmement practice. Alan is located in Lincolnshire, IL and Kristen is located in San Francisco, CA.

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