PBGC variable premium vs. borrow-and-fund: impact of higher premiums

Given the significant increase in variable-rate premiums included in the Ryan-Murray bi-partisan budget deal (the Bipartisan Budget Act of 2013 (BBA 2013)), we thought it would be useful to re-visit our article on variable premiums vs. borrow-and-fund.

The gist of the prior article was that Pension Benefit Guaranty Corporation (PBGC) variable premiums create an incentive for pension sponsors to borrow money and contribute it to their plan – the higher the PBGC variable premium rate, the stronger the case for borrow-and-fund.

In our stylized example (7-year mortgage amortization, 4% discount rate and return on assets), we showed that, based on the pre-2013 PBGC variable premium of $9 per $1,000 of pension underfunding, the ‘breakeven’ borrowing rate for a plan sponsor was 5.26%. In other words, sponsors who could borrow money at a rate lower than 5.26% get a ‘good deal’ from borrow-and-fund.

Under MAP-21, variable premiums were already set to increase to $18/$1,000 in 2015. Our prior article showed that this translates to a breakeven borrowing rate of 6.52% for borrow-and-fund.

BBA 2013 further increases variable premiums, to $23/$1,000 in 2015 and $28/$1,000 in 2016 (actually, the 2016 rate will probably be $30 due to wage indexing.) In effect, the variable premium will be at least a 2.8% per year charge for ‘underfunding.’ As we show below, this translates to a breakeven borrowing rate of 7.91% for a borrow-and-fund strategy.

Key variables

Here, as we see it, are the key variables that must be considered when determining the relative cost of funding over 7 years and paying the PBGC variable premium vs. borrowing and funding immediately.

PBGC variable premium rate. For purposes of this article, we’re focusing on the (unindexed) $28/$1,000 rate under BBA 2013 for 2016, using the same approach we used to analyze the $9/$1,000 and $18/$1,000 rates in our prior article.

Cost of borrowing. This rate will determine the cost of borrowing-and-funding; it will vary from sponsor to sponsor; and it is probably the most important variable in the analysis. In this article, the cost of borrowing will define the breakeven point – the point below which it is more efficient to borrow-and-fund immediately rather than fund over 7 years and pay PBGC premiums on the plan’s UVB.

Rate of return on assets. Probably the fundamental difference between paying the PBGC variable premium and borrowing-and-funding is that when you borrow you have assets (the loan principal) that, after they have been contributed to the plan, will be earning a return. Throughout this article we are going to assume a return on plan assets of 4%. (For purposes of their own analysis, sponsors will want to consider their own return assumption(s).)

Plan valuation rate. Each year, the value of plan liabilities will ‘grow’ at the plan valuation rate. For purposes of this article we are going to assume that the plan valuation rate is the same as the rate of return on assets. Again, this simplifies our analysis a lot; a more robust analysis would use different liability valuation rates and return rates.

Base case

Contributions are assumed to go in at the beginning of the year; to preserve ‘comparability’ the loan payment is also assumed to be made at the beginning of the year. The variable premium is based on UVB as of the end of the prior year; for instance, in year 1 UVB = $20,000,000, and the ($28 per $1,000) variable premium is $560,000.

In our base case, we are going to assume the company’s borrowing rate is equal to the plan’s asset return of 4%.

Table 1: Fund over 7 years + PBGC variable premium vs. borrow-and-fund immediately

Assumptions:Funding shortfall = $20 millionPBGC variable premium rate = $28 per $1,000Rate of return on assets = 4%Cost of borrowing = 4%

This example illustrates the fundamental difference between funding over 7 years and paying PBGC premiums, on the one hand, and borrowing and funding immediately, on the other. This example is ‘easy’ because identical payments are made ($3,204,031), in one case to fund the plan, in the other to repay the loan. In both cases the plan is fully funded after 7 years. The only difference: when the sponsor funds over 7 years, it also must pay PBGC premiums – more than $2.3 million in this example based on $20 million in underfunding.

So, where the cost of borrowing equals the rate of return on plan assets, the answer is easy. It is cheaper – a lot cheaper – to borrow-and-fund than to fund over 7 years and pay PBGC premiums.

The breakeven point

The next question is, then, how much higher does the cost of borrowing have to be in order to make funding over 7 years and paying the variable premium cheaper than borrowing and funding immediately? To determine the answer to this question, we have to compare the relative cost of, on the one hand, PBGC variable premiums and, on the other, what we are going to call ‘excess’ loan payments. By ‘excess loan payments’ we mean the additional cost of repaying the loan (relative to funding the plan over 7 years) because the cost of borrowing is higher than the rate of return on assets (which, as discussed above, is also our assumed plan valuation rate). Thus ‘excess loan payments’ represents the spread between the sponsor’s borrowing rate and the plan’s asset return rate.

To get these two numbers (PBGC variable premiums vs. excess loan payments) on an ‘apples to apples’ basis, we consider the future value, after 7 years, of each strategy. Thus, we credit interest (at the rate of return on assets) on both the PBGC variable premiums and the excess loan payments.

In our current example, the breakeven point is a cost of borrowing of (approximately) 7.91%. At a cost of borrowing of 7.91%, the cost of repaying the loan is $3,548,626. That is $344,795 per year greater than the $3,204,031 it costs to fund the plan.

Table 2: Breakeven demonstration: PBGC variable premium vs. ‘Excess’ loan payment

Assumptions:Funding shortfall = $20 millionPBGC variable premium rate = $28 per $1,000Rate of return on assets = 4%Cost of borrowing = 7.91%

On these assumptions, the increase in the variable premium from $9 to $28 per $1,000 increases the cost of funding over 7 years and paying the PBGC variable premium vs. borrowing and funding immediately by over 250 basis points (7.91% vs. 5.26%). Thus, under the higher variable premium rate, the borrow-and-fund option becomes more attractive and becomes viable for sponsors with higher borrowing rates.

Substantial dollar savings

While breakeven analysis is useful for the ‘yes/no’ question – is borrow-and-fund a good deal? – it doesn’t tell us just how good a deal it might be. And the answer to that depends on the company’s borrowing rate.

The table below summarizes the additional value (or cost) of borrow-and-fund versus contributions plus premiums at the end of 7 years based on different borrowing costs under $9, $18, and $28 per $1,000 underfunding premium rates:

Table 3: Incremental value of borrow-and-fund vs. contributions + PBGC premiums

_Assumptions:_Funding shortfall = $20 millionRate of return on assets = 4%7-year funding horizon

Increasing the variable premium rate from $9/$1,000 to $28/$1,000 makes borrow-and-fund a compelling strategy for the 5% borrower, who saves more than $2 million on a $20 million obligation. And higher cost-borrowers, for whom borrow-and-fund may not make sense based on a $9/$1,000 premium, see a much different result based on a $28/$1,000 premium.

Obviously, this is a very stylized analysis. The point is that (1) there is a trade-off — at certain costs of borrowing/rates of return, borrowing and funding is cheaper (perhaps significantly cheaper) than paying the variable premium, and (2) the proposed (very large) increase in variable premiums in BBA 2013 will make borrowing and funding, at the margin, more attractive.

* * *

The willingness of Congress to increase premiums has a lot to do with Washington budget politics and perhaps, as we discuss in this article, less to do with the inadequacy of PBGC premiums.

Regardless, Congress may have given an unwitting ‘shove’ to pension funding with these rules. To the extent employers respond by accelerating pension funding (and deductions), it will, ironically, reduce the premiums PBGC collects from many sponsors and undercut much of the Washington budget math behind MAP-21 pension funding relief in the first place.