President Biden signed the American Rescue Plan Act of 2021 (ARPA) into law on March 11, 2021. The $1.9 trillion economic relief bill included another round of pension funding relief that increases corporate tax revenue by reducing required, tax-deductible contributions for single-employer defined benefit (DB) plans. This legislation further extends pension funding relief (reducing cash contributions) that was created in earlier legislation (as with MAP-21, HATFA, BBA) but was set to expire in coming years.What changed?
Previous funding relief efforts introduced interest rate smoothing over a historical 25-year horizon in order to determine the discount rate for pension liabilities used to calculate IRS contribution requirements, with corridors around that historical average that widen over time. With rates at current historical low points, the impact is artificially higher discount rates, which translate into:
- lower liabilities
- a higher funded status
- lower contribution requirements
Those rate corridors were set to fully phase out by 2024, resulting in lower discount rates and higher contributions as funding liabilities would increase. ARPA creates a tighter corridor around the historical rates that will not fully phase out until 2030, lifting up the discount rate immediately while also extending the period of discount rate smoothing.
The relief bill resets all prior funding shortfall amortization bases to zero and allows for an amortization period of 15 years instead of 7 years, spreading out any funding shortfalls over a longer time horizon and therefore reducing a major component of the contribution calculation. As a reminder, the minimum required contribution is the sum of:
- The normal cost (i.e., increase in liability over the year due to benefit accruals)
- Administrative expenses
- A rolling amortization of the funding shortfall (i.e., the amount by which assets fall short of liabilities)
The combination of higher liability discount rates and longer periods for the shortfall amortization is likely to reduce any near- and longer-term contribution requirements for corporate DB sponsors. Plans with a smaller normal cost and/or larger funding shortfall are likely to see the most dramatic reductions in required contributions over the period. If the historical smoothing is ever fully phased out, we would expect to see contribution requirements increase as liability discount rates finally decline from historical highs to match market conditions, but the longer amortization period does provide a permanent reduction in annual cash requirements.Do I need to change my investment policy?
The downside of the funding liability calculation is that this measure of funded status has always been an unrealistic measure of pension funding. It is effectively disconnected from marked-to-market interest rates for the purposes of hedging and is not reflective of the “price” of liabilities that an insurer might require to be paid in order to offload said liabilities.
For plan sponsors whose pension objectives focus on conserving cash, the relief bill could justify a higher-risk investment policy. Reduced cash requirements that are pushed out further into the future will likely change the shape of the efficient frontier and incentivize riskier asset allocations since contribution volatility is muted by these new provisions. However, sponsors should note that riskier investment policies are likely to have an adverse impact on the balance sheet and perhaps the income statement as well, and discuss implications with their investment consultants and actuaries before making any changes.
For plan sponsors whose pension objectives focus on the balance sheet funded status, the new law should have no impact on the investment policy since it only changes funding calculations. Any dynamic de-risking policies should be using marked-to-market funded status for de-risking triggers and to calculate dollar-duration hedge ratios (to measure interest rate risk), and therefore should be unchanged by these new provisions.
For plan sponsors whose pension objectives focus on eventually offloading the liabilities, the relief law should have no impact on the investment policy since funding calculations are not related to settlement pricing from insurers. However, it might change the economics around full or partial pension risk transfer decisions if:
- lower legally required contributions make it more difficult to get cash from the company in order to keep the funded status growing for an eventual transfer, or
- PBGC premium rates eventually rise (or are uncapped) as a result of lower pension funding across single-employer plan sponsors.
If cash becomes constrained for the pension plan, risk transfers may need to be delayed until the funded status is strong enough to fund them. If PBGC premium rates rise after the funding relief is enacted, risk transfers may be accelerated in order to avoid additional plan management costs. Changes in the funded status and/or risk transfer time horizon might necessitate changes in the investment policy in order to continue to support the plan sponsor’s objectives.What’s next?
The most recent round of funding relief does take some near-term pressure off of plan sponsors as they work to manage corporate cash flow and meet other demands of their businesses during the pandemic. Reduced cash flow requirements could lead to changes in the investment policy depending on what the ultimate objectives and constraints are for plan sponsors, and changes should not be made without analyzing the impact on the balance sheet, income statement, and other possible metrics like the Risk-Based Capital Ratio for insurers, rate reimbursements for utilities and government contractors, and credit ratings for companies that regularly raise cash by issuing bonds.
But these new rules may cause more headaches for some pension sponsors over the medium to long term, as they put off rather than fix funding issues. And recent history has shown that we can continue to expect pension “relief” from lawmakers, so pension sponsors should focus on managing their plans to be prepared for continued changes.