Market Pulse: Q&A with Rohit Mathur

Rohit Mathur, Head of Global Product and Market Solutions, speaks about the opportunities plan sponsors have today to close funding gaps, and why they should take steps to reduce risk now.

Q: Why is relying on capital markets not an optimal strategy to achieve full funding? What should sponsors do instead?

Plan sponsors should not simply rely on capital markets alone to achieve their objectives of being fully funded, whether it’s three or five years out. To illustrate the challenge faced by plan sponsors, we ran 2,000 stochastic simulations to project the funded status over the next four years for an “average” pension plan that is 84% funded at the beginning of the period and makes no contributions during the projection period. What we found was that in 80% of the projected scenarios, this plan would see a funded status deterioration of more than 4% over the next 4 years. The median funded status would end up at 76%, while 20% of the time, the funded status would decline to below 72%. This is largely driven by the fact that this plan has a significant percentage of retirees and benefit payments need to be paid to the retirees from the plan’s assets. In fact, we determined that even if a plan were to achieve its average expected returns on assets of 7.25% in each of the next four years, the funded status would barely change from its current level of 84%. If you are not the average plan and you are worse off in terms of your funded status, then there is an even lower probability that the capital markets alone will close your funding gap. We believe that it will take plan contributions to close these funding gaps, and now is time to fund.

Q: How should plan sponsors position themselves now that tax reform passed in December?

Tax reform is an interesting development. Despite the new 21% corporate tax rate, under IRS rules, plan sponsors with fiscal and plan years ending December 31, 2017 can make contributions before September 15, 2018 and deduct them at the old 35% tax rate, if these contributions are attributed for the 2017 plan year. The other aspect is the limitation of the deductibility of interest expense, which Corporate America has certainly grown used to. For companies affected by this limit, debt becomes less attractive because the cost of debt increases. We think that together with the lower corporate tax rate, behavior will be impacted in the near and longer term. Companies will likely rethink their mix of debt and equity in their capital structure, and many companies might decide that usage of debt could be lowered. Therefore, less issuances of high-quality debt in the marketplace is a possibility.

If I analyze what this means for a plan sponsor, I would assert there are two things a plan sponsor can do today. The first is to proactively fund your plan. Deductions before September 15 at the 35% corporate tax rate are far more valuable than they would be at 21%. Funding now also yields additional savings by reducing PBGC variable-rate premiums, which have increased three times over the last five years. The second thing plan sponsors should think about is how the market will be impacted if there are fewer high-quality issuers of debt, but the demand for the debt is unchanged. We think these factors will lead to a supply demand imbalance resulting in an increase in the cost to acquire corporate fixed-income securities in the future.

Q: What should plan sponsors do after they accelerate funding?

As funded status of plans improves through increased contributions, plan sponsors face an increasingly asymmetric risk and reward profile. This means that sponsors who choose to retain the risk of pension plans face diminishing economic benefits. This happens because excess funds from pensions generally cannot be used for other business purposes. Overfunding is disregarded by rating agencies in their evaluation of leverage, and downside risk grows. Because of this asymmetrical risk, sponsors should consider significant de-risking as their plan nears full funding.

Q: Do you expect small benefit buy-outs to continue or will we see a shift toward larger transactions?

Many companies have implemented risk transfer solutions to manage expenses by pursuing small-benefit transactions for retirees. These transactions have been attractive because they provide significant PBGC premium savings. While these transactions will continue, one thing to keep in mind is that in many instances these small-benefit transactions do not transfer meaningful risk. 

It is also important to consider that pension risk weighs on stock prices of pension-heavy companies. These pension-heavy companies underperform those that are pension-light, with either small or no DB pension plans. And financial markets reward organizations that proactively manage risk. As we highlight in our latest paper, companies that meaningfully reduced pension risk have experienced stock price outperformance relative to the market on the date of the de-risking announcement.

Today, CFOs have the biggest opportunity to reduce risk as they improve the funding of their plans. How much risk to remove will be a company-based decision, but we do expect to see more companies taking a more proactive and deliberate path to reducing their liabilities and securing benefits for retirees and beneficiaries.

The analysis provided is a general communication that should not be construed as tax, legal or investment advice to any individual or entity. Any individual or entity that has questions as to the tax and other legal implications of the matters discussed above based on its particular circumstances should consult with and rely on its own advisors and legal counsel. This communication does not constitute an offer or an agreement, or a solicitation of an offer or an agreement, to enter into any transaction (including for the provision of any services). Prudential Financial, its affiliates, and their financial professionals do not render tax or legal advice. Please consult with your tax and legal advisors regarding your personal circumstances. Insurance and reinsurance products are issued by either Prudential Retirement Insurance and Annuity Company (PRIAC), Hartford, CT, or The Prudential Insurance Company of America (PICA), Newark, NJ. Both are wholly owned subsidiaries of Prudential Financial, Inc. Each company is solely responsible for its financial condition and contractual obligations.