Borrowing to Fund: The Silver Lining of Low Rates for DB Plans

By Mike Clark, Consulting Actuary, the Principal Financial Group

If you’ve read this blog before, you probably already understand that low interest rates have a negative effect on defined benefit plan (DB) liabilities. (OK, Clark…we get it! A one percent drop in corporate bond rates increases pension liabilities for a typical DB plan by 10 to 15 percent!!! What else you got?)

And if you are responsible for managing DB liabilities as a sponsor or advisor, you’ve probably been waiting for the long, downward march of interest rates to reverse course to make liabilities more manageable.

Unfortunately, the emergence of the recession, with its accompanying investment flight to quality, Fed commitment to zero percent short term rates, and record unemployment, make the prospects of any meaningful rate increases in the near term feel pretty remote.

Going with the low rate flow

The recession has also pushed many plan sponsors to the point of exhaustion. Swimming against dropping rates has yielded limited results for many despite over a decade of effort, as discussed in The Decade That Was. Now a crisis wave has crashed over the market leaving much of the DB world gasping for breath and trying to plan a course in a “new normal” ocean.

Paradoxically, the answer to coping with a low rate riptide may be to stop fighting and go with the flow. The same rates that are making liabilities expensive are also making debt relatively cheap. So if rates refuse to come up, then maybe sponsors should relax and ride them to improve their DB situation.

Borrow to termination?

In a perfect world (admittedly a distant concept today) credit-worthy sponsors of frozen plans would simply take out a loan large enough to terminate now and eliminate most risk and expense beyond a fixed schedule of repayments.

Unfortunately, low loan rates correlate to all-time high termination liabilities. (See opening sentence!) So borrowing to termination today is tantamount to getting a great mortgage rate for a home at the height of a housing bubble. If prices stay high, it feels like a good move. But buyer’s remorse could set in if rates rise and liabilities fall before the loan is fully paid.

An efficient middle ground

Crisis driven funding ratio losses combined with generally lower revenue expectations make plan termination loans unaffordable for many. This doesn’t eliminate borrowing-to-fund as a useful option for sponsors of frozen or ongoing plans, though.

The liabilities used to determine whether a plan has a minimum required contribution or a PBGC variable-rate premium are significantly lower than the full cost of termination. So using a loan to fund to these levels can provide immediate expense savings as well as an opportunity to reduce risk.

Potential expense savings

  • Funding the Pension Protection Act (PPA) funding target shortfall can reduce or eliminate future contribution requirements to the plan. This approach effectively swaps an uncertain contribution stream (PPA funding) for a certain one (loan payments). (Potential funding reform legislation could change the fundamentals of this question as discussed in my April CARES Act blog.
  • Reducing or eliminating the unfunded PBGC vested benefit liability requires more cash, but can result in significant, immediate expense savings. The variable rate premium calculation is a bit complex, but reducing the unfunded liability can reduce premiums by as much as 4.5 percent of the contributed amount for 2020, indexed for inflation in future years. (The plan-specific impact should be reviewed by the plan actuary.) This represents a lower-risk return on the borrowed cash, which is hard to argue against these days, especially if cash can be borrowed at a lower rate.
  • Improving market value funding ratios with borrowed cash allows plan sponsors to rethink the risk in their portfolios. Increasing allocations to liability driven investments (LDI) reduces equity exposure and interest rate risk, while also increasing the attractiveness of partial risk transfers through lump sums and annuity purchases. (Plans can use loans to push themselves along risk reducing glide paths.)

Cost-benefit analysis

The decision to borrow is very specific based on each sponsor’s financial and actuarial circumstances. The cost of locking in a loan payment must be weighed against the benefits of reducing future risk and structural expenses related to the plan. Outlook for future interest rates and tax effects must also be considered.

I highly recommend you engage your plan actuary to help with this analysis (if you can find one not busy refinancing their mortgage.) They may help you discover a silver lining around the dark cloud of persistent low interest rates.

Mike Clark is a fellow of the Society of Actuaries (SOA) and a member of the American Academy of Actuaries (AAA), who is currently looking to beat 14-years remaining at 3.27%.

Affiliation Disclosure

The subject matter in this communication is educational only and provided with the understanding that Principal® is not rendering legal, accounting, investment advice or tax advice. You should consult with appropriate counsel or other advisors on all matters pertaining to legal, tax, investment or accounting obligations and requirements.

Insurance products and plan administrative services are provided by Principal Life Insurance Company, a member of the Principal Financial Group® (Principal®), Des Moines, IA 50392.