Editor’s Note: This is the first in a three-part series on pension plan funding. It features discussions with Brad Smith, Partner at consultant and investment firm NEPC and member of its Corporate Defined Benefit Team.
Pension plan funded status has long been a topic of interest and concern. But why?
Ultimately, a plan’s funded status is directly relevant to how effectively a plan can fulfill its reason for being. “Pension funding is important for many reasons, but most notably one of the main purposes of pension funding is to have assets to meet the accrued liabilities promised to employees,” says Smith. “A well-funded pension plan ensures the plan sponsor can pay benefits that were promised to employees eligible for plan benefits.”
A well-funded plan can be a boon to the employer as well, Smith adds. “Additionally, having a well-funded plan reduces the probability that a plan sponsor will have to make a required contribution in the future at a time when corporate cash could be strained, such as during an economic slowdown,” he says. “A well-funded plan also provides additional financial flexibility to an organization so they can use cash for other purposes, such as improving operations, funding new projects, etc.”
And if a plan is not well funded? There are consequences to that, Smith notes: “If a funded status is below a certain threshold (typically 80%), there are additional restrictions that may be enacted (i.e. not able to pay lump sums, required to contribute cash to the plan, etc.)
Important Factors
There are many factors that affect how well funded a plan is; two in particular are premiums set by the Pension Benefit Guaranty Corporation (PBGC) and the freezing of plans.
“PBGC premiums have become a major driver of the plan sponsor’s funding strategy,” says Smith. “The premiums come in two forms: the flat rate and variable rate. The flat-rate premium is a fixed dollar charged based upon the number of participants in the plan. The variable rate premium is determined as a percentage of the funding deficit or shortfall (subject to an annual cap). The variable rate premium is essentially a tax that the plan sponsor is required to pay on an annual basis if the plan is underfunded,” he explains. “Plan sponsors have a financial incentive to fully fund their pension plans and keep them fully funded” as a result of PBGC premiums, Smith argues.
Smith noted that in 2021, 36% of the respondents to an NEPC survey had a frozen plan. “This is a 10-percentage point increase over the last 10 years,” Smith reports. “Over the last 10 years that NEPC has conducted this survey, plans have shifted from closed status to frozen, which is the natural evolution. However, when looking at respondents with a closed plan, there was an 11-percentage point drop—38% in 2011 versus 27% in 2021.”
Next: Pension Funding and Investments
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