Odd Law Aims to Smooth Highways and Pension Funding

There are a lot of questions surrounding the recently passed Highway and Transportation Funding Act of 2014 (HATFA). The first may be how to pronounce it. Is it a short “a” like “hat”? As in, “You’ll need a HATFA outside, it’s cold!!” Or is it a long “a” like “hate”? As in, “I’d HATFA you to do a bunch of extra pension valuation work for nothing!”

Regardless of how it is pronounced, HATFA is now the law of the land for determining minimum contribution requirements for single employer defined benefit (DB) pension plans. It was passed primarily to provide temporary funding for the Highway Trust Fund (“Trust”) through next May, with $10.8 billion allocated from the Trust to the states for various infrastructure projects. Hustling to beat the clock, Congress hurriedly passed the law on August 1 before rushing out the door for summer recess. President Obama then hurriedly signed it into law on August 8 before rushing out the door for two weeks at Martha’s Vineyard.  Reportedly, both legislators and chief executive were sorely disappointed that the roads to the beach were still a bit bumpy despite their bipartisan breakthrough. While this is very “insider” and interesting, you may be asking yourself why you are reading about it in an actuary’s pension blog?

First, you should know that Congressional budgeting practices require that the funding of the Trust be offset by other revenues within the law. This leads us to “pension smoothing,” a shorthand that doesn’t appear anywhere in the 34-page law but was adopted by legislators and media folks to describe a reduction in the volatility of pension funding contributions. (So contribution patterns are “smooth” instead of bumpy, much like a finely paved road). The official name for the term is actually “funding stabilization” but “stabilization” was  determined to have too many syllables to make a good sound bite. (Thanks to intense lobbying efforts, further PBGC premium increases were also not found in HATFA! See: PBGC Becoming Four-Letter Word for Plan Sponsors.)

In reality, Congress doesn’t need contributions to be smoother—they need them to be lower. This is because pension contributions are tax deductible. Therefore, in tax-revenue driven beltway thinking:

Lower Contributions = Lower Tax Deductions = Higher Tax Revenue

HATFA accomplishes lower minimum contribution by permitting higher interest rates in the calculation of pension liabilities for funding purposes. Beginning in 2008, the Pension Protection Act (PPA) required funding liabilities to be based on market corporate bond rates. Sponsors were permitted to use a 24-month average corporate bond rate if desired, offering a minimal amount of “smoothing.” But as economic conditions and Fed policies pushed rates steadily downward and contributions upward, it was soon realized that even minimally smoothed market value funding was not sustainable for many plan sponsors.

Extended smoothing was introduced in 2012 within the grandiosely named “Moving Ahead for Progress in the 21st Century” (MAP-21) law. Recognizing that sponsors were indeed being punished by Fed-driven low rates, MAP-21 set a new minimum funding rate as a percentage of the 25-year average on high quality corporate bonds.  Since 25-year averages don’t move very quickly, this rate changes much slower than the 24-month average under PPA. It also has the added benefit of pulling in years from the early 1990s where interest rates were significantly higher than they are today (strongly correlated to hairstyles of the time). The percentage of the 25-year average under MAP-21 started at 90% in 2012, and declines 5% per year to an ultimate level of 70% in 2016, resulting in a fairly steep decline over four years.

Two years of progress in the 21st century later, HATFA retains the 25-year average corporate bond rate but locks in the 90% percentage through 2017, significantly “smoothing” the future trajectory of funding interest rates. The outcome for 2014 is a funding rate about 0.75% higher than allowed under MAP-21.  An increase of this magnitude reduces the typical pension liability by 8%-12%. Rates for 2015 and 2016 are forecast to be about 1% higher under HATFA.

 

Blog Graph

 

Application of the new rules is optional for 2013, so sponsors will have to consider whether the potential savings outweigh the additional cost of having their valuation results rerun. The decision may not be as simple as it sounds initially due to some of the complexities around pension funding rules involving prefunding balances, contribution timing and funding ratios. But time is of the essence with this decision as the last day to make contributions for a plan year beginning January 1, 2013 is only weeks away on September 15.

Some plan sponsors will greet HATFA contribution reductions enthusiastically and divert millions of dollars to other areas of operations. The new minimums may not be embraced by many others, however. Sponsors who are sensitive to  accounting results or working to terminate frozen plans are very likely to ignore HATFA, which makes you wonder how accurate those revenue estimates at the Congressional Budget Office will be.

Taken in isolation, funding stabilization is pretty sound policy. Funding a long-term obligation like a pension plan using a rate that is reasonable and stable is absolutely appropriate. Unless there is fear that a sponsor is about to fail, there is not a compelling argument to force short-term funding of market value liabilities. And remember that HATFA defines only the minimum requirement. Sponsors who want to contribute more can always consult their actuaries and financial advisors to set levels appropriate for them.

HATFA’s manipulation of pension funding laws to defer decisions on major government responsibilities is more questionable. DB pensions shouldn’t be used as the piggy bank to rationalize deficit spending when other “revenue” sources could be explored. Spending is also front loaded; the latest $10.8 billion injection will be exhausted by springtime. But the hypothetical tax revenues to cover the spending are anything but certain, and won’t be fully collected for years, if ever.

So no matter how you pronounce it, HATFA is rolling out to smooth America’s roads and pension funding patterns! It’s the budgetary pothole down the road that may wind up being rough.

 

Mike Clark is a fellow of the Society of Actuaries (SOA) and a member of the American Academy of Actuaries (AAA), who just realized that the next time highway funding is required, Congress may simply pass the HATFA donations.

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While this communication may be used to promote or market a transaction or an idea that is discussed in the publication, it is intended to provide general information about the subject matter covered and is provided with the understanding that none of the member companies of The Principal are rendering legal, accounting, or tax advice. It is not a marketed opinion and may not be used to avoid penalties under the Internal Revenue Code. You should consult with appropriate counsel or other advisors on all matters pertaining to legal, tax, or accounting obligations and requirements.

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