Business Insight: How the Tax Cuts and Jobs Act delivers a one-two punch to corporate pension plans
In a new research paper, Rutgers Business School professor Divya Anantharaman and her co-authors identify an unintended consequence of the 2017 Tax Cuts and Jobs Act that may have implications for thousands of American workers whose retirement income was tied to defined pension benefits.
How did the legislation incentivize corporations to fully fund their pension plans and then lead many of them to transfer the plans outside their corporate entity, moving them outside the protective safety net of the Pension Benefit Guaranty Corporation? Anantharaman explains in an interview.
What are defined pension benefits?
Defined benefit pensions are the traditional way in which retirement income has been provided to those who work for large corporations and for governments. In a defined benefit pension plan, the employer, or the sponsor of the plan, essentially promises the employee a defined benefit upon retirement that will be paid periodically, typically monthly, for as long as he or she may live. Essentially, it’s meant to be replacement income. The burden of setting aside enough funds and investing those funds in such a way to leave sufficient cash available to pay the benefits on retirement rests solely with the employer sponsoring the plan.
Describe the Tax Cuts and Jobs Act and how it relates to your new research?
The Tax Cuts and Jobs Act or the TCJA is a very important piece of legislation passed by the Trump Administration in December of 2017. The TCJA made sweeping changes to the structure of the tax system in America, both to the structure of personal taxes as well as corporate taxes. In our paper, we focus on the changes that the TCJA made to the structure of corporate taxes. It’s an extraordinarily long complex piece of legislation, but there are a couple of changes that are believed to be highlights. The first of those is, it took a set of corporate tax rates that operated in a tiered fashion, topping off at 35 percent, and replaced it with a flat rate of 21 percent. This was a very economically significant shift. What also happened was that a lot of tax deductions and tax credits that were allowed under the previous structure went away. The other significant change that happened was a one-time tax rate offered to American corporations to incentivize them to repatriate back to America profits that were parked in offshore subsidiaries all around the world. Corporate America had approximately $3 trillion parked in offshore subsidiaries and a tax rate of between 8 percent and 15 percent was offered to encourage companies to repatriate the profits back to the U.S. The first of these two changes is what we focus on in our paper.
How did the TCJA serve to drive pension de-risking?
The main contribution of our paper is linking pensions to the Tax Cuts and Jobs Act. There are two sets of institutional facts that we need to understand before we can talk about how the TCJA drove a reduction in pension risk. The first is about pensions and the second is about taxes. In the defined pension world, there has been a long-standing gap between theory and practice, or in other words, what economists believe is the optimal behavior for pension plans is not the behavior we see exhibited in practice. From the perspective of the corporation, or sponsor, you can think of a pension plan as having two sides, a liability side and an asset side. The liability side is essentially the discounted present value of all the benefits you have promised to various generations of employees that will become payable at different points in the future. In order to fund this liability, companies will set aside assets and usually, they’re walled off in a pension trust that can’t be breached and used for regular corporate purposes. Economists believe it is optimal for corporations to invest pension assets in bonds. What the corporation is on the hook for is a very stable, steady payment that is going to be made year-after-year for a fixed period of time. If you’re taking your assets and investing them in bonds that have a very similar maturity as your obligations, then you have a plan that is protected from lots of different types of risks like interest rate movements and things like that. But in practice, we rarely see pension plans that are completely invested in bonds. If anything, the opposite is true. Until very recently, pre-TCJA, so let’s say until 2017, the majority of pension plans in America were predominantly invested in the stock markets. You have assets that are fluctuating as the stock market fluctuates so the plan is exposed to a lot of market-related risks. This is the gap I was talking about between theory and practice. So, why are sponsors so heavily in the stock market? Many corporate pension plans are chronically underfunded. It’s not uncommon to see funding levels of about 70 percent. Sponsors invest in the stock markets to try to earn their way out of that underfunding. The reasoning is if you have one bumper year on the stock market, you can get a 15 percent or 20 percent return and earn your way out of the underfunding. With bond investments, that will never happen. In academia, we believe that if a plan gets to a place where it is well funded -- either because the sponsor put up cash contributions or because the stock market actually did well – we believe we should see plans shifting out of equities and into lower-risk investments because when plans are well-funded, the risk return trade-off that’s associated with the stock market becomes less attractive. The second institutional fact is about taxes. Pension plans have always had a special treatment in the U.S. tax code. They are in essence a legal tax shelter because any contributions that sponsors make to their defined benefit pension plans are fully tax deductible. Since the Tax Cuts and Jobs Act reduces the corporate tax rate from 35 percent to 21 percent, it also diminishes the tax benefit corporations receive for contributing to their pension plans. So If you were a sponsor with the intention of funding your plan over a period of time you have a clear incentive – if you can lay your hands on the cash – to contribute as much as possible before the Act became effective, so you could claim deductions at the higher rate. All of a sudden there were many plans that became extremely well-funded. The risk return tradeoff of staying invested in the stock market became less attractive to those sponsors, so many shifted to bonds. The magnitude of the shift from equities to bonds was quite substantial around the onset of TCJA. The order of magnitude was higher than any shift of asset allocation that we have seen in the last several years.
What’s surprising about the effect of the TCJA on pensions?
The stated objective of the TCJA was to cut corporate taxes so that companies would be left with more cash on hand that they would use to invest in opening more factories, employing more people and stimulating economic growth, hopefully, within the United States. I think it’s fair to say that in all the discussion leading up to the passage of the act, there was no mention of pensions at all. What we’re seeing is an unintended consequence.
Isn’t it a good thing for beneficiaries if companies are reducing pension funding risk?
Yes, with some caveats. To the extent to which the Act has resulted in an increase in funding and to the extent to which that increase has gone into lower risk investments, we have plans that are much better funded than they were before and are invested in lower-risk assets, so they are immunized from market risk. That is a good thing for the beneficiaries. Now the minor caveat: employees who are beneficiaries of corporate pension plans have been protected since 1974 by the Pension Benefit Guaranty Corporation (PBGC). You could make the argument that employee benefits have not become more secure because they were always secure thanks to the PBGC insurance. The conclusion is that the true beneficiary might be the PBGC because to the extent that the plans are much better funded, it becomes less likely that any of the plans are going to fail. Now, we come to the major caveat, which is where we get to pension risk transfers. Some corporations have been content to increase funding and immunize the plan from risk, holding it on their balance sheet as a self-contained unit and moving on. But many corporations have not. They have done something that is much more drastic. They have transferred the plans off their balance sheets and out of the corporate entity forever.
The way the Act is written is almost encouraging employers to transfer pension plans off their books entirely because the Act incentivizes employers to make large contributions to their plans, it also reduces the long-term attractiveness, from a tax perspective, of continuing to maintain a corporate pension plan inhouse. This is like a one-two punch to corporate pension plans. These pension risk transfers are happening in two different ways, either in lump sum offers made to employees or through settlements with insurance companies. When we incorporate this into what is happening, the question of what this implies for the beneficiaries becomes a bit more complicated because in both of these modes of risk transfer, employees lose the protection of PBGC insurance. We have to appreciate that this is something significant. What is happening is that PBGC protection of pension benefits owed to employees in these companies is being stripped away, and it’s happening under the radar.
Read the full paper entitled “The Tax Cut and Jobs Act (2017) as a Driver Pension De-risking” at https://ssrn.com/abstract=3790854.
Professor Anantharaman teaches accounting and information systems at Rutgers Business School. She is a dean's research professor. Her areas of expertise include pensions and environmental, social and governance (ESG) reporting.
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