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Companies could see a big jump in the cost of transferring pension liability risk if lower corporate tax rates become a reality under President Donald Trump.
That’s because lower tax rates would likely decrease the supply of bonds issued by corporations. There’s a good chance this would make the cost of purchasing bonds higher for pension plans and for insurance companies that take on pension liabilities from plan sponsors in annuity purchase transactions.
“Passage of tax reform could be a triggering event for many plan sponsors that have been sitting on the fence as to a decision on whether to transfer their plan’s risk,” Richard McEvoy, leader of Mercer LLC’s financial strategy group in New York, told Bloomberg BNA Aug. 17.
Consequently, “plans thinking of transferring risk through the purchase of annuities may want to speed up the buying of bonds used to match pension liabilities while bonds are still cheap,” Scott Kaplan, senior vice president of Prudential Financial’s pension risk transfer group in Newark, N.J., told Bloomberg BNA Aug. 16.
Forty percent of corporate finance executives recently surveyed by CFO Research and Prudential Financial Inc. said they either agreed or strongly agreed that lowered rates would cause them to ditch pension liabilities through an annuity purchase.
Even for plan sponsors that aren’t considering such a purchase, the prospect of lower rates is likely to motivate many of them to increase their contributions now, while such contributions enjoy a higher corporate tax deduction. This will itself increase the demand for bonds and put pressure on bond prices to rise.
A significant portion of these plan contributions will end up being invested in bonds, McEvoy said. The demand for bonds could even become a stampede as other pension plans see what’s happening in the bond marketplace and join the herd, he said.
When corporations issue bonds to investors, the company typically makes regular tax-deductible interest payments to these investors. If tax rates are lowered as part of a tax reform push by Congress and the administration, companies that pay bond interest get a lower tax deduction for these payments. This will increase the cost of bond issuance. With these costs up, corporations are likely to reduce the supply of bonds they issue.
Lower tax rates, however, aren’t likely to have any effect on the demand for bonds from pension plans that use them increasingly as a means to reduce investment risk. Plans do this by purchasing long-term corporate bonds sufficient to have their investments aligned with their ongoing benefit liabilities. Stable or increased demand for bonds, coupled with a decreasing supply, points to more expensive bonds that plans will need to purchase after their companies increase plan contributions.
Fifty-five percent of the finance executives who answered questions posed in the CFO Research/Prudential survey agreed or strongly agreed that their organization would increase plan funding in response to lower corporate tax rates.
Many plans have already been gradually increasing their allocation to long-term corporate bonds as part of a strategy to reduce their investment risk. Even plans that are maintaining a more aggressive investment allocation typically hold about 40 percent of their assets in bonds, McEvoy said. That means that at least about 40 cents of every dollar a company makes in new contributions will be earmarked for bonds, he said.
More expensive bond prices will also likely increase the cost of risk transfer annuity transactions for plans. The insurance companies that sell these annuities purchase lower-risk investments, such as bonds, to back the pension plan liabilities they take on in such transactions. These insurers could add these costs to the annuity premiums charged to plan sponsors.
Roughly 40 percent of plans are frozen—meaning that participants are no longer accruing benefits, McEvoy said. These plans will be highly motivated to increase plan contributions to fully fund their plans so they can move their liabilities to an insurer through the purchase of annuities. Sponsors of frozen plans don’t need to take any risk with their investments and will use plan contributions to buy bonds, McEvoy said.
Plan sponsors preparing for an annuity purchase have an even greater incentive to have their plans purchase bonds now. Plans that purchase lower-priced bonds before tax reform kicks in not only can more cheaply add bonds to their portfolios but can also stockpile them for use in paying the premiums owed to insurers as part of an annuity transaction, Kaplan said.
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