Executive Summary
In this week's mailbag, we look at two recent inquiries: 1) was there anything illegal in what Hostess did in stopping its pension plan contributions and leaving a huge shortfall, and how shaky is the PBGC; and 2) how do you calculate cost basis for a Master Limited Partnership (MLP) as distributions are received, and what is the tax treatment of gains when the MLP is later sold?
Question/Comment: I've been looking for reactions from financial planning thought leaders regarding the PBGC and the Hostess pension story, given that apparently management didn't fund the pension when it was supposed to, diverting money to operations instead.
Is this legal? What's the law regarding how often a pension fund is supposed to be audited by outside auditors? And what's the mood on changes to the PBGC having to go to the US Govt for a bailout because currently PBGC premiums don't nearly cover the risk of multiple Hostess wipeout?
The Hostess story is certainly a sad affair, but there's nothing illegal about what happened here (at least given the information we have publicly). Nothing was embezzled or stolen, and pension funds were not misappropriated.
The reality is that Hostess, as any business that has an employer retirement plan, is obligated to make annual contributions to its own employer retirement plan, including its pension. As a matter of cash flow convenience, most large companies make the contributions on an ongoing basis throughout the year, although technically the company can wait and do the whole thing after the end of the year, as long as the money goes in by tax day. It’s the same thing we as planners do with our clients, having them make their IRA and small business profit-sharing contributions after the end of the year but before they file their taxes.
So in the short term, all Hostess did was stop making monthly contributions for their 2012 contribution, ostensibly intending to wait and make their 2012 contribution in early 2013. There's nothing illegal nor even necessarily improper about that at all; it’s just an annual cash flow management decision, and as the story you linked pointed out, only amounted to about $30M – $40M. Given that the Hostess pension plan was likely billions of dollars of total assets, that’s barely a rounding error. They lose more than that in market volatility in a bad afternoon. So ultimately, the decision to stop ongoing contributions was neither illegal, nor likely material to the plan in the long run (although clearly material to Hostess, given its severe cash flow and business viability issues and ultimate bankruptcy).
The secondary issue is that the Hostess plan, as with MANY pension plans, are not fully funded. They may have had billions of assets in the plan, but they apparently had billions more in liabilities for future benefits. Now there’s nothing illegal about having a “modest” shortfall, either. Pension plans are allowed to have some flexibility regarding quite how much they’re funded, and it doesn’t always have to be 100%. In theory, shortfalls are something that would be made up... eventually.
However, the problem has been exacerbated in recent years, with various pieces of legislation that have allowed some plans to remain more underfunded, for the sake of trying to help corporations free up cash flow that could be redirected to hiring and growth instead. The caveat, of course, is that if the corporation ultimately goes bankruptcy, it never makes up the funding shortfall from future growth... instead, the shortfall is left to the Pension Benefit Guaranty Corporation (PBGC). And in practice, many of these shortfalls have just been getting worse over time, both because businesses continue to often fund as little as possible (given the general weakness of the economy), and because sluggish returns and low interest rates mean many pension plans aren't earning the 7% - 8% rates of return originally projected... which in turn shows up as a greater shortfall.
On the other hand, if Hostess (and many other corporations in similar positions) was forced to make the pension plan fully funded earlier, the company probably would have ALREADY gone bankrupt, as the business simply didn't HAVE the money to do this. The theory was that the relaxed funding provisions for pensions would give companies time to grow their way out; instead, it’s turned out to just give them more time to compound the shortfalls before going bankrupt and letting PGBC pick up the shortfall (which, to be fair, IS the purpose of PBGC). (Notably, there are some additional complexities in the Hostess situation, as it participated in and contributed to a multi-employer pooled plan through the union, but these details are beyond the scope of the discussion here.)
In the meantime, yes PBGC has woes of its own. Premiums are still light for the base of pensions they are obligated to support, ESPECIALLY in an environment where we allow plans to be more underfunded than ever and weak returns increase the pressure (although the PBGC did get some helpful nudges in the Pension Protection Act of 2006, but clearly not enough given the financial crisis a few years later). The caveat in better funding the PBGC, though, is that requiring plans to shore up their shortfalls, or even “just” pay more in PBGC premiums, would reduce business cash flow for growth, hiring, and investment, which has made this a sticky economic issue in Washington. As with so much else, the solution would entail short term pain for a theoretical long term gain, but Washington (and much of the public) isn’t very open to taking the short term pain right now.
In the meantime, I definitely recommend the PBGC website itself as a resource, which has both a system to look up whether a client's own pension plan is covered (one database for single-employer plans, and another for multi-employer plans). The PBGC site also has information on exactly what PBGC does and does not guarantee, and maintains a regular updated schedule of the maximum benefit that PBGC will back based on the plan's termination year and the employee's age. Ultimately, if you believe that the government will back PBGC as necessary (which seems to be the general, albeit shaky, consensus) then in theory these benefits and guarantees will hold, but the most important planning issue is simply to determine whether or not the client's pension plan is covered by PBGC in the first place (especially since most state government pension plans, which are increasingly shaky themselves in many states, are not covered by PBGC and must instead rely on state/local guarantee programs, if there are any!).
Question/Comment: A client owns EPD, an MLP, and has a gain on it. My general, big picture understanding is that his annual distributions are not taxed, but are a reduction of his basis, correct?
If correct, once that adjustment to basis is done and he sells it, is the remaining gain treated as a capital gain or taxed differently?
