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Congress passes temporary funding relief – President signs into law

Jan 14, 2009

Before adjourning for the year, Congress passed, and President Bush has since signed into law, H.R. 7327, the "Worker, Retiree, and Employer Recovery Act of 2008" (WRERA). H.R. 7327 includes technical corrections to the Pension Protection Act (PPA) and certain "Pension Provisions Relating To Economic Crisis." The latter provisions (hereafter, "pension relief") provide some of the defined benefit (DB) funding relief requested by many plan sponsors and a waiver, for 2009, of defined contribution required minimum distribution rules. In addition, as part of technical corrections, WRERA clarifies PPA asset valuation rules.

In this article we briefly discuss the legislation's asset valuation and pension relief provisions. We start with asset valuation.

Smoothing not averaging

We have written before about the controversy over how assets are to be valued in determining a plan's funded ratio. Briefly, under pre-PPA rules, sponsors could smooth asset values over up to five years, subject to an 80%/120% market value "corridor." PPA narrowed the market value corridor to 90%/110% and permitted asset averaging over up to 24 months.

Since PPA passed, there has been a controversy over whether, in PPA, "averaging" means, literally, averaging or "smoothing” of returns. Generally (and with obvious exceptions to this rule), the value of assets tends to go up, with investment returns, over time. So if you, literally, average the value of assets over the last 24 months, you will tend to understate the value of plan assets relative to their current market value – a downward bias. In contrast, "smoothing" of asset values typically reflects expected asset value growth, thus reducing funding volatility without creating a systematic understatement bias. In proposed regulations, the IRS took the position that PPA permits only literal averaging.

To clarify the rule here and to, in effect, reverse the IRS's position, WRERA provides that "averaging shall be adjusted for … expected earnings (as determined by the plan’s actuary on the basis of an assumed earnings rate specified by the actuary but not in excess of the third segment rate applicable under" PPA's yield curve rules (i.e. long-term A/Aa/Aaa bonds.). This clarification is effective retroactive to the PPA effective date.

Bottom line: smoothing is in, literal averaging is out. This change is unlikely to provide any immediate funding relief to DB plans. That's because both literal averaging and smoothing would, given the current market turmoil, produce a value that is outside the 90%/110% market value corridor limit, and thus would be limited to 110% of market value. Sponsor requests to include as part of pension relief a widening of that corridor were rejected by Congress.

Other technical corrections

A handful of other, generally helpful, technical corrections are also included in the bill. The most notable measures are summarized below:

• clarifying that small cashouts (< $5,000) are not subject to benefit restrictions
• clarifying benefit restriction rules for plans with year-end valuation dates
• conforming the mortality table used to calculate benefit limitations under Code section 415 with the table used under Code section 417, and simplifying 415 calculations for small employers

One measure in the bill that will increase employers’ contributions is the requirement to reflect “plan-related” expenses expected to be paid from plan assets in the calculation of the target normal cost, but this provision does not have to be applied until 2009.

Relief on the transition rule

Under PPA, the funding target (against which, e.g., shortfalls and shortfall funding are calculated) is generally set at 100%. The 100% funding target transitions in over four years: 92% in 2008, 94% in 2009, 96% in 2010 and 100% in 2011. But, for any year after 2007, if assets are less than the transition target, the plan's shortfall is determined based on a 100% funding target. So, for 2008, for instance, if you're not 92% funded, your funding target is 100%.

The pension relief provisions of WRERA provide modest relief for employers that do not reach the transition targets. If assets are less than the transition target, the plan’s shortfall is determined relative to the transition target, not the 100% funding target.  Importantly, though, only plans that were exempt from the pre-PPA “deficit reduction contribution” (DRC) in 2007 are eligible for this relief.

So, well-funded plans that intend to achieve the transition funding targets do not benefit from WRERA’s pension relief. At the other end of the spectrum, plans with a 2007 DRC, which are presumably some of the least well-funded plans, also do not benefit.

Plans in the middle will be the chief beneficiaries of this relief, which applies beginning in 2008. For example, a non-DRC plan that is 88% funded would have been required to amortize (over seven years) its 12% unfunded liability under PPA. Pension relief reduces the amount to be amortized in 2008 from 12% of liabilities to 4% of liabilities (92% - 88%), which translates to a reduction in the 2008 required contribution of just over 1% of liabilities.

Relief on accrual freezes

Oversimplifying somewhat, PPA provides generally that if, for any year, assets are less than 60% of liabilities, plan accruals must be frozen. For a detailed discussion of this rule, see our article Preparing for 2008 – IRS proposes PPA benefit restriction rules. The drop in asset values in the last quarter of 2008 presents the risk that many more plans than expected may be facing a mandatory accrual freeze under this rule for 2009.

The pension relief provisions of WRERA provide temporary one-year relief from this rule. Under the WRERA, solely for purposes of the below-60% funding accrual freeze rule in 2009, plans can rely on their 2008 funded percentage. So, plans with a 2008 funded percentage of at least 60% will not face a mandatory benefit freeze in 2009, regardless of 2008 experience.

Waiver of 2009 minimum required distribution

The Internal Revenue Code minimum required distribution rule ("age 70 1/2" rule under Code section 401(a)(9)) is waived for defined contribution plans for 2009. For 2008, Congress had indicated that they expected Treasury and the IRS to provide similar relief, but officials from both Treasury and the IRS have indicated that no such relief is forthcoming.

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Some sponsors are likely to feel that WRERA pension relief helps with funding challenges presented by fourth quarter 2008 investment results, but critical elements – some of which might have been more helpful – didn't make it into the package. Probably most significant, there was no widening of the PPA 90%/110% market value corridor.