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IRS publishes asset valuation guidance

Apr 14, 2009

On March 16, 2009, the Internal Revenue Service published Notice 2009-22, providing guidance on the application of new asset valuation rules included in the "Worker, Retiree, and Employer Recovery Act of 2008" (WRERA). In this article we briefly review the new guidance.

Background

Under the defined benefit plan funding provisions of the Pension Protection Act (PPA), a plan's funded status – generally, the ratio of plan assets to liabilities – is relevant to the calculation of minimum funding requirements and the application of PPA benefit restrictions. For these purposes, assets may be calculated either at fair market value or averaged over (up to) 24 months.

In regulations proposed in December 2007, the IRS held that "averaging" in these cases meant "literal" averaging, not "smoothing." We've written about this issue a number of times. Briefly: 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 fair market value – a downward bias. In contrast, smoothing of asset values typically reflects expected asset value growth, thus smoothing asset values without creating a systematic understatement bias.

To clarify the rule here and to, in effect, reverse the IRS's position, WRERA provided 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...)" This clarification was effective retroactive to the PPA effective date (for most calendar year plans, January 1, 2008).

The "new" WRERA asset valuation rule presents a number of technical issues that Notice 2009-22 addresses.

New asset valuation method may be adopted without IRS approval

For the majority of plans, the most important provision of the Notice is that plans can, for 2009, adopt a different asset valuation method from what was used for 2008 without IRS approval. Many plans may want to adopt the new WRERA smoothing rules. Here's why.

It's our understanding that the (vast) majority of plans determined 2008 asset values based on fair market value. For calendar year plans, that value was determined as of January 1, 2008, and, in the (again, vast) majority of cases, that fair market value was higher than a value determined using either "averaging" under the 2007 IRS proposal or "smoothing" under the WRERA rule. Provisions of the Notice allowing a re-calculation of 2008 asset values will generally not be attractive to these plans.

Because of 2008 asset losses, for the vast majority of plans, 24-month "smoothed" values as of January 1, 2009, will be higher than January 1, 2009, fair market value. And, as a general matter (and except where smoothing may frustrate a hedging policy), smoothing increases the predictability and reduces the volatility of funding obligations. Thus, many sponsors may want to switch to smoothing for 2009, and the Notice provides for automatic approval of that switch.

Technical rules for applying the limit on assumed earnings

Much of the Notice deals with the application of the rule that assumed earnings may not exceed the PPA third segment rate (oversimplifying, the rate on long term, investment quality corporate bonds, which were generally between 6.0% and 6.5% for the averaging period in question). While these rules provide important guidance to actuaries (e.g., on how to calculate the third segment rate limit for a period , such as 2007, when IRS has not calculated 24-month segment rates), they generally have only marginal significance for the bottom line.

Rules for 2008

As we noted, the January 1, 2008, fair market value was, for most plans, higher than either 24-month averaged or smoothed values, and it's our understanding that using averaging, rather than fair market value, was the exception rather than the rule for 2008. For those plans, the following discussion of re-calculated 2008 asset values will typically be irrelevant.

The Notice does not require that 2008 asset values be recalculated, even if (now retroactively obsolete) asset "averaging" was used. The Notice does, however, permit plans, if desired, to recalculate 2008 asset values using "smoothing" (that is, averaging + assumed earnings). But if they do, the Notice warns:

[P]lans should take into account the risk that any such redetermination may result in plan operations for the plan year having been inconsistent with the [benefit restriction] requirements of section 206(g) of ERISA (the provision that parallels § 436 of the Code).

Unfortunately, explaining the issues here will get us into some technicalities that are likely to apply in only the most exceptional of circumstances. Briefly, if, for instance, a plan used averaging in 2008, it could recalculate asset value (and the plan's assets/liabilities ratio) using smoothing. That re-calculation is likely to result in a higher asset value and thus a higher assets/liabilities ratio. But if, for instance, the plan imposed benefit restrictions based on the "old" calculation (e.g., if averaged assets generated a funding ratio under 80%) and those restrictions would not have applied under the "new" re-calculation (now over 80%), the plan may have an ERISA problem – participants affected by the restriction might be able to sue.

It's also conceivable that, for instance, a plan using averaging had a 2008 funded ratio of, for instance, 89% that would "recalculate" as 90% or more using smoothing. Under the Notice, that plan could recalculate 2008 funding and avoid the April 1, 2009, benefit restrictions 10% "haircut." (For a discussion of the April 1 "haircut," see our article PPA year 2 – key funding deadlines.)

Similar issues may also be presented in the unusual case that the 2008 fair market value was lower than a 24-month smoothed value. And all of these re-calculations may affect funding requirements as well.

Bottom line: the minority of plans using averaging in 2008 or for whom 2008 fair market value was lower than a 24-month smoothed value should consult their advisors as to whether to recalculate 2008 values.

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For most plans, this Notice simply makes it clear that funding and benefit restriction calculations can, beginning in 2009 and without IRS approval, be made based on a 24-month smoothed value of assets. Plans with special issues (e.g., those using averaging in 2008) should consult their advisors.