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Current pension legislative outlook

Apr 10, 2009

Under any policy "conditions," the current financial crisis would significantly stress sponsors of defined benefit (DB) plans. That sponsors are having to deal with significant asset losses at the same time that they are being required to change to more stringent Pension Protection Act (PPA) funding requirements raises special problems for sponsors and policymakers.

Recognizing that these are unusual and to some extent unanticipated circumstances, at the end of 2008 Congress provided some funding relief for DB plans in the "Worker, Retiree, and Employer Recovery Act of 2008" (WRERA). That relief was, however, limited, and sponsors and sponsor advocate groups are currently asking Congress for additional relief that will have a bigger impact on the funding bottom line for 2009 and 2010.

As discussed further below, on March 31, 2009, the IRS published a newsletter indicating that it will allow, for 2009, the use of "spot rates" for any of the five “applicable lookback months” (rather than only for the month preceding the valuation date) to value liabilities. For calendar-year plans, this means plans can use the (higher) October or November 2008 PPA full yield curve for 2009 valuations, which may reduce the 2009 funding target by 10% to 20% compared with other bases.

In this article we review what we have learned about the "funding problem" – how PPA is stressing DB plan sponsors in times of broader financial stress – and the various efforts (primarily, legislative) to provide some relief from that problem.

Two funding regimes

It was clear, as PPA was being considered, that Congress intended that there be two "regimes" pushing DB sponsors towards better funding. First, a new set of rules that would require the amortization of shortfalls over seven years. And second, a set of rules – benefit restrictions, at-risk rules and a limitation on funding of executive compensation – that would, in effect, penalize a sponsor for allowing a plan to drop below a specific funding "threshold" – generally 60% or 80%.

It turns out that, while the general funding rules are problematic, it's the second regime – and critically, for plans that pay lump sums, the benefit restrictions rules – that, in times of short cash, are the most critical. That's because the impact of a shortfall on funding is spread out over seven years, but dropping below a benefit restriction threshold, for instance, creates an immediate problem.

Simple example: As a result of end-of-2008 asset losses, a plan that was fully funded as of January 1, 2008, is, as of January 1, 2009, 70% funded. The 30% shortfall must be made up over seven years. But, unless something is done, benefit restrictions – critically, a limitation on the ability to pay lump sums if the funded status falls below 80% ­– will apply no later than October 1, 2009.

The "lump sum" restriction actually applies to all "accelerated payments." The most obvious accelerated payments are lump sums, and in this article we will focus on them. But this restriction would also apply to, for instance, Social Security level income options.

The other benefit restriction that is triggered when funding falls below 80% is the prohibition on plan amendments improving benefits. This restriction is less obviously problematic – you would think there would not be pressure for benefit improvements "in these times." But consider that a company's DB plan is often thought of as a key tool to be used in cushioning the impact of layoffs. Paying a (full) lump sum or adding an early retirement incentive are options that fall off the table when plan funding goes below 80%.

Other issues, such as PBGC 4010 reporting and restrictions on using credit balances in 2010, may also be issues for plans funded less than 80% during 2009. For many sponsors, less than 80% is increasingly seen as the “red zone” for pension funded status. 

Bottom line – that second funding regime is, in many cases, turning out to be more important than the first, at least in times of severe financial stress.

Fixing the numerator

Basic PPA funding requirements, benefit restrictions and other elements of the "second funding regime" all key off of a plan's funded percentage (under PPA, the funding target attainment percentage (FTAP) or adjusted funding target attainment percentage (AFTAP)). The numerator of that percentage is plan assets (in most, but not all, cases, reduced by any credit balances). The denominator is plan liabilities.

PPA reduced the "smoothing" of both the numerator (assets) and the denominator (liabilities). Indeed, as originally proposed by the Bush administration, there would have been no smoothing of either number. But sponsors pushed for some smoothing, to mitigate the effect of financial volatility such as what we are now experiencing. As finally passed, both numerator and denominator could be smoothed over two years.

It turns out, however, that, at least in the current crisis, with respect to the numerator (assets), the PPA reduction in the "fair market value corridor" was more important than the reduction in smoothing. With asset losses limited, generally, to the last four months of 2008, the two-year smoothed value of assets for most plans as of December 31, 2008, was a pretty decent number. But, while pre-PPA rules allowed plans to carry a smoothed value of assets that was as much as 120% of fair market value, PPA reduced that fair market value corridor to 110%.

Simple example: A plan has smoothed assets (before applying the corridor) of $100 and fair market value assets of $80. Under old rules this plan could use, in the numerator of the funding percentage, a number as large as $96, that is, 120% of $80. Under PPA, that number can be no higher than $88.

As we discuss below, temporary expansion of the fair market value corridor is one of the most significant pieces of funding relief sponsors are currently asking for.

Fixing the denominator

PPA requires that liabilities be valued using an investment grade corporate bond yield curve that is either smoothed over 24 months or reflects one-month "spot rates." We put "spot rates" here in quotes because these rates are actually averaged over a month. Thus they are not literally spot rates, but they are as close as PPA gets to them. It turns out, in the current crisis, that spot rates as of the end of 2008 were relatively high. High interest rates = lower liabilities = lower funding requirements. (We provide an extensive discussion of PPA yield curve rules in our article Picking the yield curve.)

IRS/Treasury have proposed regulations providing that, for calendar year plans, PPA "spot rates" are to be determined as of the end-of-year month. That is, for instance, in valuing liabilities for 2009 funding, a calendar year plan opting to use spot rates must use the rates for the month of December 2008. December 2008 rates were good (relatively high). But November, and especially October, rates were a full percent or more better.

While the issues here are very technical, there is support in PPA for allowing sponsors of calendar year plans to pick a "spot rate" yield curve based on rates for November or October (or, for that matter, September or August). The regulators rejected that approach in their proposal. But in a just released "Special Edition" (March 2009) of the IRS newsletter "Employee Plans News," the IRS stated:

[F]or plan years beginning before the effective date of the final regulations…the IRS will not challenge a reasonable interpretation of an applicable statutory provision under [the PPA funding rules]…Determining the plan's liabilities…using interest rates under the corporate bond yield curve (determined without regard to 24 month averaging) for any applicable month represents a reasonable interpretation of the new funding rules in the statute. Thus, for a calendar year plan with a January 1, 2009 valuation date, the IRS will not challenge the use of the monthly yield curve for January 2009, or any one of the four months immediately preceding January 2009.

Bottom line: calendar year plans can, for 2009 funding purposes, use (relatively high) November or October 2008 interest rates to value plan liabilities for 2009.

Allowing plans to use November or October 2008 rates will have a significant impact on funding requirements for 2009. The only remaining issue: can plans electing to use spot interest rates in 2009 switch back to smoothing in 2010? Generally smoothing reduces volatility and increases predictability. Thus, in non-crisis circumstances and except where certain hedging strategies are being pursued, most sponsors would prefer to use smoothing. Whether the IRS will ultimately allow for automatic approval of such a change from 2009 to 2010 is yet to be seen.

Funding notices

We recently posted an article on the DOL guidance with respect to new PPA funding notice requirements. 2008 notices for calendar year plans are due April 30, 2009. While there is a lot of  information that must be provided in these notices, one fairly clear pair of numbers stands out. Administrators must provide participants mark-to-market ("unsmoothed") plan asset and liability values as of the end of 2008. Because of end-of-2008 asset losses, many sponsors will have to tell participants that their benefits are not fully funded. This disclosure obligation, by itself, is causing some sponsors to consider additional plan contributions.

Legislative relief

WRERA provided only limited funding relief. Perhaps the most "useful" relief in WRERA was a provision allowing plans to use January 1, 2008, AFTAPs for purposes of the restriction on benefit accruals for 2009. Under PPA, generally plans less than 60% funded must freeze benefit accruals. In effect, WRERA suspends the benefit freeze in 2009 for plans with 2008 AFTAPs of at least 60%.

Currently, several proposals for temporary funding relief are being considered by Congress, including:

Extended amortization of 2008 losses

Expanded WRERA transition relief

Temporary expansion of the fair market value asset smoothing corridor

Expanded benefit restrictions relief

Of these proposals, the ones that will have the most impact and affect the most plans are the expansion of the fair market value corridor and benefit restriction relief. Proposals for expanding the corridor are relatively self-explanatory (see above). The proposal for expanding benefit restriction relief would extend the WRERA rule (allowing the use of January 1, 2008 assets) to all benefit restrictions (critically, the restriction on paying lump sums for plans less than 80% funded) and to 2010.

With strings attached

Of considerable concern to sponsors asking Congress for funding relief is the likelihood that policymakers will add a maintenance-of-effort rule to any relief provided. Such a rule may require a sponsor taking advantage of funding relief to commit to maintaining its defined benefit plan for some period (e.g., five years). This new obligation may prevent many sponsors from taking advantage of any relief passed by Congress.

Outlook

It's our understanding that Congressional policymakers are not particularly enthusiastic about providing funding relief. They explicitly rejected expanding the fair market value corridor when they passed WRERA. And it's arguable that, as the ability to pay lump sums merely affects the form of payment rather than the amount, there's no compelling reason for lump sum benefit restriction relief.

Thus, at this point, regulatory efforts may be more productive.

There have been, as yet, no bills introduced providing for funding relief, but we understand proposals are being worked on. As specific legislation is introduced and considered, we will update you.

Having said that, between asset smoothing, which allows plans to use an asset value up to 10% greater than market value, and the October 2008 yield curve, which allows plans to use liabilities 10% to 20% lower than a “market” value based on the December 2008 curve, most plan sponsors will now have the ability to defer, for 2009 PPA purposes, the impact of the 25% to 30% hole in their plans related to 2008 asset losses.