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Current pension legislative and regulatory outlook – September 2009 – DB plan initiatives

Sep 14, 2009

This article is one of two that we are posting reviewing the current pension legislative and regulatory agenda as Congress comes back from its August recess. In this article we focus on defined benefit plans and, critically, temporary relief from Pension Protection Act (PPA) funding requirements. Our review covers both Congressman Pomeroy's (D-ND) just-released Discussion Draft for Pension Funding Relief and H.R. 2989, reported out of the House Education and Labor Committee in June.

In a companion article we cover defined contribution plan issues – where initiatives on 401(k) fee disclosure and investment advice remain a priority – and broader issues relevant to both defined benefit (DB) and defined contribution (DC) plans.

We generally divide the material that follows into sub-discussions of the current state of the legislative and regulatory process and the substance of different proposals under consideration.

DB funding relief – process

With respect to DB plans, policymakers are focused on the effect of 4th quarter 2008 asset losses and new PPA funding rules on company cash. At the 50,000 foot level, the concern is that the combination of asset losses and new rules requiring, in many cases, accelerated funding of shortfalls, will force companies to cut expenses, perhaps by laying employees off, and in extreme cases may jeopardize the continued viability of some companies.

Modest DB funding relief was passed at the end of 2008 (see our article Congress passes temporary DB funding relief). It's true that, having spent two years (2005-2006) considering the problem of DB funding, key policymakers have been generally reluctant to revisit the compromises hammered out when PPA was passed. Nevertheless, much more significant relief is currently being, reluctantly, considered.

The House Education and Labor Committee has reported out a bill (H.R. 2989) that includes DB funding relief provisions, although this effort is widely considered a "placeholder" for more comprehensive proposals. Congressman Pomeroy has published a new version of his Discussion Draft; this version of the Discussion Draft includes a proposed bill.

PPA mechanics and 2008 asset losses

By way of background, for those not already familiar with them, here's a quick summary of the basics of the new PPA funding rules. As we have discussed in prior articles, PPA includes two funding regimes: First, a new set of rules that requires the amortization of asset-liability shortfalls over seven years. And second, a set of rules – benefit restrictions, at-risk rules and a limitation on funding of executive compensation – that, in effect, punish a sponsor for allowing a plan to drop below specific funding thresholds – generally 60% or 80%. The latter, second funding regime forces plans that wish to avoid the application of, for instance, restrictions on lump sum payments, to fund shortfalls in the current year, and not over seven years, at least up to the 80% threshold. As a general matter (and with some exceptions), a sponsor does not have to conform to regime two funding requirements, so long as it is willing to put up with the restrictions that apply if, e.g., funding falls below 80%.

For many companies, the new PPA funding rules would, in any circumstances, require an acceleration of DB funding – requiring the sponsor to put more cash into the plan sooner than under old rules. 2008 asset losses – for many plans in the 25% range – exacerbated this funding challenge.

DB funding relief – substance

With that background, the following is a summary of the main DB funding relief proposals currently under consideration:

2009 interest rates and relief for non-calendar year plans

As discussed in our article 2009 pension funding – where are we now, the IRS's change (in March 2009) in its position on valuation interest rates makes funding for 2009 non-problematic (or at least no more problematic than it had been before the 4th quarter 2008) for calendar year plans and for other plans able to use October or November 2008 "spot" valuation interest rates. Thus, for calendar year plans, 2009 is "fixed" and, for those plans, the key issue is relief for 2010 and subsequent years. As we'll see, Congressman Pomeroy's proposals often extend relief to 2009, as well as 2010, and the provisions extending relief to 2009 will be of particular help to non-calendar year plans that cannot use advantageous October 2008 spot rates.

Ability to switchback to smoothed rates for 2010

For plans using October 2008 spot rates for 2009 valuations, there remains an outstanding issue. Under PPA, in valuing liabilities, plans may use either spot rates or smoothed rates (rates averaged over 24 months). As a general matter, smoothing works to the advantage of plan sponsors, by reducing volatility and increasing predictability. For 2010, smoothing has the added benefit of allowing you to use high October and November 2008 interest rates in the average, in effect bumping the average up. So, given the preference for smoothing, a big question is: will plans that use October 2008 spot rates for 2009 funding be allowed to switch to smoothing in 2010?

Whether they will be allowed to do so depends, in the first place, on the position the IRS and Treasury take – and they have taken none yet. There does appear to be broad support in Congress for allowing plans to switch back to smoothing in 2010; such a proposal was a non-controversial part of H.R. 2989 and is included in Congressman Pomeroy's Discussion Draft.

120% asset smoothing corridor

Under PPA, plan asset gains and losses may be smoothed over two years. There is, however, a limit to how much smoothing a sponsor may use: "smoothed" assets cannot exceed 110% of fair market value. This is usually called the 110% "asset smoothing corridor." Simple example: A plan has smoothed assets of $100 and fair market value assets of $80. This plan may not use, in the numerator of its funding percentage, a number larger than $88.

Currently under consideration is a proposal to expand the asset smoothing corridor, for 2009 and 2010, to 120%. Based on current asset values (and assuming no dramatic increase in asset values before year end) the 110% corridor will (in many cases) significantly limit the amount by which the fair market value of assets may be "written up" via smoothing. Expanding the asset smoothing corridor to 120% for 2009 would allow most plans to increase assets by another 10% reducing a plan's shortfall and thus reducing required contributions. For 2010, the wider corridor would allow for a higher asset value for a typical plan if assets earn less than 10% or so during 2009.

There has been resistance to this proposal among policymakers. It was considered and rejected by the House Education and Labor Committee in its deliberations with respect to H.R. 2989. It appears, however, that no one, including Chairman Miller, believes that the provisions of H.R. 2989 are the "last word" on DB funding relief. This proposal is included in Congressman Pomeroy's Discussion Draft.

Extended amortization of 2008 losses

Generally, PPA requires that plan asset-liability shortfalls be amortized over seven years. Policymakers have, for some time, been considering two alternative proposals for postponing recognition of shortfalls attributable to 2008 asset losses. Those alternatives are: "2+7" (interest only for two years, then regular PPA amortization of losses) or "15 years" (amortization of 2008 losses over 15 years). Here's Congressman Pomeroy's (current) version of this proposal:

Interest only for two years. "[E]xtend the period for nine years delaying the seven amortization payments for two years with employers making interest payments in the first two years." A minimum contribution would be required under this alternative equal to (oversimplifying somewhat) 105% - 115% of the minimum required contribution for the 2008 plan year.

or

15-year amortization. "[F]und the '2008 losses' over a 15 year amortization period"

As noted, this proposal was include in Congressman Pomeroy's Discussion Draft; the 2+7 alternative was included, by amendment during committee deliberations, in H.R. 2989.

Maintenance of effort

Obviously, delayed amortization of 2008 losses would considerably reduce the shock to company cash produced by the combined effect of 2008 losses and new PPA funding requirements. The main problem, for sponsors, with these delayed amortization proposals is that Congressional Democrats seem to be determined that they come with strings attached.

Here are the "strings" that are currently part of Congressman Pomeroy's Discussion Draft. Sponsors electing to use an extended amortization period must either:

(1) Provide a DB plan with accruals at a rate at least equal to:

(A) the greater of the rate of benefit accrual under the plan's benefit formula as of (i) July 1, 2009 or (ii) the last date prior to the effective date of any plan freeze, or

(B) a target normal cost (without regard to plan administrative expenses) of least three percent of the aggregate compensation

(2) Provide a DC plan with a minimum non-elective employer contribution of at least three percent of pay.

(3) Freeze benefits for any management or highly compensated employees under any nonqualified deferred compensation plan and subject those plans to PPA benefit restriction rules.

For sponsors using the 2+7 alternative, these requirements would apply for three years; for sponsors using the 15 year alternative, these requirements would apply for 14 years. Different alternatives could be used with respect to different participants or participant groups and with respect to different years.

Plans that fail to comply with the maintenance of effort rules will lose the more liberal amortization treatment, but, generally, such plans will not be held to a higher cumulative funding standard than plans that don’t adopt an alternative amortization.

No maintenance of effort provision was included in H.R. 2989, but we re-emphasize that the DB funding relief provisions of that bill are generally regarded as a placeholder for more comprehensive proposals. Those more comprehensive proposals will, in all likelihood, include a maintenance of effort requirement.

Some observations on alternative 3, the proposal to subject executive nonqualified deferred compensation plans to PPA benefit restrictions. Whether, to get relief, a company would be prepared to accept this "string" will depend, to some extent, on how difficult its financial condition actually is. But it is possible that some companies will be put under (perhaps irresistible) pressure to accept this relief, as an alternative to, e.g., layoffs. And discomfort with accepting restrictions on executive benefits may not be an adequate defense against that pressure – "You'd rather lay off employees than jeopardize your executive benefits?" is an entirely plausible complaint in the current environment.

There is, also, with respect to restrictions on executive benefits, a question of contractual rights. Companies may not be able to simply unilaterally declare that from now on unfunded executive pay agreements will be subject to PPA-like restrictions.

Finally, we should keep in mind that, unlike rank and file pension benefits, executive benefits are unfunded and uninsured (by the Pension Benefit Guaranty Corporation). Accepting restrictions on the payment of these benefits puts them in real financial jeopardy, especially where the sponsor is in financial distress. Thus, the "strings" being proposed may have serious consequences for executives.

Other relief proposals

Congressman Pomeroy's Discussion Draft includes the following additional proposals that can be considered part of DB funding relief:

Extend WRERA accrual freeze relief to 2010. PPA requires, generally, that plans that are less than 60% funded must freeze benefit accruals. The Worker, Retiree, and Employer Recovery Act of 2008 (WRERA) provided relief for 2009 from this rule, allowing plans to use beginning-of-2008 asset values in calculating the plan's funding ratio for this purpose. The Discussion Draft proposes extending this relief to 2010. We would expect this proposal to have broad support. There have been industry proposals to extend this relief beyond accrual freezes and, critically, to lump sum payment restrictions (where the funding ratio is below 80%). These latter proposals do not seem to have gotten much support from policymakers.

Relief on use of credit balances. Generally (and oversimplifying a lot), a sponsor may not use credit balances to satisfy funding obligations if its funding ratio is below 80%. The Discussion Draft proposes allowing sponsors to use beginning-of-2008 asset values in determining a plan's funding ratio for this purpose for 2009 and 2010. This proposal would allow some sponsors with credit balances more flexibility with respect to the timing of contributions. For a complete discussion of the use of credit balances under PPA, see our article Credit balances and contribution timing under PPA.

Benefit restriction relief for union plans. The Discussion Draft includes a proposal to delay the application of PPA benefit restriction rules for collectively bargained plans until plan years beginning after December 31, 2011.

Other "non-relief" proposals

The Discussion Draft includes certain other proposals affecting DB plans that are not directly related to funding relief. The Discussion Draft includes proposals to:

Prohibit the adoption of early retirement window arrangements under which benefits are payable in a lump sum unless the plan, after taking into account the additional benefits, is at least 120% funded. Alternatively, the sponsor could fund the full cost of the additional benefits. If such an amendment does take effect, all benefits under the plan would be required to be 100% vested.

Revise 4010 reporting rules; the new trigger would require filing when a plan has aggregate unfunded vested benefits of more than $100 million and would disregard plans that are at least 90% funded. For a discussion of current rules, see our article PBGC finalizes rules for 4010 reporting.

Exclude Social Security level-income options from the benefit restriction limiting lump sums and other prohibited payments.

Change the determination of the amount of the PBGC guarantee by using the date of plan termination rather than the date the plan sponsor enters bankruptcy.

Revise PBGC reportable event rules applicable to a reduction in the number of active participants in a plan.

Finalization of PPA funding rules

The IRS has proposed rules implementing new PPA DB funding requirements, but it is unclear when those rules will be finalized. There are a number of controversial areas, and a number of areas where practitioners regard the approach taken by the IRS as impractical. Plan years that begin before the release of final regulations can continue to rely on a reasonable interpretation of PPA, and H.R. 2989 includes a proposal that would, in effect, extend this reasonable interpretation treatment to 2009 plan years for all plans, even if the 2009 plan year does not begin until after final regulations are issued.

*     *     *

Of course, the biggest issue is, in the current context, will Congress have time for pension policy at all? Our guess is that the answer to that question will depend on the economy and on how critical DB funding relief is perceived to be to the health of key companies. If a persuasive case can be made that relief is needed sooner rather than later, then we're likely to see DB funding legislation this year or early next year. But a lot has to happen between now and the passage of such a bill.

We will continue to follow these issues.