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2009 pension funding – Where are we now?

May 14, 2009

In a "Special Edition" (March 2009) of the IRS newsletter "Employee Plans News," the IRS stated 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 2009 defined benefit plan liabilities under the Pension Protection Act (PPA). This means that calendar year plans can use the October 2008 PPA full yield curve for 2009 valuations, significantly reducing 2009 funding requirements.

In this article we analyze the impact of this one change – a change in the 2009 valuation interest rate from December 2008 spot rates to October 2008 spot rates – on plan funding obligations. Our purpose is to provide sponsors with a better understanding of just where PPA funding stress is occurring, so that they will have a better idea how, in 2009 and the future, PPA funding obligations may affect corporate cash. The extraordinary interest rate volatility and asset losses in 2008 provide an excellent experiment in just how great that effect can be. The second article in this series will look at the impact on future years, particularly 2010 and 2011.

Framework

Let's begin with the basic PPA funding framework. There are, under PPA, two funding regimes pushing DB sponsors towards better funding. First, a new set of rules that 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, punish a sponsor for allowing a plan to drop below specific funding thresholds – generally 60% or 80%.

Basic PPA funding requirements under both regimes key off of a plan's funded percentage (under PPA generally, 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.

Under the second funding regime there are certain "special" funding ratios. If you're on the wrong side of one of these special ratios, bad things happen. Here's an oversimplified version of the key ratios:

There's also a ratio that, if you're on the right side of it, good things happen. If your plan is "fully funded," then credit balances are generally not subtracted from assets in determining your funding ratio. After transition, "fully funded" simply means assets equal or exceed liabilities. This rule phases in: "fully funded" equals 94% in 2009; 96% in 2010; and 100% thereafter.

All of that is, perhaps, a little complicated. Oversimplifying, and disregarding transition issues and the minority of plans for whom 60% funding is an issue, the rules are: under 80% is bad, over 100% is good, between 80% and 100% is manageable but may be complicated.

Baseline

Now let's consider how these rules are working in 2009, and let's begin with, as a "baseline," what happened to a typical plan in 2008. For purposes of our discussion we'll consider a plan with $100 million in liabilities, with a liability duration of 12 years. We'll be comparing PPA funding requirements given different funding levels, but our baseline – the way to find where your plan might fall in any chart – always depends on January 1, 2008 funded status. Also, for simplicity, we assume no 2008 benefit accruals (i.e., no “normal cost”) or benefit payments.

Chart 1 describes, on the x-axis, the plan's FTAP (funding ratio), and on the y-axis the contribution required under PPA for our plan for 2008. (Note- for plans between 92% and 100% in 2008, we have reflected an amortization of any unfunded liability.) Thus, at an FTAP of 70%, the required contribution was $5 million; at 80% it was about $3.3 million, etc.

2009 expected

What would this plan's sponsor have expected as a 2009 contribution? The chart below shows 2009 expected funding requirements based on what we knew a year ago (again, based on the assumed 2008 FTAP/shortfall described in Chart 1).

As you would expect – assuming no unexpected changes in interest rates and asset values – contributions go down (very) slightly versus 2008, based on an assumed 2008 asset return (7.5%) a bit above the assumed liability discount rate (6.5%.) For purposes of this chart we assume funding requirements based on PPA as of the beginning of 2008; that is, we're disregarding (for now) the amendment to the PPA funding target transition rule provided by the Worker, Retiree, and Employer Recovery Act of 2008 (WRERA).

2009 mark-to-market

Chart 3 describes the impact of end-of-2008 interest rate and asset performance. We make the following assumptions: interest rates (for December 2008) are 50 basis points higher than expected; asset return for 2008 is negative 27%. (We're describing just the impact of these "real world" changes, so available asset smoothing is not yet being taken into account.)

The way this chart, and the ones that follow, work may be a little confusing, because the x-axis is always the 2008 FTAP, even where we're considering 2009 FTAP and funding obligations. The idea is to approach the analysis of 2009 funding – "post" the financial crisis, and based on this or that funding obligation or element of relief – relative to where you were as of January 1, 2008. So, for instance, our 70% funded plan was 70% funded as of January 1, 2008, and in Chart 3 you find its "Expected" and "Market" funding obligation for 2009 at 70% on the x-axis. Below the chart, we include 2009 FTAPs that reflect 2008 experience. But we want to keep coming back to the same baseline, so we show the 2009 funding obligation for this plan at 70% in the x-axis, based on its 2008 FTAP.

We'll get to elements of PPA that "buffer" this result in a moment, but it is worth considering just how great an impact on the raw numbers the financial crisis has had. Our 70% funded plan has gone from an expected contribution of $5 million to a contribution of $7.4 million. And our (formerly) 100% funded plan has gone from a contribution of $0 to a contribution of $4.5 million.

Note that the plan that was 70% funded in 2008 is now 55% funded (a drop of 15%), while the plan funded 150% in 2008 is now 110% funded (a drop of 40%). Less well-funded plans generally see a smaller decline in funded status during 2008, since (a) they are assumed to make contributions in 2008, and, more importantly (b) a smaller asset base leaves these plans less exposed to a drop in asset values.

Hitting the 80% funding target

Before we get to "relief," let's consider one more set of numbers. What if our plan "must" get above the 80% funding threshold – that is, for one reason or another (the most obvious – the company is committed to paying lump sums), the plan must get to a funded ratio of 80% or above. On a mark-to-market basis, Chart 3a describes what that would require.

This chart dramatically illustrates the impact of the second PPA funding regime. Assuming plans less than 80% funded in 2008 don't care about getting to 80%, but those that were at least 80% funded in 2008 do, this chart illustrates the spike in contributions required. For a plan on the bubble (80% in 2008), expected vs. mark-to-market goes from a little less than $3 million to almost $19 million.

Impact of asset smoothing

PPA asset smoothing mitigates the funding impact of real world performance somewhat. As we discussed in our April 2009 current legislative outlook, however, the 10% fair market value corridor generally defines, for 2009, the limit on the sponsor's ability to "inflate" the funding ratio numerator by smoothing asset performance.

Chart 4 shows the reduction in funding obligations under the first funding regime when sponsors are allowed to, in effect, write-up asset values by 10%. Generally, the annual funding obligation goes down by from 1% to 1.5% of total liabilities (here, $100 million, with a smoothing-related reduction of from $1 to $1.5 million), with the impact diminishing as the plan approaches full funding.

For plans affected by the second funding regime the math is simpler. Generally, funding requirements simply go down by 10% of the current fair market value of assets. (The exception to that general rule: where 10% of the current fair market value of assets is greater than the amount it takes to increase assets to 80% of liabilities.)

Chart 4a graphs the difference in funding under the second funding regime using a smoothed value of assets.

Impact of WRERA transition rule change

As discussed in our article Congress passes temporary DB funding relief, WRERA changed the PPA transition rule to make the funding target, for most plans, for 2009, 94% of plan liabilities (that is, the funding shortfall subject to the amortization is relative to 94% of the liabilities, not 100%). As Chart 5 illustrates, with certain exceptions (critically, plans subject to the deficit reduction contribution rules in 2007), this relief reduces the contribution obligations of plans that are less than 94% funded.

Again, the math is simple. For any plan less than 94% funded in 2009, generally WRERA reduces the shortfall subject to amortization by 6%, generating a drop in contribution requirements equal to about 1% of the funding target (in our example, $1 million).

As Chart 5a illustrates, the WRERA change provided no relief from PPA’s second funding regime requirements.

Impact of the IRS guidance

Now let's look at the impact of the IRS's recent guidance. Instead of using December 2008 spot rates, we use October 2008 spot rates. We assume that generates about a 130 basis point increase in our valuation interest rate. (Yes, the difference between October and December 2008 rates was that great. For instance, the rate for12-year zero-coupon bonds under the IRS's published yield curve for December was 7.31%; the rate for October was 8.89%.)

Chart 6 reflects the impact of this change under both funding regimes.

It's hard to find the right words to describe this result. Not only does using October (rather than December) 2008 rates make all of the problems related to 2009 funding resulting from end-of-2008 losses go away, for underfunded plans, the required contribution is actually less than what we would have expected it to be a year ago.

The 2009 FTAP numbers below the chart tell the same story. In effect, the combination of asset smoothing and the October 2008 yield curve allows most plans to calculate 2009 FTAPs that are very similar to what was used for 2008.

Finally, plans that were at least 92% funded in 2008 may have been planning on maintaining “fully funded” status in 2009 by reaching a 94% FTAP. For many of these plans, 2008 experience put this target well out of reach, and the reduced amortization under WRERA reduced the incentive to achieve this target. We still see some value in reaching these targets, however, particularly for plans that can maintain a significant “carryover balance.” Chart 7 below reflects the 2009 contribution that plans with a 92% FTAP in 2008 would need to make to remain “fully funded” in 2009 (while plans between 80% and 92% strive to maintain 80%), and the impact of all relief on such plans.

The third funding "regime"

There is actually a third "regime" pushing sponsors towards better funding: new requirements for disclosure to participants about funded status. To date, the new disclosure requirement that has had the most impact is the PPA funding notice rule. Calendar year plans had to provide the new funding notice by April 30, 2009. As discussed in our article (DOL issues funding notice guidance), while the funding notice requires a lot of information that participants may find confusing, there is one set of hard, "real world" numbers that must be in the notice: mark-to-market assets and liabilities as of December 31, 2008. None of the relief discussed above has any effect on that number.

Chart 8 describes what that notice will show for our "typical" plans vs. what those plans' sponsors might have expected to show before the end-of-2008 financial environment.

Some sponsors made 2008 plan year contributions just to improve this number – the number that must be disclosed to participants.

Conclusion

For many (calendar year) plans, IRS guidance allowing the use of October 2008 interest rates to value liabilities for 2009 funding purposes is real funding relief. Of course, using asset smoothing and the October 2008 yield curve will not change the “real” assets or liabilities of the plan, so these devices will not, ultimately, solve any pension shortfalls.   In our next article we will discuss the mid-term outlook, including a discussion of the impact of end-of-2008 interest rate and asset performance on 2010 and 2011 funding requirements.