Credit Balances in Funding Reform — Will They Be Real or Illusory?

Under pension funding law established over 30 years ago in ERISA, plan sponsors that contribute more than the minimum funding requirement in any plan year accumulate the overpayments as "credit balances" in their funding standard accounts.¹ This encourages sponsors to prefund their plans when they can afford to, generally during good economic times, so there is less need for additional funding during poorer economic times. A sponsor can apply its credit balance to a current or future year's minimum funding requirement. Generally, contributing a dollar more than the minimum in one year allows the sponsor to contribute a dollar (plus interest) less in a later year. However, credit balances do not affect a plan's funded status, which is solely a matter of assets versus liabilities.

As Congress debates legislation that would overhaul the pension funding rules, credit balances have become a key issue. The three reform proposals — the administration's proposal, the Pension Protection Act (PPA) and the National Employee Savings and Trust Equity Guarantee Act (NESTEG) — take different approaches to credit balances. Changing the rules for when credit balances can be used and their role in the valuation of plan assets could have significant financial implications for plan sponsors.

The administration's funding reform proposals released earlier this year recommended eliminating credit balances (both past and future). The administration argued that plans with funding shortfalls needed to make progress toward eliminating the funding shortfall each year, and having contributed more than the minimum in previous years was irrelevant. Sponsors maintained that eliminating credit balances would simply make the problem of insufficient plan funding worse.

The House Education and the Workforce Committee approved the PPA on June 30, 2005. The PPA would allow credit balances but would restrict their use. For most purposes, plans would have to subtract credit balances from plan assets. In addition, sponsors would have to adjust credit balances annually to reflect the actual investment experience of plan assets. Finally, plans would have to meet certain funded status requirements in order to use credit balances to reduce contribution requirements. Some critics question whether all these restrictions would simply eliminate current incentives to contribute more than the annual minimum.

NESTEG would allow employers to continue using credit balances. Like the PPA, NESTEG would require plan sponsors to adjust credit balances annually to reflect investment gains and losses. In addition, plan sponsors would have to subtract credit balances from the value of plan assets when determining their plans' funding shortfalls and minimum required contributions. But plan sponsors would not have to subtract credit balances from plan assets when determining whether the act's benefit restrictions applied.

PPA Creates Special Problems for Plan Sponsors

In lieu of tracking and applying credit balances to reduce future minimum contribution requirements, the PPA would permit sponsors to permanently ignore part or all of their credit balances. Why would a sponsor want to permanently elect to ignore an excess contribution? In some circumstances, the PPA would actually penalize sponsors that contributed more than the minimum.

For example, suppose that two sponsors have the same funded status, but sponsor A has contributed more than the minimum contributions in the past and so has a $50,000 credit balance. Sponsor B has always contributed the minimum amount required.

To determine plan A's minimum funding requirement under the PPA, the sponsor would have to subtract the $50,000 credit balance from the assets of $800,000, leaving the plan with a funding shortfall of $250,000. The minimum contribution requirement for plan A would be the plan's normal cost plus seven-year amortization of the funding shortfall of $250,000. For plan B, the minimum contribution requirement would be normal cost plus the seven-year amortization of $200,000. Even though sponsor A has a $50,000 credit balance available to reduce the higher minimum contribution amount, the PPA would prohibit plans whose funded status was less than 80 percent for the previous year from applying credit balances to contribution requirements. For this purpose, credit balances accumulated after the PPA would be subtracted from valuation assets (pre-PPA credit balances would not). Thus, in our example, depending on when plan A made the higher contributions, it might not be able to apply any of its credit balance to reduce its higher contribution requirement. In that case, sponsor A would probably elect to permanently ignore the credit balance, since it would constitute a penalty rather than a benefit.

In other PPA provisions, subtracting credit balances from plan assets would produce even more questionable results. For example, the PPA would prohibit plans that were at least 60 percent funded but less than 80 percent funded from making lump sum distributions. For this purpose, sponsors would have to subtract credit balances from plan assets. So plan A, whose funded status would be 75 percent after subtracting its credit balance, could not pay out lump sum benefits, whereas plan B — which was no better funded than plan A — could.

If plan A had a $250,000 credit balance, its funded status would drop below 60 percent. If a plan's funded status dropped below 60 percent, the PPA would impose even higher funding requirements and freeze plan benefits. Thus, unless sponsor A elected to have its credit balance permanently ignored, it would have to fund to higher levels and freeze plan benefits, while sponsor B — with the same plan liabilities and plan assets — would be required to do neither.

In addition to requiring sponsors to subtract credit balances from plan assets and restricting the use of credit balances, the PPA would also separate credit balances into pre-PPA credit balances (called the funding standard carryover balance) and post-PPA credit balances (called the prefunding balance). In some circumstances, only prefunding balances would be subtracted from plan assets. In addition, the PPA would require plans to apply the funding standard carryover balance before the prefunding balance. It is difficult to see the point of the distinctions, which appear confusing and unnecessarily complicated.

While the PPA preserves credit balances in name, the act would likely eliminate or at least make them much less useful in practice. The PPA's treatment of credit balances is complicated and many of the rules seem counterintuitive to improving plan funding. NESTEG would give employers more flexibility but would still require plans to subtract credit balances in determining the plans' funded status in many circumstances. Both proposals would penalize plan sponsors with credit balances in other circumstances as well, including quarterly contribution requirements, maximum deductible contributions, and possibly PBGC flat-rate and variable-rate premiums. In their currently proposed forms, all three proposals might simply encourage many sponsors to keep future contributions to the minimum.

¹ A bookkeeping account that is maintained to determine whether a defined benefit pension plan is meeting minimum funding standards set by law. Many of the entries to the account are derived actuarially.