|
Congress Approves Pension Overhaul
Congress has approved a major overhaul of the pension rules, finally concluding a debate that has swirled around Capitol Hill for years. When President Bush signs the Pension Protection Act (PPA) of 2006 (H.R.4) into law, its sweeping changes will affect defined benefit plan sponsors, workers and — eventually — retirees.
The PPA establishes new funding and disclosure rules for single- and multiemployer defined benefit plans. The act settles the legal validity of hybrid plans, such as cash balance and pension equity plans (PEPs). It creates new requirements for existing hybrid plans and conversion rules for new hybrid plans. The act also addresses defined contribution plans and includes provisions aimed at encouraging retirement savings and education.
The new law will affect plan sponsors differently, depending on their plan design and demographics, funded status and other factors. For some sponsors, annual contributions may be much higher and/or much more volatile from year to year. Some sponsors may not be able to increase benefits, pay lump-sum distributions or continue benefit accruals under their plans. For others, the changes may be more moderate. But all sponsors must understand the new rules and begin taking the necessary steps to implement them.
Corporate Bond Rate Temporarily Extended
Interest rate uncertainty plagued plan sponsors throughout 2006. The corporate bond rate used to determine current liability and Pension Benefit Guaranty Corporation (PBGC) premiums during the 2004 and 2005 plan years expired on December 31, 2005 — and an extension of that rate was tied to the broad pension overhaul. As negotiations seemed to languish, plan sponsors didn’t know which interest rate they would be using for their 2006 valuations.
Now they know. The PPA extends the corporate bond rate for plan years beginning in 2006 and 2007. Beginning in 2008, plan sponsors will operate under the new rules enacted by the PPA.
Single-Employer Defined Benefit Plans: New Funding and Disclosure Rules
The act increases the funding target for all single-employer defined benefit plans. Most plans will have to fund to 100 percent of their new funding target. This will generally be the present value of all benefits accrued or earned as of the beginning of the plan year. Funding shortfalls will be amortized over seven years, but the act also allows amortization of gains — an important change that could mitigate the higher contributions and volatility some plan sponsors will encounter under the new rules. A plan’s annual funding requirement will be its target normal cost for the year (i.e., the present value of benefits expected to accrue during the plan year), plus the amount needed to amortize current and prior funding shortfalls and funding waivers.
The PPA provides a phase-in period for the new funding requirements. For purposes of determining whether a plan has a funding shortfall that must be amortized, the funding target will be 92 percent in 2008, 94 percent in 2009, 96 percent in 2010 and 100 percent thereafter. However, plans that were subject to deficit reduction contributions in 2007 will not be eligible for the phase-in period. And, plans must meet all funding target percentages during the phase-in period. If a plan misses even one target, its funding target immediately becomes 100 percent.
At-Risk Rules
One of the most contentious areas in pension reform was how to determine “at-risk” status. To calculate their liability, at-risk plans must use more conservative actuarial assumptions aimed at increasing their funding target, and some at-risk plans must add an additional loading factor to their liabilities.
Under the final rules, at-risk status is determined under a two-part test. The first test is whether the plan’s funded status for the previous plan year was less than 80 percent of its regular funding target. The second test is whether the plan’s funded status was less than 70 percent of its at-risk funding target. A plan would have to fail both tests to be considered at risk. The 80 percent target in the first test will be phased in. In addition, at-risk funding rules will be phased in by 20 percent for each year that the plan is considered at risk. Once a plan ceases to be at risk, the regular funding rules apply, but amortization bases created while the plan was at risk may not decrease.
In performing these tests, the plan sponsor must subtract all credit balances from the value of the plan’s assets — so even reasonably well-funded plans could find themselves at risk after subtracting their credit balances. In that case, the plan sponsor could elect to forfeit some or all of the plan’s credit balance to avoid the at-risk determination.
To determine the at-risk funding target, the plan generally must assume that all participants eligible to retire during the next 10 years will retire at the earliest possible date (but not before the end of the current plan year). They must also assume that retirees will take their distribution in whatever form would create the highest liability. So, plans that pay generous early retirement subsidies or whose workforces are approaching retirement age could find themselves at risk.
Plans that have been at risk for two of the previous four years also must add a loading factor of 4 percent to the plan’s liabilities, plus pay $700 per plan participant.
Additional Funding Provisions for Single-Employer Plans
The way plan assets are valued is key to determining a plan’s funded status, and it was another contentious issue during conference negotiations. Under current law, plan assets may be averaged — or smoothed — over five years, and asset values may range from 80 percent to 120 percent of their fair market value. The act reduces the smoothing period to 24 months and narrows the smoothing corridor to 90 percent to 110 percent of the assets’ fair market value.
The PPA provides for a permanent interest rate basis, which will take effect after the extension of the corporate bond rate expires. Beginning in 2008, plan sponsors must use either a modified yield curve that includes three segment rates averaged over two years, or a yield curve of rates that have not been averaged. Under the modified yield curve, three separate interest rates will be used to discount projected benefits payable within five years, between five and 20 years, or after 20 years. The Treasury Secretary will determine the three rates based on a yield curve of investment-grade corporate bonds of varying maturities taken from the three highest-quality levels — AAA, AA and A. The modified yield curve will be phased in for plan years beginning in 2008 and 2009 and fully implemented in 2010, although plan sponsors may opt out of the phase-in period.
Plan sponsors also must use the modified yield curve (without the 24-month average) to determine lump-sum distributions. For lump-sum distributions, the modified yield curve will be phased in over five years beginning in 2008.
Previous versions of the funding reform legislation would have mandated the use of the RP-2000 Combined Mortality Table, but the PPA allows the Treasury Secretary to prescribe the mortality table. The Treasury Department released proposed mortality regulations in December 2005, which will likely form the basis for the mortality table mandated under the act. Plan sponsors may request plan-specific mortality tables. The Treasury Department would have to agree that the substitute table reflects actual plan experience and projected mortality trends, and the plan must have enough plan participants and sufficient experience to support its request. If a plan sponsor uses a plan-specific mortality table, each plan maintained by the plan sponsor and members of the sponsor’s controlled group must use the plan-specific tables as well.
Plan sponsors have long asked for the ability to contribute more to their pension plans during good economic times to mitigate the effects of economic downturns. Throughout the pension reform debate, lawmakers and administration officials also supported this position. So, the act increases the maximum deductible contribution.
Beginning in 2008, employers may deduct up to the greater of the sum of (1) the plan’s funding target, (2) the target normal cost for the year and (3) a funding cushion, or the plan’s at-risk contribution amount. The funding cushion will be 50 percent of the funding target, plus an amount to cover future pay increases (or future benefit increases for flat-dollar plans). For a terminating plan, the maximum deductible contribution will not be less than the amount needed to pay the plan’s benefit obligations. For plan years beginning in 2006 and 2007, the act generally increases the maximum deductible contribution to 150 percent of current liability over plan assets.
Credit Balances
Credit balances were also a point of contention during negotiations. Credit balances accumulate when sponsors contribute more than their required minimum contributions. The sponsor can then use the credit balance to offset its minimum pension contribution in a future year. Early in the pension reform debate, credit balances came under strong criticism from administration officials and some lawmakers. Credit balance critics complained that the current rules weakened plan funding by allowing credit balances to grow with assumed interest, even if actual investment returns fell short of assumptions. Plan sponsors countered that credit balances were a form of pre-funding and should be encouraged.
The act allows credit balances but establishes new rules that may discourage plan sponsors from accumulating credit balances or force them to forfeit their existing credit balances.
The act divides credit balances into two categories: funding standard account carryover balances (amounts accumulated before 2008) and prefunding balances (credit balances accumulated after 2008). After 2007, plan sponsors must adjust their credit balances every year to reflect investment gains or losses. Sponsors may elect when to use their credit balances to offset their minimum required contribution, as long as their plan remains at least 80 percent funded after subtracting prefunding balances from plan assets. Carryover balances must be used first.
Under many of the new rules and funding triggers, sponsors must subtract credit balances from plan assets. For example, plan sponsors must subtract both the carryover and prefunding balances when determining whether a plan is in at-risk status. They must also subtract both balances to determine the minimum required contribution and the plan’s funding shortfall; however, a special rule applies if the plan sponsor has a binding agreement with the PBGC that prohibits its use of credit balances to offset its minimum required contributions. In determining whether a shortfall amortization base is required for the current year, plan sponsors must subtract prefunding balances if they plan to use the prefunding balance to offset their minimum required contribution.
Special rules apply for benefit restrictions on underfunded plans. Plan sponsors that are 100 percent funded (or funded to a phase-in percentage during the special transition period) do not need to subtract credit balances when determining whether they are subject to benefit limitations. Otherwise, all credit balances must be subtracted.
The rules for subtracting credit balances raise important questions about when and whether employers should accumulate credit balances, since they could be forced to forfeit their credit balances to avoid at-risk status or benefit restrictions.
New Rules for PBGC Variable-Rate Premiums
The PBGC’s financial status was one of the driving forces behind pension reform and improving the agency’s finances is one of its goals. In early 2006, the Deficit Reduction Act increased the flat-rate premiums for single-employer and multiemployer pension plans and created a new termination premium for plans undergoing a distress or involuntary termination (see Watson Wyatt Insider, February 2006).
Now, many plan sponsors face higher variable-rate premiums, too. The act eliminates the current-law full-funding limit exemption and requires that all underfunded plans pay a risk-based premium, regardless of their funded status in prior plan years. In 2008 and later plan years, the premium amount will be determined using the three segment rates from the modified yield curve, without any 24-month averaging. The premium will be based on the plan’s funding shortfall for the year (without regard to the special transition rule for shortfall amortization bases), but only vested benefits will be taken into account. Sponsors must use the fair market value rather than a smoothed value of the plan’s assets.
The termination premium enacted by the Deficit Reduction Act was scheduled to expire in 2011, but the PPA makes the premium permanent.
New Benefit Restrictions
The act imposes benefit restrictions on underfunded plans, including restrictions on benefit increases and lump-sum distributions. Underfunded plan sponsors may be required to freeze benefit accruals. The act also restricts plant shut-down benefits and limits nonqualified deferred compensation.
Plans that are less than 80 percent funded — or whose funding is greater than 80 percent before the increase but would be less than 80 percent after the increase — may not increase benefits, unless the sponsor contributes more to the plan. If the plan is less than 80 percent funded, the plan sponsor must fund the full increase. If the plan would be less than 80 percent funded after increasing benefits, the plan sponsor must contribute enough to bring funding to 80 percent.
Plans that are less than 60 percent funded may not pay lump sum distributions. Plans whose sponsors are in bankruptcy may not pay lump sum distributions unless they are 100 percent funded. If the plan is between 60 percent and 80 percent funded, lump-sum distributions are generally limited to the lesser of 50 percent of the otherwise payable distribution or the present value of the benefits guaranteed by the PBGC. The balance of the benefit is payable as an annuity.
Benefit accruals are restricted in plans that are less than 60 percent funded, unless the plan sponsor contributes enough to bring the plan’s funded status to 60 percent as of the beginning of the year.
A plan whose funding level is less than 60 percent may not pay shut-down benefits, unless the plan sponsor contributes more to the plan. If the plan is less than 60 percent funded, the plan sponsor must fund the full amount of the shut-down benefits. If the plan’s funding would fall below 60 percent after paying the benefits, the plan sponsor must contribute enough to bring funding up to 60 percent. For plans that are more than 60 percent funded, the PBGC guarantee for shut-down benefits will be phased in over five years.
As discussed above, credit balances will play an important role in benefit restrictions. To determine whether these benefit restrictions apply, credit balances will be subtracted from plan assets, unless the plan is 100 percent funded. The 100 percent level will be phased in gradually — it will be 92 percent in 2008, 94 percent in 2009, 96 percent in 2010 and 100 percent thereafter. So, a plan that is well funded — but not fully funded — when credit balances are included could face benefit restrictions after the balances are subtracted. Plan sponsors may choose to forfeit their credit balances to avoid benefit restrictions and may need to forfeit their credit balances to avoid the restrictions on lump-sum distributions. Sponsors of collectively bargained plans may need to forfeit their credit balances to avoid the other benefit restrictions as well.
Once a sponsor becomes subject to a restriction, the plan’s funding level is presumed to be unchanged until the plan’s actuary certifies otherwise. If the funding level during a preceding year was less than 10 percentage points above the trigger for a restriction, it will be presumed to drop 10 percentage points the fourth month of the next plan year, unless the plan actuary certifies a different funding level by then. The funding level of any plan that has not been certified by the 10th month of the plan year will be assumed to be less than 60 percent. So sponsors may need results from their actuaries sooner than before.
The law also restricts nonqualified deferred compensation for plans in at-risk status or whose sponsors are in bankruptcy. The act imposes income taxes, interest and penalties on amounts set aside to pay nonqualified deferred compensation to certain executives if the sponsor or a member of its controlled group is bankrupt, sponsors an at-risk plan or sponsored a plan that terminated without enough assets to pay benefits. Income taxes, interest and penalties will also apply if the nonqualified deferred compensation arrangement provided for the transfer of assets in connection with such an event. Employers may not deduct “gross ups” intended to cover penalties incurred by prohibited funding of nonqualified arrangements.
Multiemployer Plans
The act establishes new rules for multiemployer plans, with special funding requirements for plans that are deemed to be in endangered or critical status.
All multiemployer plans will be affected by new amortization rules, which reduce the amortization period to 15 years for past service liabilities and gains and losses resulting from changes to actuarial assumptions. But, amounts for which amortization had begun before the effective date will continue to be amortized under the old amortization rules.
A plan takes on endangered status for the year if it is less than 80 percent funded, if it has an accumulated funding deficiency or if it is expected to have an accumulated funding deficiency during any of the six succeeding plan years. Plans in endangered status must establish a 10-year funding improvement plan, which generally must achieve a one-third improvement in funding status and avoid an accumulated funding deficiency during the improvement period. Plans less than 70 percent funded and those 70 percent to 80 percent funded may meet alternative funding improvement benchmarks if they cannot achieve the one-third funding improvement requirement.
A plan will be considered in critical status if it fails one of a series of funding-based tests. Plans in critical status must adopt a rehabilitation plan designed to exit critical status, or to forestall insolvency if the plan sponsor determines that the plan will remain in critical status.
The new multiemployer rules will take effect for plan years beginning in 2008. They will sunset on December 31, 2014, but any funding improvement or rehabilitation plans already in place on the sunset date will remain in effect.
Disclosure
For plan years beginning in 2008, the act establishes new disclosure rules and amends some existing ones. All single-employer and multiemployer plans must provide annual funding notices to plan participants and beneficiaries, contributing employers, labor unions and the PBGC. The notice must disclose plan assets and liabilities for the year, the plan’s funding policy, asset allocations and other information. It is due within 120 days after the plan year ends.
Single-employer and multiemployer plans must include more information in their annual reports and on Schedule B. For example, the plan actuary must explain the actuarial assumptions used to project future retirements and asset allocations. Multiemployer plans must identify the number of contributing plan sponsors and the number of participants who no longer have a contributing employer.
Currently, plans that are underfunded by $50 million or more must file a notice with the PBGC under ERISA section 4010. Under the act, plan sponsors (and members of their controlled groups) whose plans are less than 80 percent funded must file the notice.
Hybrid Pension Plans
The legal uncertainty surrounding hybrid plans has beleaguered plan sponsors and the defined benefit system for several years. The act tries to untangle some of the ambiguity. A hybrid plan does not violate age discrimination law as long as the accrued benefit of any worker is at least equal to the accrued benefit of a similarly situated younger worker. The clarification takes effect for periods after June 29, 2005.
Hybrid pension plans must vest participants after three years of service and are subject to interest crediting requirements. Conversions of traditional plans to hybrid plans are subject to new requirements that ban wear-away. So, in a conversion, participants must receive the benefits they accrued before the conversion, plus the amount they accrue under the hybrid plan. The new law prohibits wear-away of normal or early retirement benefits.
The bill also provides whipsaw relief. Cash balance plans may pay lump sums equal to their account balances as long as the interest crediting rate does not exceed a market rate of return.
Defined Contribution Plans
Several provisions affect defined contribution plans. Key provisions extend retirement savings provisions enacted in 2001, encourage automatic enrollment in 401(k) plans, and aim to improve the investment advice and retirement education employees receive.
The Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA) increased benefit and compensation limits, allowed catch-up contributions, authorized Roth 401(k) plans, created a tax credit to encourage low- and moderate-income taxpayers to save for retirement and made many other changes. But the act was scheduled to expire after December 31, 2010. The PPA makes the pension and retirement savings provisions permanent.
To encourage automatic enrollment, the act preempts certain state laws that may interfere with such arrangements. The preemption will apply after President Bush signs the act. It also directs the Secretary of Labor to issue regulations governing the investment of 401(k) deferrals when an employee fails to make investment elections.
Beginning in 2008, the act creates a new safe harbor for employers that adopt certain automatic enrollment arrangements. To meet the safe harbor, an employer must automatically enroll new employees in the plan at a deferral rate of at least 3 percent of compensation, unless the participant declines to participate or chooses another deferral percentage. Some existing employees must also be enrolled in the arrangement. The employer must increase participants’ deferral percentage by at least 1 percentage point annually up to 6 percent of compensation, and the employer may continue increasing the deferral percentage up to 10 percent of compensation. The employer must match 100 percent of the first 1 percent of the employee’s compensation, then 50 percent up to 6 percent of compensation. Alternatively, employers may provide a nonelective contribution of 3 percent of compensation. Employer contributions must vest after two years of service.
The act also includes retirement education and investment advice provisions. Employers may now hire so-called fiduciary advisers to provide investment advice to plan participants. Fiduciary advisers may provide specific advice to plan participants, including investment options in which the fiduciary adviser has an interest, as long as certain conditions are met. Either the adviser’s compensation must not be affected by investment transactions, or the advice must be provided under a computer model that meets specific requirements and has been reviewed by an independent auditor.
Next Steps and Action Items
The act includes many more provisions affecting defined benefit, defined contribution and health plans. Now, the act goes to the White House for President Bush’s signature, which is expected soon.
Most of the funding reform provisions take effect for plan years beginning on January 1, 2008, so plan sponsors have some time to get ready for implementation (although some provisions take effect sooner). But, the new rules are long and complex, and their effects will vary considerably. And, actions plan sponsors take in 2006 and 2007 could significantly affect the transition to the new rules, so plan sponsors should begin preparing as soon as possible.
August 2006
|
Back
Issues 
