The IRS recently released proposed regulations on benefit restrictions soon to be imposed on certain underfunded pension plans (and on those deemed to be underfunded by the new rules). The regulations address credit balances, limitations on benefits and accelerated payouts, and the certification of funded status under the Pension Protection Act of 2006 (PPA). These restrictions generally will not affect most calendar-year plans until April 1, 2008,1 but many plan sponsors and their actuaries will need to act relatively quickly to avoid them.
Under the PPA, a plan that is less than 60 percent funded generally must freeze benefits and stop paying accelerated payments. A plan whose funding level is between 60 percent and 80 percent may continue accruing benefits, but may pay only partial lump sums and may not increase benefits without funding the benefit improvement first. The specific limitations are discussed in more detail later in this article.
Certifications, Assumptions and Timing
The PPAís restrictions and limitations are based on the planís adjusted funding target attainment percentage (AFTAP) for the plan year as certified by an enrolled actuary based on participant data, plan provisions and plan assets as of the beginning of the year. Because the actuary cannot certify the AFTAP until after the first day of the plan year, certain assumptions will be derived from the previous yearís AFTAP. These assumptions will determine whether the plan will be subject to one or more benefit limitations until the actuary certifies the current yearís AFTAP.
If a planís AFTAP is less than 90 percent in one year, its AFTAP will be assumed to drop 10 percentage points the next year unless the actuary certifies a different AFTAP by April 1.
For all calendar-year plans, if the actuary does not certify a specific AFTAP by October 1, the AFTAP is assumed to be less than 60 percent, in which case the plan must freeze accruals and may not pay lump sums or contingent-event benefits.
Although the actuary must always certify a specific AFTAP by the tenth month of the plan year to avoid full application of the restrictions, he or she may certify a percentage range to meet earlier certification deadlines. The permissible ranges are: (1) at least 60 percent but less than 80 percent, (2) 80 percent or higher or (3) 100 percent or higher.
Funding Levels, Credit Balances and Limitations
To calculate a planís AFTAP, the credit balance is subtracted from the value of plan assets, and the result is divided by the funding target. For 2007, if the AFTAP before subtracting the credit balance is at least 90 percent, the credit balance need not be subtracted. This percentage will rise to 92 for 2008, 94 for 2009, 96 for 2010 and 100 percent for 2011 and later.
Having to subtract the credit balance can make a crucial difference. For example, a plan whose AFTAP is 89 percent and whose credit balance represents 10 percent of its assets would have a net AFTAP of only 79 percent. Whereas if the same plan had an AFTAP of 90 percent, its net AFTAP would remain 90 percent.
Table 1 below briefly summarizes the cutoffs and applicable restrictions.
AFTAP Cutoffs and Associated Restrictions
||None, unless sponsor is in bankruptcy
||Plan cannot pay lump sum distributions or other accelerated forms of payment in excess of the lesser of 50% of the present value of the participantís benefit or the present value of the maximum PBGC guaranteed benefit.
Plans cannot be amended to increase benefits unless the sponsor contributes an amount equal to the increase in the target liability or as necessary to increase the AFTAP
to 80%, whichever is less.
||Plan cannot make lump sum distributions and no further
benefit accruals are allowed. Further, no shutdown benefits may be paid
unless the sponsor contributes the associated increase in plan
Source: Watson Wyatt Worlwide
Most sponsors are particularly concerned about the new restrictions on accelerated benefit payments. While these are typically lump sum payments, they may be any form of benefit that pays benefits faster than a straight-life annuity.
Generally, the 2007 AFTAP will determine the time frame for 2008 actuarial certifications.
- If the planís 2007 AFTAP is 90 percent or higher, the actuary must certify a specific AFTAP for the 2008 plan year by October 1, 2008. Otherwise, the AFTAP will be deemed to be less than 60 percent on that date, triggering all applicable benefit restrictions.
If the planís 2007 AFTAP is between 70 percent and 90 percent, the sponsor will likely want to have the 2008 AFTAP certified (either by a range or by a specific percentage) by April 1, 2008. Otherwise, the 2008 AFTAP will be deemed to be 10 percentage points less than the 2007 AFTAP on that date, making the plan subject to applicable restrictions. If the actuary certifies an estimated range of the 2008 AFTAP by April 1, 2008, he or she also must certify a specific AFTAP before October 1, 2008, or else the plan will become subject to all applicable restrictions on that date.
- If the planís 2007 AFTAP is less than 70 percent, unless the sponsor has the 2008 AFTAP certified (either by a range or by a specific percentage) by April 1, 2008, the 2008 AFTAP will be deemed to be 10 percentage points lower than the 2007 AFTAP. The plan will be subject to all of the applicable restrictions until its AFTAP is certified to be higher than 60 percent.
Calculating the 2007 AFTAP
For the 2007 AFTAP, plans must use modified versions of the 2007 current liability and actuarial value of plan assets. Plan assets must be valued within a 90 percent to 110 percent corridor of their fair market value. Both values must be increased by aggregate annuity purchases for nonhighly compensated employees during the previous two plan years unless the plan is 90 percent funded before subtracting credit balances.
Avoiding Restrictions in 2008
Plan sponsors whose modified 2007 current-liability funded status is at least 90 percent will be safe from benefit restrictions until October 1, 2008, unless the actuary certifies a 2008 AFTAP of less than 80 percent before then. If the 2008 AFTAP is 92 percent or higher without subtracting the credit balance from assets, the plan is safe from benefit restrictions for the 2008 plan year as well as for most of the 2009 plan year. Otherwise, the credit balance must be subtracted, and if the 2008 AFTAP drops below 80 percent, restrictions may apply.
Sponsors whose 2007 AFTAPs fall below 90 percent have another option for avoiding limitations, but it involves more work for them and their actuary. By certifying that the 2008 AFTAP falls within certain ranges before April 1, 2008, the plan can avoid the assumption of a 10 percentage point drop in the AFTAP for the 2008 plan year.
For example, assume a plan has a credit balance worth 10 percent of its assets and its 2007 AFTAP is 89 percent before subtracting the credit balance and 79 percent after subtracting it. Unless the actuary certifies a higher AFTAP by April 1, 2008, the AFTAP will be deemed to drop to 69 percent on that date. The only way to avoid applicable restrictions for this plan is for the actuary to certify a 2008 AFTAP higher than 80 percent, either as a specific certification or as a range certification, by April 1, 2008. Even if the sponsor forfeits its credit balance by January 1, 2008, its 2007 AFTAP could not be higher than 89 percent (rather than 79 percent), and the 10 percentage-point ďpresumedĒ reduction would still subject the sponsor to the 80 percent restrictions.
If the actuary certifies a range for the 2008 AFTAP, but the later specific 2008 AFTAP is outside the certified range and would have required the plan to have done things differently, the IRS will deem this a ďmaterial changeĒ in the planís AFTAP certification. If the difference causes the plan to violate the tax code or the plan document, it could be a potentially disqualifying event. In these cases, the sponsor would likely have to make additional contributions to bring the plan up to the initial range certified (if the subsequent AFTAP were lower) or make participants affected by the restrictions whole (if the subsequent AFTAP were higher).
Some sponsors may need to rethink their funding, investment and credit balance management strategies to avoid benefit limitations and restrictions in the future. Sponsors generally will want to achieve a consistently high enough AFTAP to avoid the benefit restrictions. They must also coordinate with their actuaries to ensure that all necessary certifications are ready in time to avoid the consequences of late certifications or material changes.
For 2008, possible options for avoiding benefit restrictions include forfeiting credit balances, making voluntary contributions or, if applicable, merging the plan with another plan in the sponsorís controlled group before December 31, 2007.
If a plan becomes subject to benefit restrictions, sponsors must notify all participants of the new restrictions within 30 days after they take effect. It is not clear whether this requirement also applies to retired participants whose benefits are unaffected by the benefit restrictions.
Comments are due by November 29, 2007. The IRS is likely to hold a public hearing on the proposed regulations, so they are not likely to be finalized before April 1, 2008. As a practical matter, this means that most sponsors will have to comply with these proposed regulations for their 2008 plan year.
The new law exempts plans that were frozen on or before September 1, 2005, from the lump sum restrictions, provided that the plan did not provide additional accruals to some or all participants.
1 For the sake of simplicity, the dates in the article apply to calendar-year plans. Restrictions on shutdown benefits and plan amendments increasing benefits may apply as early as January 1, 2008, for a calendar-year plan if the 2007 AFTAP is below the trigger thresholds or the 2007 AFTAP is not certified before December 31, 2007.