New Relief From IRS Reduces Required DB Plan Contributions for 2009, but Large Increase Looms for 2010

The IRS is allowing defined benefit (DB) plans to use a reasonable interpretation in selecting a yield curve for determining a plan’s liabilities for funding purposes. The guidance, which appeared in a March 31, 2009, special edition of Employee Plans News, says that “for a calendar year plan with a January 1, 2009 valuation date, the IRS will not challenge the use of the monthly yield curve for January 2009, or any one of the four months immediately preceding January 2009.”

Interest rates play an integral role in valuing a plan’s liabilities, with higher rates resulting in lower liability values. The IRS guidance, combined with the changes to asset valuation methods and other relief enacted by the Worker, Retiree, and Employer Recovery Act (WRERA), will significantly ameliorate the impact of last year’s market decline on 2009 required contributions, as plan sponsors likely change both asset and liability valuation methods. Unless capital markets recover substantially, however, required contributions for 2010 are projected to shoot up dramatically.

The highest IRS composite corporate bond rate (as proxy for the full yield curve) was 7.72 percent for November 2008, which is the applicable month that generates the lowest value of liabilities. We estimate the impact of applying this most favorable rate, instead of a bond rate of 6.64 percent (as a proxy for the full yield curve) for December 2008, to determine funding obligations for 2009.¹

For the 2009 plan year and onward, we consider two “types” of elections for asset and liability valuations: uniform and mixed. Uniform elections are when DB plans elect either a full smoothing or a full mark-to-market approach for both assets and liabilities. Mixed elections are any combination of valuation methods. Smoothed asset value combined with mark-to-market liabilities would generate the lowest contribution for 2009. Under current rules, however, sponsors cannot change valuation elections after the 2009 plan year without permission from the IRS, so this mix may not be the best long-term choice for many plans. On the other hand, the IRS might give plan sponsors another opportunity to switch valuation methods after this financial turmoil has settled down. Moreover, the credit crunch and lack of cash may compel some plan sponsors to use the mixed election.

Figure 1 reports the simulated results for funding ratios and required and other contributions under WRERA, assuming uniform or mixed election, as well as the additional relief given by the IRS. These projections are based on a Watson Wyatt model used in an earlier analysis.² The model uses 2006 initial funded status, 2008 asset allocations, market conditions as of Dec. 31, 2008, and projections under the “back to normal” economic assumptions (see appendix).

Under WRERA plus mixed elections (scenario 2 in Figure 1), the estimated funded status is around 83 percent on average for both 2009 and 2010. The minimum required contributions in aggregate are about $78 billion and $96 billion for 2009 and 2010, respectively. These funding obligations more than double the pre-crisis $38 billion contribution in 2008. To avoid benefit restrictions associated with the 80 percent funded threshold, some plans on the verge would need to contribute almost another $4 billion in 2009.

Figure 1
Projected impact of WRERA and IRS relief on plan funding

Notes: Contributions are the minimum required by law. Extra contributions by certain plans are to avoid benefit restrictions at the 80 percent funded status level.

Source: Watson Wyatt estimates.

In scenario 3, mixed elections plus the application of the November 2008 spot yield rate, the average funded level for DB plans is expected to be roughly 93 percent for the 2009 plan year. DB plan sponsors will be required to contribute about $36 billion in aggregate, plus another $1 billion or so for some plans to avoid benefit restrictions. For the 2010 plan year, however, the funding ratio is expected to drop to roughly 80 percent on average, and required contributions to jump to more than $108 billion. To avoid lump-sum payment restrictions, some sponsors will need to contribute another $6.5 billion in 2010. Note that we have assumed here that there are no changes in valuation methods in 2010.

According to these results, using the applicable month rule plus the WRERA relief allows plan sponsors to postpone a large part of their funding obligations by one year. However, the 2010 obligations become even larger — almost triple the 2008 obligations. Thus, absent a remarkable market rebound in 2009, funding obligations for the 2010 plan year will be sizable, and further relief may be needed. Also, using the applicable month rule might lock plan sponsors into using the spot yield curve, unless the IRS gives automatic permission to elect smoothed interest rates in 2010. The spot yield curve may result in more volatility than some plan sponsors find desirable when combined with smoothed asset valuations.

The model assumes that all plans are calendar-year plans and thus does not reflect the ongoing 2009 funding challenges for many non-calendar-year plans, which are not helped by the applicable month rule. As reported in Figure 2, about 14 percent of DB plans have fiscal years that end before November — the most favorable yield curve is therefore not applicable. Required 2009 contributions for these non-calendar-year plans may be considerably larger compared with 2008.

Figure 2
Distribution of DB plan years by ending month

Source: Watson Wyatt tabulation based on 2006 Form 5500 data.

Appendix: Assumptions
As shown in Figure A-1, we assume that market interest rates, including the yield curve, will gradually recover to end-of-2007 levels by year-end 2010. We also assume that equity and bond assets will produce modest annual returns of 7.9 and 5.3 percent, respectively — neither a full recovery of asset values nor a further decline, as we have experienced so far in 2009.

Figure A-1
“Back to normal” economic assumptions, end of calendar years

Notes:
Asset returns for 2008 are based on equity and bond indexes as of Dec. 31, 2008. Annual equity and bond returns for 2009 and 2010 are based on Watson Wyatt Investment Consulting forward-looking (October 2008) assumptions. Monthly returns are log-linearly interpolated.

Source: IRS data and Watson Wyatt Worldwide assumptions.

¹ See Figure A-1 in the appendix for other assumptions about interest rates and asset returns.
² For more information about the model, see “The Future of DB Plan Funding Under PPA, Recovery Act and Relief Proposals,” Watson Wyatt Insider, January 2009.