Blogging Employee Benefits

August 3, 2006

PPA: “At-Risk” Plans

Filed under: Legislation, Pensions — Fuguerre @ 6:08 am

For a plan sponsor that is financially weak, the funding target generally is the plan’s at-risk liability. – Administration’s Pension Reform Proposal, Strengthen Funding for Single-Employer Pension Plans 2/7/2005, pg. 14

The Pension Protection Act of 2006 (H.R. 4), as passed last Friday by the House and awaiting possible Senate action this week, includes special rules for a single-employer defined benefit pension plan that is characterized as being “at-risk.” The Administration failed to have at-risk status depend in part on financial weakness of the plan’s sponsor, as had been approved by the Senate in last year’s S. 1783, but much of the remaining at-risk rules in the Administrations funding reform proposal (e.g., see page 16 of the document cited at the head of this post) survived to the compromise version of the legislation. An at-risk pension plan faces accelerated funding requirements, persisting for as much as 6 years following emergence from at-risk status. In addition, restrictions are placed on nonqualified deferred compensation programs maintained by an employer that sponsors an at-risk pension plan.

Determination of At-Risk Status. A single-employer defined benefit pension plan that is subject to ERISA’s minimum funding standards is at-risk for a plan year if all three of the following conditions are present:

  1. Ineligible for Small Plan Exception – The plan has more than 500 participants on one or more days of the preceding plan year. For this rule, all defined benefit plans (not including multiemployer plans) of the employer’s controlled group are considered a single plan, but only participants of the employer are counted.
  2. 80% At-Risk Test – The plan’s funded status for the preceding plan year, determined on the basis of otherwise applicable actuarial assumptions, is less than 80% (phased in over 4 years as described in the next paragaph of this post); and
  3. 70% At-Risk Test – The plan’s funded status for the preceding plan year, determined on the basis of at-risk actuarial assumptions, is less than 70% (not phased in).

[ERISA §303(i), added by PPA §102(a); IRC §430(i), added by PPA §112(a)] All three conditions must be present, or else the plan is not at-risk. For example, if the funded status of a plan with 1000 participants under usual assumptions was below 80%, but the funded status under at-risk assumptions is over 70% because few employees will retire in the near-term with signficant subsidized early retirement benefits, then the plan will not be at-risk. Thus, if the plan’s funded status does not fall below the 80% at-risk test’s threshold, then a second actuarial valuation using the at-risk assumptions for the 70% at-risk test is unnecessary.

Phase-In of 80% At-Risk Condition. The 80% condition is phased in during the first 4 years of PPA application: 65% for 2008 (compared with the funded status for 2007, estimated using methods to be provided by IRS regulations); 70% for 2009 (compared with the funded status for 2008); 75% for 2010 (compared with the funded status for 2009); and 80% thereafter (et cetera). Since the 70% condition based on at-risk assumptions is not phased in, and since the effect of the at-risk assumptions would increase the value of the plan’s liabilities, one practical effect of the phase-in of the 80% condition will be to make the at-risk determination dependent solely on the 80% at-risk test for 2008 and 2009.

The Credit Balance Connection. To determine if a plan is at-risk, the plan’s funded status is determined using the value of plan assets after reduction for the plan’s credit balance (or, in PPA’s framework, the plan’s “carryover balance” and “prefunding balance”). The at-risk determination includes no exception for a plan that has a funded status in excess of 100% without reduction of plan assets by the credit balance. So a plan could have had assets in excess of all plan liabilities for the prior plan year, thereby at that time posing absolutely no risk to the PBGC nor to any plan participant; yet if reduction of the plan assets by the plan’s credit balance would have caused the plan’s funded status to fall beneath both of the funded status at-risk thresholds, then the plan would be considered at-risk.

The practical solution out of this crazy predicament is for the plan sponsor to make an election under new IRC §430(f)(5) to reduce the credit balance, thereby gaining recognition of the existing assets sufficiently to avoid at-risk characterization. Since such an election must be made at the beginning of a plan year, the employer with pension plan credit balances on hand would need to check the situation out in advance of the beginning of the plan year prior to the year threatened with at-risk characterization. For example, for a plan with a calendar plan year, the first decision point comes at the 1/1/2007 valuation, which will determine at-risk status for the 2008 plan year. As noted above, only the first of the two funded status conditions will be of practical effect, and the phased-in threshold under that rule will be 70%. Say that the plan’s present value of benefits under PPA’s usual assumptions (estimated under IRS rules hopefully – but unlikely – published by 12/31/2006, since we won’t actually have PPA assumptions such as the 3-segment yield curve by then) as of 1/1/2007 would be $100 million and the value of plan assets is $90 million; but say the plan has a credit balance on 1/1/2007 equal to $25 million. Reducing the plan assets by the credit balance produces a funded status of 65%, threatening failure of the at-risk test, which would characterize the plan as at-risk for the 2008 plan year. If the employer instead elects to reduce the credit balance by $5 million, then the 1/1/2007 funded status would be 70%, satisfying the at-risk threshold, thereby avoiding at-risk characterization for the 2008 plan year. Such election would need to be made before actually completing the relevant actuarial valuation. In the case of the first decision point for the 2007 valuation, one practical problem might be that elections to reduce credit balances are to be made as prescribed by IRS regulations, which may not yet have been published by the time that first decision needs to be made. And of course, when the credit balance has been reduced via IRC §430(f)(5), the forfeited credit balance can no longer be applied against minimum required contributions.

At-Risk Actuarial Assumptions. In addition to otherwise applicable PPA actuarial assumptions (e.g., the 3-segment yield curve), an at-risk actuarial valuation must include the assumption that all plan participants who are not already assumed to retire within the current plan year, but who are eligible to retire during the plan year being valued and the succeeding 10 plan years, will retire at the earliest retirement age under the plan terms, but not before the end of the plan year of the determination. For example, consider a plan that is at-risk for 2008 (as noted above, the second of the two funded status at-risk conditions, which would itself rely on an at-risk valuation, will not need to be completed in 2007 for the initial test; but if the plan does fail the 2007 test under the first of the two funded status conditions, then it will be at-risk for 2008, thus will need a 2008 at-risk determination for purposes of additional required contributions). In our example, have the plan’s terms permit early retirement at age 55 and that the plan’s actuary usually assumes a retirement age of 62 for the usual actuarial valuation. Any employee age 62 or over in 2008 would already be assumed to retire in 2008 under the actuary’s retirement age assumption; and any employee age 61 in 2008 would be assumed to retire in 2009 under either the actuary’s own assumption or the at-risk assumption. The at-risk valuation would accelerate the retirement age assumption for any employee age 52-60 in 2008: all employees age 54 through 60 would be assumed to retire in 2009; and all employees age 52 and 53 would be assumed to retire during the year they would reach age 55, the earliest retirement age under the plan.

At each employee’s assumed retirement, the employee is then assumed to elect the retirement benefit available under the plan that would result in the highest present value of benefits.

At-Risk Actuarial Values. Funding Target – The at-risk actuarial assumptions are used to value the present value of acccrued benefits under the plan for purposes of – (1) The 70% at-risk condition, which in practice will only be relevant for at-risk determinations for the 2010 at-risk determination and later; and (2) For determination of the funded target used for the minimum required contribution for an at-risk plan. All other PPA rules that depend on a plan’s funded status, such as restrictions on benefits and the criteria for ERISA 4010 filing, do not depend on the at-risk funding target.

If the plan is at-risk and was also at-risk for at least 2 of the preceding 4 plan years, then for purposes of the minimum required contribution, an additional loading factor is added to the funding target, equal to 4% of the funded target measured without using at-risk actuarial assumptions, plus an additional $700 per participant. For the minimum required contribution, the difference between the full at-risk funding target and the usual funding target is then phased in over a period of 5 consecutive years of at-risk status, including the current plan year, but excluding any year before 2008. For example, if the plan was not at-risk the preceding plan year, then 20% of the difference between the full at-risk funding target and the usual funding target is recognized; if the plan was at-risk the preceding plan year but not the plan year before that, then 40% of the difference is recognized; et cetera. If the plan had been at-risk, but then has at least one plan year during which it was not at-risk, then this 5-year phase-in starts again from 20% if the plan subsequently reenters at-risk status in a subsequent plan year. The at-risk funding target, with the additional load if applicable, then phased in as applicable, is then used to determine the shortfall amortization charge for the at-risk plan year, to be amortized over the next 7 plan years beginning with that plan year. The resulting higher amortization charge continues to be a factor in the required contribution for that full 7-year period, even if the plan subsequently emerges from at-risk status during the period.

Normal Cost – For purposes of the minimum contribution for a plan year in which the plan is at-risk, the normal cost is determined using the at-risk actuarial assumptions. In addition, if the at-risk for at least 2 of the preceding 4 plan years, then a loading factor is added to the normal cost, equal to 4% of the normal cost measured without using the at-risk assumptions. Similar to the at-risk funding target, the difference between the full at-risk normal cost and the usual normal cost is phased in over a period of 5 consecutive years of at-risk status.

ERISA 4010 Reporting. If a plan is required to submit an ERISA 4010 filing to the PBGC, then information in the filing must include the plan’s funded target determined as if the plan had been at-risk for at least 5 years, that is – (1) Including the 4% and $700-per-participant loads; and (2) Fully phased in, as if the plan had been at-risk for at least 5 consecutive years (without excluding pre-2008 plan years or any plan years prior to plan establishment in that count). [PPA §505]

Restrictions on Funding of Nonqualified Deferred Compensation. If any single-employer defined benefit plan is in at-risk status for a plan year, then assets reserved or transferred for payment of nonqualified deferred deferred compensation for certain covered executives during that plan year are subject to harsh tax penalties. [PPA §116] Note that the lag between the application of the at-risk conditions and actual entry of a plan into at-risk status leaves a door open. For example, if a plan is not at-risk during 2011, but the 1/1/2011 actuarial valuation indicates that the plan will be at-risk for the 2012 plan year, then an asset transfer to a nonqualified deferred compensation program during 2011 would not be subject to the new PPA restrictions.

Effective Dates. The at-risk rules for single-employer pension plan funding and ERISA 4010 funding generally take effect for plan years beginning on or after January 1, 2008. As noted, however, to determine whether a plan is at-risk for the 2008 plan year, an estimate of funded status under PPA assumptions (not including the special at-risk assumptions) must be made at the beginning of the 2007 plan year. Since the special loading factors would require at-risk status in at least 2 preceding years, the earliest those loading factors would apply would be 2010.

Special delays in the funding requirement effective dates also delay the effective date of the at-risk rules. For example, an eligible government contractor plan would not be subject to the at-risk rules until 2011 (or the effective date of CAS pension harmonization rules, if earlier).

The restrictions on funding of nonqualified deferred compensation take effect immediately upon PPA enactment. However, that effective date is only relevant for separate rules that apply those restrictions upon employer bankruptcy or certain plan terminations. At-risk status of a plan becomes relevant to the nonqualified deferred compensation restrictions only after the at-risk rules themseves take effect, beginning in 2008.

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1 Comment »

  1. Deductibility of Employer Contributions. In general, the limit on deductible contributions to a single-employer defined benefit pension plan is equal to the excess of the plan’s funding target, plus the target normal cost and a cushion of 50% of the funding target, over the value of the plan’s assets. [IRC §404(o)] For an at-risk plan, as discussed in this post, the funding target would be valued using at-risk assumptions. For a plan that is not in at-risk status, the funding target, cushion, and target normal cost are valued at the at-risk assumptions, thereby raising the ceiling for deductible contributions. [IRC §404(o)(2)(B)]

    Comment by Fuguerre — August 5, 2006 @ 12:04 pm


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