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Due to the convergence of low interest rates and reduced asset values, sponsors of single-employer defined benefit pension plans (DB plans) face enormous funding challenges. (1) Plans that had been reasonably well funded and required little or no new contribution dollars now represent significant burdens to the income statements, balance sheets, and cash flows of the employers that sponsor DB plans. This article explores the available methods of managing contributions to DB plans as well as the responsibilities and penalties for failure to fund DP plans properly. As this article is written, Congress is debating methods of providing relief to DB plans, the most likely of which would be an upward adjustment in the interest rates by which the present value of plan liabilities are calculated. The contemplated legislation, if adopted, would reduce the contribution requirements generally but would not eliminate the challenges faced by DB plans.
At its essence, a DB plan is an identifiable promise to pay a determinable sum at retirement. (2) The Employee Retirement Income Security Act of 1974 (ERISA) is the direct consequence of DB plan failures to pay benefits when the sponsoring employers became bankrupt. In addition to certain qualification and operating requirements, ERISA required DB plans to be funded in a third-party trust beyond the claims of creditors of the plan sponsor, set actuarial methodologies for determining the plan sponsor's periodic contribution obligations to that third party trust, and required the payment of insurance premiums to the Pension Benefit Guaranty Corporation (PBGC) to insure against DB plan failures to pay benefits in defined circumstances.
ERISA added Section 412 to the Internal Revenue Code (3) (IRC) to set the parameters for determining the amount that must be contributed to a DB plan from time to time. The prime building block for determining funding requirements is the funding standard account that operates like a ledger to be balanced each year. Very generally, the annual debits to this ledger are the annual cost (benefit accruals and expenses) of the plan promise and amortization of any previously accrued but unpaid costs (generally, amortization of past service liabilities and previously waived funding deficiencies), and the annual credits to the ledger consist of actual or constructive contributions, the amount of any funding deficiency waived for that year and recognition of decreases in previous obligations. These debits and credits are the product of actuarial calculation that take into account not only factors unique to the particular plan but also general factors. Examples of the factors unique to a particular plan are the benefit promise of the plan, the then value of the assets in the third party trust and the age, service, and compensation levels of the plan's participants. Examples of the general factors include the prevailing investment and interest rate markets, particularly the rate of return on Treasury securities, and mortality factors prescribed by the Secretary of the Treasury.
The core obligation under IRC Section 412 is to avoid an accumulated funding deficiency, which is defined as a negative balance in the funding standard account as at the end of a plan year. The balancing is done on a snapshot basis annually under IRC Section 412(c)(9). In order to avoid an accumulated funding deficiency, credits permitted under IRC Section 412(b)(3) must be generated to equal the debits that must be taken into account under IRC Section 412(b)(2). The most typical credits are cash contributions. The amount of a waived funding deficiency and the amount representing amortization, however, experience gains, separately--gains due to changes in plan provisions and gains due to changes in actuarial methods which are treated as cash contributions for funding purposes. Debits include the normal cost of the plan for the year and the amount necessary to amortize, separately, past service liabilities, experience losses, and prior waived funding deficiencies.
CONSIDERATIONS BEFORE SEEKING STATUTORY RELIEF
Internal Revenue Code restrictions must be taken into evaluated when employers are considering changes to actuarial methods or accrual rates.
Changes in Actuarial Methods
A great deal of administrative guidance sets the rules for choosing or changing actuarial funding methods and assumptions for DB plans under IRC Section 412(c)(5). The range of choices of funding methods and assumptions for a particular DB plan is dependent upon the choices made in prior years and, therefore, the choices available for any particular plan are unique to that plan. As such, it is not possible to describe each possible nuance.
Some changes in actuarial methods or assumptions can moderate DB plan contribution obligations in the short term. In light of the prerequisites for statutory relief, it is arguably necessary for a plan to explore these moderating effects. A plan that has not explored more common means to alleviate a contribution obligation may have less credibility when applying for a funding waiver or an extension of amortization periods.
Under IRC Section 412(c)(5), changes in actuarial methods require Internal Revenue Service (IRS) approval but the IRS has published guidance that permits certain changes without specific application and approval if certain conditions are met. For example, a plan that uses the market value of assets could benefit from a change to the actuarial smoothing method of determining asset values. Actuarial smoothing has the effect of averaging out the investment losses experienced over recent completed calendar years, which, in turn, has the effect of reducing the associated debits to the funding standard account. A plan can elect the actuarial smoothing method without IRS approval if there had been no change in the method of determining asset values for the five previous plan years. Conversely, the plan will need IRS approval to snap …