In August of 2006 President
Bush signed the Pension Protection Act of 2006 (PPA) into law primarily to
address the financial security of the defined benefit plan system.
Generally, the changes to the funding requirements for defined benefit plans
brought about by this new law are effective for plan years commencing in
2008.
PPA attempts to improve the financial security of the defined benefit
system by focusing on the funding adequacy of a plan on a plan termination
basis rather than addressing the funding sufficiency at the time a
participant reaches retirement age. Generally, the pre-PPA funding
requirements intended to create a level funding of a participant’s benefit
over their working lifetimes. The PPA rules attempt to ensure that benefits
accrued to date are fully funded based on current market interest rates.
Further, as a result of PPA, a great deal of flexibility has been taken
away from the enrolled actuary. The funding method as well as the mortality
table and interest rates used to determine a plan’s minimum funding
requirement is now dictated by the Internal Revenue Code’s minimum funding
requirements.
As this article will address in detail, plans that are not adequately
funded on a plan termination basis may be subject to restrictions on benefit
accruals and distributions as well as limitations on the ability to amend
the plan to improve benefits. In addition, as described below, PPA has
significantly revised the method of calculating a participant’s lump sum
benefit.
Basic Funding Requirements
Prior to PPA, the actuary for a defined benefit plan was able to choose
from a variety of different funding methods as well as choose the
appropriate mortality table and interest rate in determining a plan’s
minimum funding requirement. PPA now mandates the single funding method as
well as the mortality table and interest rates to be used for minimum
funding purposes.
Generally, PPA’s funding method determines the minimum funding
requirement by adding the present value of the benefits accrued in the
current year by all plan participants, called the normal cost, to the
payment required to pay down the plan’s underfunding over a seven year
period called the shortfall amortization payment. The valuation liabilities,
known as the target liability, are determined by calculating the plan’s
termination liability based on current market interest rates. An
underfunding exists to the extent that plan assets are less than the target
liability.
In determining the plan liabilities for actuarial valuation purposes, the
plan’s actuary is required to use three different interest rates, known as
segment rates, that are based on investment grade corporate bond rates.
Applicable interest rates vary based on the length of time until a benefit
is payable.
The above funding requirements will be subject to transitional rules that
may eliminate the need to pay the shortfall amortization payment if the plan
assets are close to the target liability. Further, plan assets and
contribution requirements must be adjusted for the credit balance. The
credit balance, which represents the accumulation of contributions exceeding
minimum funding requirements, has become more complex under PPA. Credit
balances based on contributions prior to the effective date of PPA are
treated differently than post PPA contributions.
Basis for Limits and Restrictions
Each year a plan’s funding ratio, known as the Adjusted Funding Target
Attainment Percentage (AFTAP), must be certified by the plan actuary.
Generally, the AFTAP is determined by dividing the plan assets by the plan’s
target liability. To the extent that these liabilities fall below ratios
specified in the new law, limitations are imposed on:
- Benefit increases;
- Benefit accruals;
- Distributions in a form other than an annuity; or
- Shutdown benefits.
In determining the plan’s AFTAP, plan assets must be adjusted for certain
credit balances.
Limitation on Benefit Increases
A plan cannot be amended to increase benefits if the AFTAP is below 80%
or would be under 80% if the amendment was adopted by the plan. An employer
desiring to increase plan benefits with an AFTAP below 80% would be required
to make a contribution (or provide security) which would bring the AFTAP up
to 80%.
Plan amendments subject to this restriction include improvements to the
benefit formula as well as any other amendment increasing the value of plan
benefits, such as an improvement in the plan’s vesting schedule. The funding
based restriction on plan amendments is not applicable in the first five
years of a newly established plan.
Restrictions on Benefit Accruals
A plan is required to cease benefit accruals if the AFTAP is less than
60%. The restriction on benefit accruals will continue until the plan’s
funding ratio improves and the AFTAP exceeds 60%.
Once the AFTAP exceeds 60%, the plan document does not need to be amended
to restore lost benefit accruals if the accrual restrictions were in place
for less than 12 months. However, if the accrual restrictions were in place
for more than 12 months, an amendment will be required to restore the
benefits that were lost during the time that the AFTAP was less than 60% and
benefits were frozen. As detailed above, such an amendment restoring lost
accruals could only be executed if the AFTAP increases to more than 80%.
Once again, the funding based restriction on benefit accruals is not
applicable in the first five years of a newly established plan.
Restrictions on Benefit Distributions
If a plan’s AFTAP is less than 60%, distributions may only be made in the
form of a life annuity. Therefore, plans that permit distributions in the
form of a lump sum or installment payments would be prohibited from offering
these forms until their AFTAP reached the 60% level. Plans would be required
to provide that participants affected by this restriction have the ability
to defer payment or elect another form of payment.
If the plan’s AFTAP is between 60% and 80%, payments in a form other than
a life annuity will be restricted. Plans within this funding range may only
make payments to the extent that their value does not exceed:
- One-half of the payment that could be made absent any restrictions, or
- The present value of the maximum benefit guaranteed by the Pension
Benefit Guaranty Corporation which is currently $4,312 per month.
In other words, a plan which permits lump sum distributions would be
restricted to paying out one-half of the lump sum if the plan’s AFTAP was
between 60% and 80%. In this situation, the plan would be required to defer
payment or elect another form of payment. Although not required by law, the
plan could permit the payment of one-half of the lump sum and allow the
participant to defer payment of the remaining lump sum until such time as
there is no funding based restriction.
How is the Plan’s AFTAP Certified?
The plan’s enrolled actuary is required to certify the plan’s AFTAP in
writing. The timing of such certification is critical in determining the
applicable AFTAP. Generally, the AFTAP should be certified by the first day
of the fourth month of the plan year. If the actuary is unable to certify
the AFTAP by this deadline, the AFTAP is the prior year’s AFTAP less 10%.
For example, let’s assume that the plan year is the calendar year and the
AFTAP for 2007 was 85%. The applicable AFTAP for 2008 must be determined by
April 1, 2008. If the AFTAP is not determined by that date, as of April 1,
2008 the AFTAP becomes the 2007 AFTAP less 10% or 75%. As the AFTAP is now
less than 80%, the plan may not be amended to improve benefits, and plans
permitting lump sum distributions may only pay one-half of the lump sum
otherwise payable to a terminated participant.
Further, let’s assume that on July 1, 2008 the actuary certifies the 2008
AFTAP to be 88%. As of July 1, 2008 the above restrictions are no longer
applicable. If the actuary was able to complete the certification by April
1, 2008, these restrictions would not have been applicable at any point
during the year.
If the actuary is unable to certify the AFTAP by the first day of the
tenth month of the plan year, the AFTAP is automatically deemed to be 60%
and all of the restrictions addressed in this article will become
applicable. These restrictions will remain in place for the remainder of the
year regardless of when the actuary ultimately certifies the AFTAP.
Let’s go back to our example above. However, let’s now assume that the
actuary does not complete the AFTAP certification until October 15, 2008.
Under this scenario, the applicable AFTAP for 2008 would be as follows:
- January 1, 2008 through March 31, 2008 the AFTAP will be equal to the
2007 AFTAP which was 85%, and there would be no applicable limitations or
restrictions.
- From April 1, 2008 through September 30, 2008 the applicable AFTAP
would be 75%, which is the 2007 AFTAP less 10%.
- From October 1, 2008 through December 31, 2008 the applicable AFTAP
would be 60%.
The above highlights the importance of the timing of the actuary’s
certification of the plan’s AFTAP for a particular year. The actual AFTAP
determined by the actuary was 88% which would not have imposed any
limitations or restrictions if it was certified by April 1. However, since
the certification was not completed until October 15, the adjusted 2007
AFTAP resulted in the application of certain restrictions as of April 1 and
all restrictions and limitations as of October 1.
In order to avoid the unnecessary imposition of any restrictions or
limitations, it is imperative that the sponsor of a defined benefit plan
provide the plan actuary with the necessary census and asset information as
soon as possible so that the actuary has the opportunity to calculate the
plan’s AFTAP within the first three months of a plan year.
Lump Sum Distributions
Effective for plan years commencing in 2008, PPA has significantly
changed the interest rate and mortality table used to determine the lump sum
distribution payable to plan participants. Prior to PPA, the applicable
30-year Treasury rate was used to determine a participant’s lump sum
benefit. This rate is replaced by what PPA calls a three-segment rate
approach, which varies based on the length of time until the benefit is
payable or expected to be paid. These segment rates are based on a yield
curve using investment-grade corporate bonds, which typically carry higher
yields than treasuries and will ultimately result in lower lump sum
payments.
To mitigate the immediate impact on plan participants, the segment rates
are phased in over the next four years. During this transition period, lump
sums will be determined using a blend of the 30-year Treasury rate and the
new segment rates.
Conclusion
PPA has made dramatic changes to the funding rules and the determination
of lump sum benefits for defined benefit plans. Further guidance is
forthcoming to deal with the many nuances in the law that may impact the
application of the new rules to a specific plan.
The sponsor of a defined benefit plan needs to work closely with the
plan’s actuary to monitor the plan’s funded status in order to avoid the
imposition of unintended restrictions or limitations on the plan. To
facilitate this process, which requires the actuary to determine the funded
status on a timely basis, the plan sponsor must diligently respond to any
requests for census data and plan investment information.
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