The Pension Protection Act of 2006 (PPA), which
fundamentally changed the funding of defined benefit plans, was signed into
law about three years ago. Guidance needed to interpret this new law has
trickled in over these three years.
This newsletter summarizes the recent guidance
that we have received regarding PPA as well as some potential strategies for
addressing the increased costs for the 2009 year brought about by the
adverse market conditions. Further, PPA has imposed additional requirements
with respect to defined benefit plan documents and participant notices which
will also be reviewed.
2009 Funding Requirements
PPA changed the interest rates used to determine
plan costs and limited flexibility in determining the actuarial value of
plan assets. Under PPA, interest rates used to determine a plan's funding
requirement must be a function of corporate bond interest rates, and the
actuarial value of plan assets may not be less than 90% nor more than 110%
of the market value of plan assets.
Typically, the 2008 actuarial valuation of a
defined benefit plan determined the plan's funding requirement based on
three interest rate segments (based on a 24-month average of corporate bond
rates). The corporate bond rates used to determine the segmented interest
rates steadily climbed during most of 2008. Simultaneously, many defined
benefit plan sponsors suffered in light of current economic conditions and
sought to limit their funding requirement for 2009.
One approach many practitioners consider is a
switch in the basis for determining interest rates for funding purposes to
what is known as the "yield curve." Unlike the above-mentioned segment
rates, corporate bond rates are not averaged in determining the underlying
interest rates of the yield curve. Therefore, switching to the yield curve
would allow plan sponsors to take advantage of the funding reductions
associated with the run up in the 2008 corporate bond rates.
However, PPA requires IRS approval to switch from
the segmented interest rates used in 2008 to the yield curve in 2009.
Recognizing this problem, the IRS stated in March that final regulations
will indicate that any change in the determination of interest rates used
for 2009 funding purposes will be automatically approved.
The determination of the actuarial value of plan
assets for funding purposes experienced similar issues. A typical defined
benefit plan used the market value of plan assets to determine the 2008
funding requirements. Due to the severe declines in the financial markets
during 2008, the use of the plan's market value of assets to determine 2009
funding requirements will lead to a significant cost increase.
For 2009 valuation dates, switching to an average
asset value will often result in an actuarial value of plan assets that is
110% of the market value of the assets. Once again, PPA required IRS
approval to switch from a market value of plan assets to an average asset
value. However, relief found in IRS Notice 2009-22 stated that such a change
in the determination of the actuarial value of plan assets will receive
automatic approval.
Market declines have led to increased funding
requirements in 2009 in an economic environment that requires employers to
minimize expenditures wherever possible. In light of these economic times,
defined benefit sponsors could look to take advantage of the relief that is
available in changing the basis of their funding interest rates and the
determination of the actuarial value of plan assets to help mitigate the
impact of the difficult economic conditions.
PPA Plan Amendment
PPA changes many of the rules associated with the
plan funding, plan operations and potential benefit restrictions due to a
plan's funded status. A sponsor of a defined benefit plan has been required
to operate in compliance with PPA rules but was not required to amend its
plan document until the end of the 2009 plan year. As this deadline is
rapidly approaching, below is a description of many of the issues that need
to be addressed in the PPA plan amendment.
Actuarial Assumptions
for Lump Sum Distributions
Commencing with the 2008 plan year, lump sum
distributions from defined benefit plans must be based on prevailing
corporate bond rates. However, prior to PPA, lump sum benefits were
determined based on 30-year Treasury rates. In order to ease the impact of
the change in the basis for lump sum determination, there is a transition
period from 2008 through 2011 where lump sum distributions are based on a
combination of the prevailing corporate bond and 30-year Treasury rates.
Qualified Optional Survivor
Annuity
Generally, defined benefit plans must offer plan
benefits in the form of an annuity. If a participant is married, a joint and
survivor annuity must be offered as a benefit option. Prior to PPA, a plan
was only required to offer a single form of joint and survivor annuity
(typically a joint and 50% survivor benefit). PPA requires an optional
survivor annuity form in addition to the pre-PPA requirements.
Non-Spouse Beneficiary
Rollovers
Commencing with distribution after December 31,
2006, PPA allows non-spouse beneficiaries of tax-qualified retirement plans
to roll over distributions to an IRA. This was originally a voluntary
feature that will become mandatory for distributions occurring after
December 31, 2009.
Notice and Election Period
Extended
Upon becoming eligible to receive plan benefits, a
defined benefit plan was permitted to notify plan participants of their
benefit options and elect their form of benefit up to 90 days prior to the
benefit commencement date. Commencing with plan years after December 31,
2006, PPA allows a defined benefit plan to voluntarily extend the election
period to 180 days.
Age 62 In-Service
Distributions
Commencing for plan years after December 31, 2006,
PPA allows a defined benefit plan to make distributions to participants that
have reached age 62 even if they are still employed by the plan sponsor.
Such a feature may be voluntarily elected by a defined benefit plan sponsor.
Benefit Restrictions
If a defined benefit plan's funded status falls
below 80%, the plan may be subject to a funding-based benefit restriction.
This restriction, which became effective for plan years beginning in 2008,
must be detailed in the terms of the plan document.
Normal Retirement Age
In 2007, the IRS issued regulations and subsequent
guidance regarding the definition of a reasonable normal retirement age.
These rules have particular importance because a defined benefit plan is
permitted to make a distribution to a participant who has reached the plan's
normal retirement age even though such a participant remains actively
employed.
In order to take advantage of this rule, plans
were established using a very low normal retirement age so that participants
could take out a lump sum benefit (determined based on plan defined
actuarial assumptions). Upon receipt of the lump sum, the benefit was then
rolled over to an IRA or 401(k) plan that allowed the participant to direct
how the lump sum benefit was invested.
In order to prevent such arrangements, the final
regulations and subsequent guidance basically state that, if a plan uses a
normal retirement age prior to age 65, it must be reasonably representative
of the typical retirement age for the industry in which the covered
workforce is employed.
A normal retirement age between the age of 62 and
65 is deemed to be reasonable. According to the guidance, deference is given
to a plan using a retirement age between 55 and 62 assuming it is reasonable
under the facts and circumstances. In practice, the IRS has not necessarily
been showing deference to plans using a normal retirement age between ages
55 and 62. In these cases, they have been asking for data substantiating the
plan's defined normal retirement age. Such data is very difficult to provide
for a small retirement plan that has limited data regarding the age of the
employer's typical retiree.
Generally, a defined benefit plan can be amended to comply with the 2007
normal retirement age regulations. Such an amendment must be adopted by the
later of the end of the first plan year beginning after June 30, 2008 or the
due date for filing the employer’s tax return for the employer’s taxable
year that includes the first day of the plan year beginning after June 30,
2008.
The IRS is closely scrutinizing plans that use a normal retirement age
between the ages of 55 and 62. Without obtaining a determination letter that
approves the use of such retirement age, a plan’s qualified status could be
jeopardized.
Reporting Requirements
Missed Quarterly
Contributions
Generally, the Pension Benefit Guaranty
Corporation (PBGC) must be informed whenever a minimum funding obligation is
not met. A failure to make a plan's required quarterly contribution on a
timely basis is considered to be such a failure. Historically, the PBGC
waived this requirement for a plan with less than 100 participants. However,
the PBGC eliminated this waiver for plan years commencing in 2009.
After an outcry from practitioners and plan
sponsors, the PBGC issued limited relief from the requirement that they must
be notified each time a plan sponsor fails to make a required quarterly
contribution. This relief is only provided if the plan sponsor paid the PBGC
flat rate premium in 2008 and the financial inability of the plan sponsor to
make the contribution is not the reason for the missed quarterly
contribution.
The relief also applies to plans with 25 to 99
participants. Such plans only have to inform the PBGC of their first failure
to make the required quarterly contribution on a timely basis.
Annual Funding Notice
Defined benefit plans that are covered by the
PBGC's insurance program have a new notice requirement commencing with the
2008 year. The new notice brought about by PPA is known as the Annual
Funding Notice and replaces the Summary Annual Report. The purpose of this
new notice is to provide plan participants with additional information
regarding a defined benefit plan's funded status. The new notice must
provide information regarding:
- The plan's funding policy;
- The plan's asset allocation;
- A general description of benefits eligible to be guaranteed by PBGC;
- Statement of right to obtain copy of Form 5500 on request;
- Impact of plan amendments;
- Specific information regarding the plan's funded status; and
- Summary of rules regarding a plan termination.
The notice must be provided no later than 120 days
after the end of a plan year if the plan has at least 100 participants. For
plans with less than 100 participants, the notice must be provided no later
than the date the plan sponsor files its Form 5500.
Conclusion
PPA has changed life significantly for sponsors of
defined benefit plans. There have been dramatic changes to the funding
requirements which can create burdens on plan sponsors during difficult
economic conditions. Plan sponsors need to work closely with their advisors
to ensure that appropriate funding techniques are being utilized, the plan
is timely amended and new notice requirements are being satisfied.
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