Chapters 14 and 15: funding defined benefit plans

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Chapters 14 and 15 funding defined benefit plans

• Last updated 11/6/04

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Problems in using the current market values of
securities

• Market values will generally be relatively high
  in periods of high corporate earnings
• thereby reducing the apparent need for
  contributions (and also the tax deductible
  limits)
• at times when the employer may be best able to
  make large contributions toward the pension fund
  
• Measuring a plan's unfunded liabilities on any
  given date by the current market values of the
  fund's equities could produce a very irregular
  funding pattern
• the antithesis of the orderly procedure, which is
  an essential characteristic of a satisfactory
  pension funding program.

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Actuarial valuation of assets

• The value of a plan's assets must be determined
  by a reasonable actuarial valuation method that
  takes into account fair market value
• Generally, the Internal Revenue Service has taken
  the position that this condition is satisfied if
  the asset valuation method generates an asset
  value which is within 20 of the fair market value

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Actuarial cost method

• Technique for establishing the amounts and
  incidence of the normal costs and supplemental
  costs pertaining to the benefits of a pension
  plan

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Advance funding can provide a buffer during
periods of financial stress

• During a period of low earnings or operating
  losses, an employer may find it advisable to
  reduce or eliminate pension contributions for a
  year or even a longer period
• This can be done in those cases where the
  pension fund is of sufficient size that a
  temporary reduction of contributions does not
  violate the minimum funding requirements imposed
  by ERISA
• This financing flexibility does not necessitate
  any reduction in or termination of pension
  benefits
• unlike defined contribution plans

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Choice of an actuarial cost method and the
ultimate cost of a pension plan

• Having different actuarial cost methods to
  accumulate annual pension costs is analogous to
  having different methods for determining the
  annual amount of depreciation of plant and
  equipment charged against operations
• Similarly, the various actuarial cost methods
  will produce different levels of annual cost, but
  the choice of a particular actuarial cost method
  will not affect the ultimate cost of the plan
• However, if an actuarial cost method is chosen
  that produces higher initial contributions than
  other methods, the asset accumulation will be
  greater in the early years of the plan
• thereby producing greater investment income

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Normal cost and supplemental cost

• The normal cost of a plan is the amount of annual
  cost, determined in accordance with a particular
  actuarial cost method, attributable to the given
  year of the plan's operation.
• If the normal cost under the particular cost
  method is calculated on the assumption that
  annual costs have been paid or accrued from the
  earliest date of credited service (when in fact
  they have not), the plan starts out with a
  supplemental liability.
• At the inception of the plan, the supplemental
  liability arises from the fact that credit for
  past service is granted, or part of the total
  benefit is imputed, to years prior to the
  inception of this plan.
• The supplemental cost is the portion of the
  annual cost that is applied toward the reduction
  of a plan's supplemental liability.

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amortization periods for single employer plans
that are not underfunded

• For plans in existence on January 1, 1974, the
  maximum amortization period for supplemental
  liability is 40 years
• for single employer plans established after
  January 1, 1974, the maximum amortization period
  is 30 years.
• experience gains and losses for single employer
  plans must be amortized over a five-year period.
• Changes in supplemental liabilities associated
  with changes in actuarial assumptions must be
  amortized over a period not longer than ten
  years.

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variances from the minimum funding requirements

• the secretary of labor may extend, for a period
  of up to ten years, the amortization period for
  supplemental liabilities and experience losses
  for both single employer and multiemployer plans.
• In those circumstances where an employer would
  incur temporary substantial business hardships
  and if strict enforcement of the minimum funding
  standards would adversely affect plan
  participants, the secretary of the treasury may
  waive for a particular year payment of all or a
  part of a plan's normal cost and the additional
  liabilities to be funded during that year.
• The law provides that no more than three waivers
  may be granted a plan within a consecutive
  15-year period the amount waived, plus interest,
  must be amortized not less rapidly than ratably
  over five years.

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exemptions from the mandated minimum funding
standards

• Government and church plans unless they elect to
  comply
• Fully insured pension plans funded exclusively
  through individual or group permanent insurance
  contracts, provided all premiums are paid when
  due and no policy loans are allowed
• Plans that are designed to provide deferred
  compensation to highly compensated employees,
  plans that provide supplemental benefits on an
  unfunded, nonqualified basis and those plans to
  which the employer does not contribute.

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funding standard account

• All pension plans subject to the minimum funding
  requirements must establish a funding standard
  account'' that provides a comparison between
  actual contributions and those required under the
  minimum funding requirements.
• The funding standard account is charged, each
  plan year, for
• the normal cost for the year
• the minimum required amortization payment of
  initial supplemental liabilities, increase in
  plan liabilities, experience losses and
  previously waived contributions.
• an interest adjustment recognizing the period
  between the time each charge is incurred and the
  end of the year.
• The funding standard account is credited in each
  plan year for
• the employer contributions
• the amortized portions of experience gains and
  any decrease in plan liabilities
• amounts for any waived contributions for that
  year.
• an interest adjustment reflecting the period
  between the time the contribution or payment is
  credited and the end of the year.

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impact of (a) a positive balance and (b) a
negative balance for the funding standard account
at the end of the year

• If the funding standard account has a positive
  balance at the end of the year, such balance will
  be credited with interest in future years.
  Therefore, the need for future contributions to
  meet the minimum funding standards will be
  reduced to the extent of the positive balance
  plus the interest credit.
• If the funding standard account shows a deficit
  (negative) balance (called the accumulated
  funding deficiency), the account will be charged
  with interest at the rate used to determine plan
  costs. Moreover, the plan will be subject to an
  excise tax of 5 of the accumulated funding
  deficiency. In addition to the excise tax, the
  employer may be subjected to civil action in the
  courts for failure to meet the minimum funding
  standards.

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plans subject to the additional minimum funding
requirements established by the Omnibus Budget
Reconciliation Act of 1987

• The additional minimum funding requirements apply
  to plans covering more than 100 participants and
  that are not at least 100 funded for current
  liabilities.
• the current liability is the plan's liability
  determined on a plan termination basis.
• the unfunded liability is calculated by
  subtracting the actuarial value of assets any
  credit balance in the funding standard account
  must first be subtracted from the actuarial value
  of assets.

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Deficit reduction contribution.

• The deficit reduction contribution is equal to
  the sum of the unfunded old liability amount and
  the unfunded new liability amount.
• The unfunded old liability amount equals an
  18-year amortization, beginning in 1989, of the
  unfunded current liability, if any, at the
  beginning of the 1988 plan year (called the
  unfunded old liability) based on the plan
  provisions in effect on October 16, 1987.
• The unfunded new liability amount equals a
  specific percentage of the unfunded new
  liability.
• The unfunded new liability equals the excess, if
  any, of the unfunded current liability over the
  unamortized portion of the unfunded old
  liability, and without regard to the liability
  for unpredictable contingent events.
• The percentage of the unfunded new liability
  recognized depends on the funded current
  liability percentage, defined as the ratio of the
  plan's actuarial value of assets, net of the
  credit balance, to its current liability.
• If this ratio is 35 or less, the percentage of
  the unfunded new liability recognized is 30. For
  every percentage point by which the funded
  current liability percentage exceeds 35, the
  percentage of unfunded new liability recognized
  declines by .25.

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Additional funding requirements for certain plans

• Additional contributions may be required under a
  special funding rule for certain single-employer
  defined benefit pension plans.
• These additional funding requirements were
  enacted in 1987 and amended in 1994 to address
  demands on the PBGC insurance system as a result
  of terminations of underfunded plans.
• Under the special funding rule, additional
  contributions are generally required if the value
  of the plan assets is less than 90 percent of the
  plans current liability.
• The value of plan assets as a percentage of
  current liability is the plans funded current
  liability percentage.
• The minimum required contribution under the
  special rule is, in general, the greater of (1)
  the amount determined under the normal funding
  rules, or (2) the deficit reduction contribution,
  plus the amount required with respect to benefits
  that are contingent on unpredictable events.
• The deficit reduction contribution is the sum of
  (1) the unfunded old liability amount, (2) the
  unfunded new liability amount, (3) the expected
  increase in current liability due to benefits
  accruing during the plan year, and (4) the amount
  needed to amortize increases in current liability
  due to certain future changes in the mortality
  table required to be used in determining current
  liability.
• The amount of additional contributions required
  under the special funding rule cannot exceed the
  amount needed to increase the plans funded
  current liability percentage to 100 percent.

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Unfunded old liability amount

• The unfunded old liability amount is the sum of
  two amounts.
• The first amount is, in general, the amount
  necessary to amortize the unfunded old liability
  under the plan in equal annual installments
  (until fully amortized) over a fixed period of 18
  plan years, beginning with the first plan year
  beginning after December 31, 1988.
• The unfunded old liability with respect to a
  plan is generally the unfunded current liability
  of the plan as of the beginning of the first plan
  year beginning after December 31, 1987,
  determined without regard to any plan amendment
  adopted after October 16, 1987, that increases
  plan liabilities (other than amendments adopted
  pursuant to certain collective bargaining
  agreements).
• The second amount is, in general, the amount
  needed to amortize the additional old unfunded
  liability over a period of 12 years, beginning
  with the first plan year beginning after December
  31, 1994.
• The additional old unfunded liability is the
  increase in the unfunded old liability resulting
  from statutory changes made in the interest rate
  and mortality assumptions used to determine
  current liability for plan years beginning after
  December 31, 1994.

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Unfunded new liability amount

• The unfunded new liability amount for a plan year
  is the applicable percentage of the plans
  unfunded new liability.
• Unfunded new liability means the unfunded
  current liability of the plan for the plan year,
  determined without regard to (1) the unamortized
  portion of the unfunded old liability amount, any
  unfunded mortality increases, and certain
  unfunded liabilities under a collectively
  bargained plan, and (2) the liability with
  respect to any unpredictable contingent event
  benefits, without regard to whether or not the
  event has occurred.
• Thus, in calculating the unfunded new liability,
  all unpredictable contingent event benefits are
  disregarded, even if the event on which that
  benefit is contingent has occurred.
• If the funded current liability percentage is
  less than 60 percent, then the applicable
  percentage is 30 percent.
• The applicable percentage decreases by .40 of one
  percentage point for each percentage point by
  which the plans funded current liability
  percentage exceeds 60 percent.

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Unpredictable contingent event benefits

• The value of any unpredictable contingent event
  benefit is not considered until the event has
  occurred.
• In the case of a plan that is subject to the
  additional funding requirements, if the event on
  which an unpredictable contingent event benefit
  is contingent occurs during the plan year and the
  assets of the plan are less than current
  liability (calculated after the event has
  occurred), then an additional contribution (over
  and above the minimum funding contribution
  otherwise due) is required.
• Unpredictable contingent event benefits include
  benefits that depend on contingencies that, like
  facility shutdowns or reductions or contractions
  in workforce, are not reliably and reasonably
  predictable.
• The event on which an unpredictable contingent
  event benefit is contingent is generally not
  considered to have occurred until all events on
  which the benefit is contingent have occurred.

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Uceb continued

• The amount of the additional contribution is
  generally equal to the greatest of the following
  three amounts
• (1) the unfunded portion of the unpredictable
  contingent event benefits paid during the plan
  year, including (except as provided by the
  Secretary) any payment for the purchase of an
  annuity contract for a participant with respect
  to unpredictable contingent event benefits
• (2) the amount that would be determined for the
  year if the unpredictable contingent event
  benefit liabilities were amortized in equal
  annual installments over seven years, beginning
  with the plan year in which the event occurs and
  
• (3) the additional contribution that would be
  required if the unpredictable contingent event
  benefit liabilities were included in the
  calculation of the plans unfunded new liability
  for the plan year.
• In addition, the present value of the additional
  funding contribution with respect to one event is
  limited to the unpredictable contingent event
  benefit liabilities attributable to that event.

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Required interest rate

• Specific interest rate and mortality assumptions
  must be used in determining a plans current
  liability for purposes of the special funding
  rule.
• Nb this will not apply for the general
  calculation
• The interest rate used to determine a plans
  current liability must be within a permissible
  range of the weighted average of the interest
  rates on 30-year Treasury securities for the
  four-year period ending on the last day before
  the plan year begins.
• The permissible range is generally from 90
  percent to 105 percent.
• The IRS publishes the applicable rate on a
  monthly basis.
• The Department of the Treasury does not currently
  issue 30-year Treasury securities.
• As of March 2002, the IRS publishes the average
  yield on the 30-year Treasury bond maturing in
  February 2031 as a substitute.

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Pension Funding Equity Act (April 2004)

• Temporarily replaces the 30-year Treasury bond
  interest rate with a higher composite corporate
  bond rate as the benchmark for plan funding
  calculations
• Also provide airlines and steel manufacturers
  relief from contributions required of underfunded
  plans
• Allows them to select an alternative drc, see
  Announcement 2004-38 for more details

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Limits on tax-deductible contributions to trust
fund plans

• permits the employer to deduct the normal cost of
  the plan plus the amount necessary to amortize
  any past service or other supplementary pension
  or annuity credits in equal annual installments
  over a 10-year period.
• the maximum tax-deductible limit cannot exceed
  the amount needed to bring the plan to its full
  funding limit.
• defined as the lesser of 100 percent of the
  plan's actuarial accrued liability (including
  normal cost)
• Obra 87 added a new funding constraint for most
  overfunded plans (150 percent of the plan's
  current liability, reduced by the lesser of the
  market value of plan assets or their actuarial
  value)
• This has recently been repealed for plan years
  beginning in 2004 and thereafter.
• the maximum tax deductible limit will never be
  less than the amount necessary to satisfy the
  Code's minimum funding standards.