If companies do not comply, benefit restrictions may be imposed

 

The Pension Protection Act of 2006 (PPA) requires that most companies (there are some exceptions) achieve a fully funded status for their defined benefit pension plans within seven years. To ensure progress towards full funding, milestones are included in the PPA. For example, most companies must be 92 percent funded in 2008, 94 percent in 2009, and so on. To facilitate compliance with the funding milestones, the PPA provides enhanced tax deduction limits and requires companies that fall short of a milestone to accelerate funding. Funded status is defined as the difference between plan assets and plan liabilities.

 

In addition, the PPA mandates benefit restrictions for plans that fail to meet certain funding targets. For example, if a pension plan’s funded status falls below 80 percent, the sponsor must: (i) accelerate funding, (ii) limit lump sum distributions to 50 percent of the lump sum benefit otherwise due with the remainder paid as an annuity, and (iii) not amend the plan to increase benefits. If a plan is less than 60 percent funded, it will automatically be frozen and participant benefit accruals will thereafter cease. In addition, benefit payments cannot be made in lump sum form but rather, must be paid in the form of an annuity. Due to these restrictions, companies may find it strategically valuable to contribute enough to their plans to meet the 60 percent or 80 percent thresholds in order to minimize or avoid the mandated benefit restrictions.

 

The recently passed Worker, Retiree, and Employer Recovery Act of 2008 (WRERA) allows plans to look back to the previous plan year to determine whether the 60 percent funding requirement is satisfied. This applies only to plan years beginning on or after October 1, 2008 and before October 1, 2009. For calendar-year plans this means looking back to January 1, 2008 valuations in order to avoid an otherwise mandatory benefit freeze for plans failing to meet the 60 percent funded threshold under current market conditions.

 

Pressure on Congress to Relax Rules In Light of Economic Crisis

Recently, there has been increased pressure on Congress to relax the PPA’s funding rules. Most defined benefit plans have a considerable portion of the assets allocated to equity investments, and these investments have suffered significant losses over the past year. Additionally, the combination of lower earnings and tight credit markets makes it difficult for plan sponsors to find the cash to fund ongoing normal costs let alone catch up for existing shortfalls. For many companies, meeting the 92 percent milestone may require immediate and major reallocation and/or dislocation of resources that will handicap the company for years to come, or may be simply impossible. 

 

During these unusually difficult times, companies are being challenged to balance the competing organizational needs for cash generated from operations. This was clearly expressed in a November 12, 2008 appeal sent to the House Ways and Means Committee Chairman, Congressman Charles Rangel.  One striking example in the letter describes a Florida company that contributed $673,000 to its pension plan in 2008, but, due to investment losses and the new rules, would be required to contribute $15 million in 2009. 

 

According to a report in CFO Magazine¹, the aggregate deficit of the pension plans of the S&P 1500 hit $280 billion at the end of November 2008, compared to a $60 billion surplus at the end of 2007.

 

According to another recent report in The Wall Street Journal², the average funded status of 100 of the largest plans was expected to fall to 76 percent by the end of 2008.  As noted above, if a pension plan’s funded status falls below 80 percent, in addition to the accelerated funding requirement, the company may pay only 50 percent of a lump sum distribution, with the remainder being paid as an annuity.  Furthermore, in order to comply with the 92 percent threshold of the PPA, these 100 largest corporate pension funds would require an estimated $92 billion in contributions in 2009. This amount is roughly three times the contribution amount required to meet the minimum funding requirements under the PPA in 2008 ($32 billion).

 

WRERA has not significantly addressed the pension funding concerns mentioned above. For example under PPA, missing the 94 percent funded threshold required additional contributions to fund 100 percent of the asset-to-liability shortfall over seven years. Under WRERA, 94 percent of the shortfall must be subject to funding. The 94 percent increases to 96 percent in 2010 and 100 percent in 2011.

 

Mandatory Funding Under the PPA

Determining funded status essentially requires the use of fair values for plan assets (with potential smoothing or averaging over 24 months) and the choice of a discount rate for liabilities. With respect to the latter, companies may use 24-month averages. The average rates are calculated for three time periods (“segments”): short term (0-5 years), medium term (6-20 years), and long term (over 20 years). The rates are applied to the liability segments that correspond to the expected payout of benefits. For example, the first segment is for employees who will become eligible for retirement benefits within five years.

Alternatively, companies may use spot rates, rather than the average/segment rates. Even though equity values fell dramatically through 2008, rising corporate bond yields mitigated the impact on the funded status because higher rates result in a lower present value of the liability. The use of spot rates, however, increases the unpredictability and volatility of future measurements of the liability. If interest rates subsequently fall, companies will have to revalue their liabilities upward.

 

Falling corporate bond yields, resulting in increases in pension liabilities, taken together with the problems stemming from the losses in equity values in corporate pension plans, have created a “perfect storm” of economic forces impacting pension funding.

 

Economic Issues and Financial Reporting Consequences

Employers are required to report the funded status of defined benefit pension and other post-retirement plans on an annual basis. They are required to measure at the balance sheet date both the plan assets and the benefit obligations. The funded status of a plan would be affected by both the change in value of plan assets and the actuarially determined value of plan obligations. Given the “perfect storm” of economic forces, the impact of plan underfunding on the financial condition of an employer could be significant.

 

Stay Tuned

If Congress does not relax the funding requirements, many companies may be forced into financial distress, even bankruptcy in extreme cases. This could result in the Pension Benefit Guarantee Corporation (PBGC) taking over their pension plans. The PBGC provides insurance for pension plans, similar to how the FDIC provides insurance on bank deposits. At FYE 2007, the PBGC had a $14.1 billion deficit ($68.4 billion in assets in $82.5 billion in liabilities). If companies struggle (similar to the way they did in the 2002 period), the PBGC may take over other large pension plans, greatly impacting its own funding status.  

 

One possibility to forestall a “pension crisis” would be for Congress to allow funding waivers, which would allow companies to restructure required payments so that they are paid out over a period of time, rather than in a single year. Alternatively, Congress could amend the PPA to allow longer periods of time to become fully funded, as it did for the airline industry when it initially drafted the legislation.

How the pension saga unfolds depends upon many interconnected variables: Congress, discount rates, equity values, the economy, and others. Keep an eye out for updates, which are likely to appear, and as always, reach out to us to discuss the impact on your company at any time. 

 

For more information about this and other issues affecting public companies, contact Kenneth Nielsen Goldmann, Capital Markets and SEC Practice Director, at kgoldmann@jhcohn.com or 973-618-6232.  

¹Stephen Taub, “Pension Plan Plunges Spread Corporate Pain,” CFO Magazine, December 2, 2008

²Jilian Mincer, “Record Losses Hit Pensions of Big Firms,” The Wall Street Journal, November 17, 2008