President Biden is scheduled to sign the House approved Infrastructure bill (HR3684) that includes the provision to extend interest rate stabilization used for calculation of the annual minimum funding requirement for defined benefit (DB) plans for an additional five years beyond the legislation passed in the American Rescue Plan Act of 2021. These changes could result in minimum required contributions remaining at $0 over at least the next 10 years, if actual asset returns equal or exceed expected returns, depending on plan design and other demographic experience. Does this mean that the minimum funding requirement calculations are essentially meaningless? What impacts could this have on the future of defined benefit plans? How do you determine the best funding policy for your plan?
Changes included in the infrastructure bill
The segment rates used to determine the DB plan’s liabilities for minimum funding and benefit restriction purposes must be within a specified range around a 25-year average of corporate bond yields. The American Rescue Plan Act of 2021, enacted on March 11, 2021, specified that the segment rates must be within a 5% corridor of the 25-year average values for plan years beginning in 2021. In addition, each 25-year average rate may not be less than 5%, prior to application of the corridor. Starting with plan years beginning in 2026, the corridor widens by 5% each year until reaching 30% for plan years beginning in 2030 and later. The infrastructure bill extends the application of the corridor to apply the 5% corridor through the plan years beginning in 2030, with the corridor widening by 5% each year until reaching 30% in plan years beginning in 2035 and later. In addition, the American Rescue Plan Act of 2021 changed the amortization period of the funding shortfall from a seven-year period to a 15-year period. The infrastructure bill does not make any adjustments to the 15-year period.
How does this impact your defined benefit pension plan?
By extending the corridor for the interest rate stabilization, the liability to determine the annual minimum funding requirement will use a discount rate of no less than 4.75% over the next 10 years. Extending the period of time that plan sponsors are allowed to use this higher discount rate allows them to defer contributions to a later date than otherwise would have been required. Many plan sponsors have seen their minimum contribution requirements for 2021 decrease to $0 with the relief provisions included in the American Rescue Plan Act of 2021. While recent legislation may add flexibility to your contribution schedule, a minimum required contribution of $0 doesn’t mean that contributing $0 annually is necessarily an appropriate funding policy.
There are several reasons to contribute more than the minimum required contribution, including annual benefit accruals, ability to pay lump sums to restricted employees, Pension Benefit Guaranty Corporation (PBGC) savings, elimination of PBGC 4010 filing, contribution smoothing, contributions based on accounting results, and preparing for plan termination.
Annual benefit accruals: While the minimum required contribution may be $0, if active participants in your plan are accruing benefits, then contributions may be necessary to keep the funded status of the plan from decreasing year-over-year. Unless asset returns are equal to the sum of the present value of annual benefit accruals plus interest on the unfunded liability, the funded status will begin to deteriorate, absent additional contributions to the plan.
Ability to pay lump sums to restricted employees: Restricted employees are highly compensated employees (HCEs) who are on the “High 25” list. The High 25 list represents the 25 highest-paid employees historically. Treasury regulation section 1.401(a)(4)-5(b) states that a defined benefit plan has the effect of discriminating significantly in favor of HCEs and former HCEs unless it incorporates certain provisions restricting distributions of benefits to or on behalf of a restricted employee. Assuming that the value of the distribution to the restricted employee is greater than 1% of the current liability prior to the distribution, the value of the plan assets must be equal or greater than 110% of the current liability after the distribution to the restricted employee. Contributions may be needed to attain the 110% funded threshold.
PBGC savings: While the liability calculation for minimum funding requirement purposes uses a 25-year average and an applicable corridor to calculate the discount rate, the liability calculation for PBGC purposes does not incorporate these stabilization features. Therefore, while many plans are fully funded on a minimum required contribution basis, they are underfunded on a PBGC basis. For plan years beginning in 2022, the PBGC variable-rate premium is 4.8% of the unfunded PBGC liability, up to a cap of $598 per participant. Both of these figures will continue to increase with inflation in the future. If your plan is underfunded on a PBGC basis, it may be worthwhile to make contributions to the plan. Assuming that your plan is below the PBGC per-participant cap, any contribution made for the 2021 plan year will essentially have an immediate 4.8% return, as the premium due to the PBGC will be decreased by that amount. For plans over the cap, it may be worthwhile to create a funding policy to increase the PBGC funded percentage and get below that cap in the near future to attain these PBGC savings.
Elimination of PBGC 4010 filing: Similar to the discount rate used for PBGC variable rate premium liability purposes, the discount rate for the PBGC 4010 filings does not include the stabilization features. The plan’s funded status must be greater than 80% to avoid filing a PBGC Form 4010. There are some exemptions as to whether a PBGC 4010 filing is needed, such as the sum of unfunded liability for all plans under control of the plan sponsor being less than $15 million.
Contribution smoothing: While the legislation extends the 95%-105% corridor around the 25-year averages through 2030, the corridor will start to widen 5% each year through 2034 until it is 70% to 130% for plan years beginning 2035 and later. In our experience, once contributions are removed from the budget, it can be very difficult to reinsert them into future budgets. Therefore, even contributing a minimal amount each year will help reduce the potential for significantly larger contributions due in the future. Working with your actuary is extremely helpful to develop a contribution policy that smooths future contributions, while considering the company’s overall financial position.
Contributions based on accounting results: Many plan sponsors are impacted by the results of the Accounting Standards Codification (ASC) 715, Statement of Statutory Accounting Principles (SSAP) 102, and International Accounting Standard (IAS) 19 accounting disclosure reports. Contributions may be needed to meet or exceed a certain funding threshold on this basis. The accounting results have significantly more volatility than the minimum required contribution calculations, as they are impacted by market conditions as of the fiscal yearend. Contributions not only improve the plan’s funded status as of the fiscal yearend, but also decrease the following year’s annual accounting expense.
Preparing for plan termination: : The liability calculations for plan termination purposes are based upon lump sum and annuity purchase rates as of the date of the plan termination. Plan termination liability can generally be estimated as 105% to 110% of the plan’s accounting liability. For plans that may want to terminate in the near future, contributions may be needed to attain appropriate funding levels to achieve termination.
There are some additional impacts that the American Rescue Plan Act of 2021 and the infrastructure bill could have on defined benefit pension plans. As previously discussed, the bill adds flexibility to the contribution requirements and may allow defined benefit plans an opportunity to implement a de-risking strategy without increasing their short-term contribution requirements.
Implementing a de-risking strategy such as a lump sum window, annuity purchase, or plan spin-off may have less severe contribution consequences than would have resulted without the latest extensions of interest rate stabilization. This is due to the starting funded percentage being higher than prior to the stabilization, although many of these de-risking strategies have the short-term impact of decreasing the funded status of the plan on a minimum required funding basis because benefits are paid using current market discount rates, while the funding present value calculations are based on the higher stabilized rates. The initial increase in the plan’s funded status creates flexibility to implement a de-risking strategy as plans may now be able to complete the strategy without triggering benefit restrictions. Extending the stabilized rates allows for additional time for the plan’s assets to make up that decrease over a longer period of time. For a plan spin-off, extending the amortization period of the unfunded liability from a seven-year period to a 15-year period allows plan sponsors to contribute less in the near term than before, which may make this strategy more appealing. Because the liability calculations from a PBGC, accounting, and plan termination basis have not changed due to this legislation, de-risking the plan can still provide beneficial results.
While these changes lower the minimum required contribution, depending on the goal of the plan sponsor, the minimum required contribution may still be relevant. We don’t foresee this legislation having a significant impact on defined benefit pension plans, although it does provide additional contribution relief and flexibility. Many plan sponsors welcome the short-term funding relief provided by the American Rescue Plan Act of 2021 and potentially by the additional legislation, but they should also consider the aspects described above when determining the appropriate funding policies for their plans.