RSM Resources

When President Bush signed the Pension Protection Act of 2006 (PPA),he said it "establishes sound standards for pension funding" and "willhelp shore up our pension insurance system."

Some greeted thepresident’s statements and the law with skepticism. For example, AliciaMunnell, director of the Center for Retirement Research at BostonCollege, told Kiplinger’s "the law may actually acceleratethe demise of traditional pensions" as employers react to new fundingregulations. Critics say the cost of ramping up pension funding andperceived complexity of the law may lead companies to suspend theirpension plans.

But industry experts say the law — which requirescompanies with defined benefit plans, or traditional pension plans, tofully fund their pension obligations using new standardized actuarialassumptions — is a net positive for companies. Scott Greeno, consultingactuary with RSM McGladrey Retirement Resources, agrees, noting thatthe PPA simplifies cash funding rules.

Pension Protection Act requirements

The PPA:

• Requires companies to measure pension plan obligations using standardized methods and assumptions.
• Sets a funding target of 100 percent of plan obligations, with any shortfalls to be amortized over seven years.
• Raisescaps on the amount employers can put into their pension plans, enablingthem to contribute more money during better years and build a cushionto help smooth contribution levels during poor market periods.
• Prevents"at-risk" plans from promising extra benefits to their workers anddigging a bigger hole of potential debt without paying the cost of thebenefit increase upfront.
• Mandates companies that terminatetheir pension plans in bankruptcy provide extra funding to the pensioninsurance system: $1,250 per plan participant for three years followingemergence from bankruptcy.

At the center of the pensiondiscussion is the federal agency that insures pension plans, thePension Benefit Guaranty Corporation (PBGC). The PBGC has previouslyreported an estimated $23 billion deficit, much of it due tobankruptcies in the airline and steel industries. The PBGC hasestimated its exposure to "new probable terminations" at $108 billion,according to The Wall Street Journal.

Defined benefitplans cover about 44 million workers. Due in part to a poorlyperforming stock market, the number of underfunded plans increased tomore than 70 percent of all insured plans from 20 percent of allinsured plans between 2000 and 2003, according to the PBGC’s Pension Insurance Data Book 2005.

PPA sponsors hope the new law will strengthen employers’ pension plans and bolster the PBGC, preventing a taxpayer bailout.

Phased-in approach

ThePPA will take effect starting in 2008, so businesses have time to planhow they’ll handle potential funding shortfalls. Current regulationsapply for 2006 and 2007.

Numerous phase-in provisions areavailable as companies make progress toward fully funding their pensionplans. Fully funded plans have enough money set aside today to funddistribution of pension benefits in the future, based on standardassumptions of obligations and pension fund investment growth.

Plansconsidered at-risk under the new rules will be subject to acceleratedfunding rules and potential benefit restrictions. To avoid beinglabeled at-risk, companies must achieve pension funding levels of 65percent in 2008, 70 percent in 2009, 75 percent in 2010 and 80 percentin 2011. The at-risk assessment does not consider the financialstrength of a company, just the plan’s funding level.

Toencourage companies to make additional tax-deductible contributions totheir pension funds, the cap increases to 150 percent of currentliabilities from 100 percent beginning in 2006.

White House officials told The Wall Street Journal that giving businesses transition time will help companies meet their obligations.

"Youhave to have a balance," says Stephen S. McMillin, deputy director ofthe Office of Management and Budget. "If you push some of thesecompanies too hard too fast, you’re going to be pushing them into asituation where you’ve created actual harm to them in the first fewyears."

Potential penalties

The governmentconsiders the at-risk threshold to be 80 percent, with a phase-inperiod as described previously. Most penalties target companies withseverely underfunded plans, or those with funded levels of 60 percentor less. Organizations with severely underfunded plans may face certainbenefit restrictions, such as a prohibition on lump-sum payments or acessation of benefit accruals under the plan. At-risk plans may alsoincur limits on executive compensation and higher PBGC premiums.

Credit balances

ThePPA does not eliminate existing credit balances or prevent futurecontributions in excess of base funding requirements from being kept asa credit balance when the new rules take effect in 2008. However, sincecredit balances will be excluded from plan assets for many purposes, aplan sponsor will need to decide whether to use such balances to offsetrequired contributions or to include credit balances in plan assets inorder to meet certain funded percentage thresholds. Generally, a plan’sfunded status must be 80 percent or greater to use a credit balance tosatisfy required contributions. Given these considerations, consultyour actuary annually when deciding whether to apply or hold a creditbalance for the following year.

Cash-balance plans

ThePPA provides greater legal certainty for cash balance plans which,added to the resolution of earlier court challenges, may lead tobroader adoption. This type of plan looks and feels like a definedcontribution plan to participants, in that a notional account balancegrows with contribution credits and interest each year, and planparticipants may receive the notional account balance as a lump-sumbenefit rather than through annuity distributions like a traditionalpension plan. Employers fund the trust just like a traditional definedbenefit pension plan, and the employer invests the assets and bears theinvestment risk. Participants tend to like this type of plan, in part,for its portability, meaning vested participants can take the fundswith them when they leave a job.

Expanded evaluation

Underthe PPA, your company has two years to prepare for changes in pensionfunding. Now is the time to evaluate how the new standards may affectyour plan. For example, if your plan is well-funded, your contributionrequirements may even turn out to be lower under the new standards.

Everycompany faces a different funding situation, so it’s important to seekprojections and recommendations from your actuary for your company’sspecific needs. Your actuary should provide guidelines on what to watchfor over the next year or two, and continue to monitor your annualprogress toward fully funding your pension plan.

"You can’tplease all of the people all of the time," President Lincoln said. ThePPA is bound to have its detractors, but most plan sponsors should findit contains positive opportunities for their organizations.