The New Reality For Defined Benefit Pension Plans
The question that sponsors of defined benefit plans need to ask right now is, "Can we meet the plan's minimum funding requirements?" If the answer is no, the employer should immediately consider applying to the IRS for a waiver of the minimum funding requirements.
Companies sponsoring defined benefit pension plans bear the risk of investment. In other words, if plan investments do not perform as well as expected, the company must contribute additional funds to make up for the shortfall. The sponsoring company is basically guaranteeing the payment of monthly pension benefits earned by its employees. That is why the valuation of a plan's assets and its benefits liabilities is critical.
In order to determine a plan's funded status (i.e., a comparison of the plan's current assets with its current liabilities), the plan's actuaries use certain assumptions to determine the present value of future pension obligations. As with all present value formulas, the lower the assumed rate of interest, the higher the present value (in this case, the plan's liabilities). On top of this, the government has established, and recently revised, minimum funding standards for defined benefit pension plans to help ensure that most plans are funded sufficiently to provide the promised benefits as and when they become due. In a perfect world, all such plans would be more than 100% funded, providing a cushion against unanticipated drops in investment returns.
If your practice traditionally has been to leave matters of your defined benefit plan to your third party administrator or actuary, consider the following:
- The S&P 500 Index lost almost 40% in value in 2008. If a defined benefit plan were invested more conservatively, say a 60% equity/40% bond portfolio, it still would have lost more than 20% of its value. Many (probably most) defined benefit funds were invested more aggressively and, as a result, lost more than 25% of their value in 2008.
- At the same time plan asset values were plunging, the interest rates used to determine plan liabilities dropped by approximately 200 basis points. As a result, the present value of pension plan liabilities increased.
- The combination of sinking asset values and rising pension liabilities has caused many of the country's largest and best managed pension plans to become significantly underfunded. According to a recent Watson Wyatt Worldwide analysis, funding levels for more than 60% of the Fortune 1000 firms would be in the 50% to 70% range.
- As if things were not hard enough for defined benefit pension plans, the Pension Protection Act of 2006 and new proposed rules issued by the IRS are raising the bar in terms of funding requirements.
What all this means is that suggested and required minimum contributions to defined benefit pension plans will increase significantly in the near term and for a while to come. Unfortunately, the nature of these plans is to cost more at times when the economy is bad and the sponsor is less financially secure.
If you are a larger company, particularly a public company, you may have been made well aware of these issues by your legions of advisers. However, if you are a small, privately held company, you may not be getting as much advice about these issues from your actuary or TPA. In fact, if you do not yet know what your plan's funded status is for 2009, you should immediately contact your plan's actuary.
Depending on the funded status of your plan, your required minimum contribution for the 2008 plan year and your estimated required minimum contribution for the 2009 plan year, you want (or need) to consider:
- Applying for a waiver of your minimum funding requirement for the 2008 year. Unfortunately, such an application must be filed with the IRS no later that 2-1/2 months after the end of the plan year (i.e., by March 15 if your plan year end is December 31). Even if you miss the application deadline, you need be aware of the potential penalties (10% to 100% of the funding deficiency), as well as other options for deferring your contribution.
- Modifying or even freezing benefit accruals for the current year. Remember, this can be done only prior to the time your participants earn, or accrue, this year's benefit (except in rare circumstances with the approval of the IRS).
- Any notices you may have to give participants and the government due to the underfunded status of your plan.
- Any benefit payment restrictions that may apply to your plan if it is significantly underfunded. For example, under the new rules, certain lump sum payments may be limited or prohibited as long as the plan's so-called adjusted funding target attainment percentage is less than 80%.
The economy outlook is cloudy and the rules governing what is a properly funded plan have been rewritten. For companies that haven't already done so, it's time to take control of the situation.