The Pension Protection Act of 2006 (PPA) defined specifically how defined benefit (DB) plans should measure funded status—using high-quality corporate bond interest rates and a specific mortality table, explains Matt McDaniel, U.S. head of DB risk at Mercer in Philadelphia.
It also prescribed a calculation for minimum required contributions each year, and plan sponsors had seven years to get their plans fully funded.
However, since PPA’s passage, the rules have already been tweaked a number of times. “These tweaks probably wouldn’t have been needed, if we hadn’t gone into a recession. The PPA was reasonable at the time,” McDaniel says.
Shelby George, senior vice president of Advisor Services at Manning & Napier in Rochester, New York, explains that each year, DB plan sponsors are required to make a certain level of contributions based on three factors—one being interest rates. When the financial crisis of 2008 hit, not only did assets decrease as the market went down, but interest rates went artificially lower due to Fed practices, so employers had to make higher contributions.
Funding plans was more difficult for plan sponsors, McDaniel adds.
So, in 2008, the Internal Revenue Service (IRS) allowed for a longer period of smoothing assets than originally allowed in the PPA, so a higher asset value could be used to calculate funding, says Ned McGuire, vice president and a member of the pension risk solutions group of Wilshire Consulting in Santa Monica, California. In 2009, the IRS offered flexibility in using segment rates or the corporate bond yield curve. Sponsors could switch between them, decrease their liabilities and lower contributions.
McGuire also notes that in 2010, the Preservation of Access to Care for Medicare Beneficiaries and Pension Relief Act allowed DB plan sponsors to amortize payment over nine or 15 years rather than the seven years required by the PPA. This reduced required minimum contributions. In 2012, the Moving Ahead for Progress in the 21st Century Act (MAP-21) changed the corridor of interest rates that could be used to calculate funded ratios. This increased the discount rate used, lowered pension liabilities and lowered required contributions, McGuire explains. In 2014, the Highway and Transportation Funding Act (HATFA) extended provisions of MAP-21. And, finally, in 2015, the Bipartisan Budget Act further extended MAP-21 provisions, but it also increased Pension Benefit Guaranty Corporation (PGBC) premiums.
NEXT: Should the PPA be amended permanently?
With market volatility and relief for DB plan sponsors in required minimum contributions, DB funding rates have decreased since passage of the PPA. McDaniel says Mercer tracks on a monthly basis mark-to-market funded status on a U.S. Generally Accepted Accounting Principles (GAAP) accounting basis, because with PPA rules and funding relief, there are so many levels of smoothing, so PPA funded status doesn’t give a true look at what a plan’s status is. According to Mercer, at the end of 2006 DB plans were about 98% funded. McDaniel says this improved a bit in 2007, but today the average funded status is at 79%.
McGuire says, since 2008, the Wilshire Corporate Pension Funding Study has shown year-end ratios around the low 80s. “It has been stagnant over the 10 years since the PPA was passed,” he says.
McDaniel believes Congress keeps extending pension funding relief less because plan sponsors need it, and more because pension relief is a revenue raiser for the U.S. budget. “Smaller contributions means smaller tax deductions. I think that has been the motive of at least the last two rounds of relief,” he says.
McDaniel adds that if interest rates increase again to somewhere near a more historical norm, he believes relief won’t be needed. But there are not a lot of signs that rates will skyrocket quickly.
George says instead of focusing on congressional action, DB plan sponsors should focus on their responsibility, understand their objectives and come up with strategies for portfolio construction and contributions. “Funding relief allowed employers to use a higher interest rate, so with lower required contributions, employers were in a better financial position and could better manage contributions. But plans still need to get to 100% funding eventually. It is a mistake to assume that because there is funding relief, plan sponsors should contribute the minimum. There should be a broader discussion about what sponsors should do about contributions,” she says.
McDaniel notes that the latest relief allows for fairly low cash contributions, but less-funded DBs are punished by higher PBGC variable rate premiums, which he says will more than quadruple over a four- or five-year period. Because of this, many plan sponsors are not taking the relief, he notes.
“I don’t think the PPA should be amended permanently—we do want contributions tied to inherent funded status. But, it has just been difficult to adhere to the rules with rates sliding down so significantly,” McDaniel says. “The PPA is not inherently flawed. One of the things it did was unmask some of the financial volatility of pensions that was previously hidden by smoothing over a long time.”
But, he concludes, now plan sponsors feel pain much sooner and are less interested in sponsoring plans.