In recent years there have been many news stories about the financial burden that pension plans have placed upon old-line companies in the automobile, steel, and airline industries. At a time when companies in these industries faced stiff competition from newer companies, the old-line companies needed to make large contributions to their pension plans, as a result of their deterioration in funded status. This article summarizes the events that led to that deterioration and the interim relief that Congress provided with the Pension Funding Equity Act of 2004 (PFEA), then subsequently modified and extended permanently with the Pension Protection Act of 2006.
With the downturn in the stock market in recent years, many pension plans of large companies experienced significant asset losses that led them from the overfunded status that had existed for a large part of the 1990s into underfunded status. Because these plans are subject to the minimum funding requirements of the pension laws, the asset losses must be paid for through increased minimum funding requirements. While almost all pension plans required additional contributions, pension plans of large companies were especially impacted because of the additional funding rules that apply to these plans.
For large pension plans, one part of the minimum funding requirement is based upon the difference between the plan's current liability and the value of the plan's assets. The current liability is a measure of the value of the benefits earned to date and is generally calculated using an interest rate based upon the interest rates on 30-year Treasury securities as specified by the Commissioner.[1] The contribution based upon this difference is called the deficit reduction contribution (because it makes up the deficit between the current liability and the value of the plan's assets). The deficit reduction contribution (DRC) resulted in relatively large increases in contributions for employers with large underfunded plans, many of whom had no funding requirements for the prior few years.
The increased contribution requirements came at a time when many companies and industries were still recovering from the economic downturn that occurred at the same time the markets declined. Employers had found that the DRC had increased markedly for two reasons. The first was the asset losses described above, which widened (or created) the deficit between current liability and assets. The second was that the interest rate used to calculate the current liability had been depressed in comparison to other interest rates in the market place. Accordingly, employers had argued that interest rates more reflective of the market should be used to calculate current liability. In response, Congress adjusted the interest rate used for plan years beginning in 2002 and 2003 to allow interest rates as high as 120% of the 30-year Treasury rate, rather than 105%.
The airline and steel industries had been particularly hard hit by the funding requirements for their pension plans. Some companies had taken the step of terminating their underfunded plans, which added to the liability of the Pension Benefit Guaranty Corporation. To provide interim relief, in April 2004, Congress passed the Pension Funding Equity Act of 2004. PFEA provided relief for the 2004 and 2005 plan years by:
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Replacing the interest rate based upon the 30-year Treasury securities with an interest rate based upon long-term investment grade corporate bonds; and
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Allowing for the election of an alternate DRC calculation for certain plans of employers in the airline and steel industries.
The interest rate based on long-term investment grade corporate bonds is significantly higher than the interest rate based on the 30-year Treasury securities. The use of a higher interest rate reduces the calculated current liability and thus has the effect of reducing the DRC for an underfunded plan. In cases with only some underfunding, the use of the rate based on corporate bond rates eliminates the need to make a DRC altogether. This relief applied to all defined benefit plans, not to plans in specific industries.
The alternate DRC calculation allows an employer in the airline and steel industries to elect to determine the DRC as 20% of the otherwise applicable amount (i.e., an 80% reduction). In order to do an election, it must be filed with the IRS, followed by notification of the PBGC, and notification of plan participants of the election. Also, restrictions are placed upon the ability to increase benefits under a plan for which the alternate DRC election has been made.
Multiemployer plans are not subject to the DRC calculation; however, they also needed to increase the funding requirements because of the asset losses. Under PFEA, multiemployer plans can elect to defer the amortization of certain investment losses.
Lastly, for 2004 and 2005, PFEA changed the interest rate used for non-annuity benefits under section 415(b) of the Code by replacing the 30-year Treasury rate with a flat rate of 5.5 percent.
The following lists the announcements and notices that have been issued with respect to PFEA:
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Notice 2004-34 provides guidance as to how the interest rate based upon long-term investment grade corporate bonds is determined.[2]
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Announcement 2004-38 sets forth how the employer may make the alternate DRC election for eligible plans.
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Announcement 2004-43 (corrected by Announcement 2004-51) sets forth the requirements for notifying the PBGC and plan participants of the alternate DRC election and sets forth the deadline for making the election.
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Notice 2004-59 provides guidance on restrictions placed on plan amendments following an employer's election of the alternative deficit reduction contribution.
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Notice 2004-78 provides guidance regarding the interest rate to be used to determine benefit limitations under section 415 of the Code for non-annuity benefits in 2004 and 2005.
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Notice 2005-40 sets forth guidance regarding the election that may be made by a multiemployer plan to defer charges with respect to certain net experience losses. The notice also addresses certification and notification requirements related to such an election.
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Notice 2005-95 includes transitional relief for the plan amendment deadline relating to the change in interest rate assumption under section 415 of the Code.
The Pension Protection Act of 2006 (PPA) modified and extended key provisions of PFEA in the context of comprehensive reform of pension funding standards and other pension rules. The PFEA interest rate replacement of the 30-year Treasury yield basis is extended through 2006 and 2007, and has been permanently replaced for plan years after 2007 by a corporate bond yield curve and segment rates. The alternative deficit reduction election is extended through the end of 2007 for certain employers. Lastly, the special interest rate used for the determination of the limitation under section 415 of the Code for non-annuity distributions is modified and permanently extended. See guidance provided under PPA for further details.
[1] Each month a Notice is published in the Internal Revenue Bulletin specifying the 30-year Treasury rate for the prior month as well as related rates.
[2] Subsequent notices set forth the corporate bond rates and related interest rates as well as for the 30-year Treasury rate.
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