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Session 501/601 - PPA Funding III - Funding Based Restrictions and Ramifications of Underfunding
Speakers: Heidi Rackley, Marjorie R. Martin, and James E. Holland
Recorder: Laura S. Stewart

The Pension Protection Act of 2006 (PPA) revolutionized funding rules and added new restrictions and notification requirements for underfunded plans. This session discussed those restrictions and included discussion of gray areas.

Benefit restrictions under PPA may include restrictions on shutdown benefits, amendments to improve benefits, lump sums and other accelerated distributions, and ongoing accruals. All of these restrictions would have a significant impact on a plan’s administration and participant relations. While most plans will not have any restrictions, this is a significant issue for those that do.

Effective Dates and Plans Affected

These rules are generally effective in 2008 for single- and multiple-employer plans, with delayed effective dates for most collectively bargained plans. Plans exempt from ERISA funding rules are exempt from these restrictions. New plans for the first five years are exempt from all restrictions except accelerated distribution restrictions. Also, plans frozen by September 1, 2005 are exempt from accelerated distribution restrictions. One area of uncertainty is the definition of “accrual” for a frozen plan, as any accrual would remove the frozen plan from the exemption. During the session, a few of these issues were discussed. A 415 COLA is possibly an additional accrual. However, changing optional form factors or cash balance plan annuity conversion factors is likely not an additional accrual. New guidance will hopefully clarify these issues.

Once the PPA rules are effective, the plan’s adjusted funding target attainment percentage (AFTAP) must be calculated to determine whether restrictions apply. For this purpose, AFTAP equals actuarial value of assets (AVA) minus prefunding balance (PFB) minus carryover balance (COB), divided by not-at-risk funding target.  If there were any nonhighly compensated employee (NHCE) annuity purchases in the last two years, the amount of NHCE annuity purchases is also added to both the numerator and the denominator. There are special rules for the 2007 lookback and special transition rules. There are three ways to determine the AFTAP – presumed, range certification, or specific certification. As always, certain limitations apply for each of these certifications.

Overview of Benefit Restrictions

Unpredictable Contingent Event Benefits

Restrictions on unpredictable contingent event benefit (UCEB)/shutdown benefits may be required if the plan’s AFTAP is below or is presumed to be below 60% (or would be below 60% taking into account the UCEB).  Shutdown benefits include benefits that are related to an event and not based on age, service, receipt of pay, death, or disability.

Plan Amendments to Improve Benefits

Another possible restriction is the restriction on amendments to improve benefits. In general, these include amendments improving past service benefits - formula improvements, faster accrual, and faster vesting which is not statutorily mandated. Amendments restoring previously restricted benefits are also included. Many “stealth” plan amendments requiring no employer action may fall under these restrictions. Amendments are potentially restricted if they increase the funding target, such as the annual 415 limit COLA, a flat dollar multiplier increase for all service, and optional vesting improvements. Amendments that do not increase the funding target because they increase only future service benefits and target normal cost (TNC) are not restricted. Examples would include the annual 401(a)(17) limit COLA, a flat dollar multiplier increase for future service only. The proposed regulations also exempt mandated vesting improvements for ongoing or terminating plans. It is unclear whether some other types of amendments are restricted, such as the annual update to the 417(e)(3) mortality table, which might be characterized as a mandated vesting improvement because the 411 vesting rules require compliance with the 417(e)(3) present value rules. Similarly, it is unclear whether changes in cash balance plan annuity conversion rates that result in higher equivalent annuity values, would be restricted. If a plan sponsor is subject to amendment restrictions, care must be taken as there are many issues with respect to the timing of these amendments. Guidance is also needed to resolve the interaction of these plan amendment restrictions and the Section 430 funding rules.

Lump Sums and Other Accelerated Distributions

Lump sum payments or any other accelerated distributions greater than the amount paid under a single life annuity may be restricted if the plan’s AFTAP is below or is presumed to be below a certain threshold. Examples of an accelerated distribution include lump sums, Social Security level income options (SSLI), installment payments for fixed period such as 5 or 10 years, Retroactive Annuity Starting Date options (back payments with interest), refund of employee contributions, cash refund annuity, or an annuity purchase.

If the plan sponsor is not in bankruptcy, accelerated distributions are permitted if the AFTAP is greater than or equal to 80%. Limited accelerated distributions are allowed for AFTAPs greater than or equal to 60% but less than 80%. In this case, the present value of the permissible distribution is the lesser of 1) the present value of 50% of the benefit or 2) the present value of the PBGC maximum guarantee. If under 80%, even small lump sums under $5,000 are currently restricted. Technical corrections are expected shortly that would provide an exception for these small amounts. For AFTAPs under 60%, no accelerated distributions are allowed. If the plan sponsor is in bankruptcy, no accelerated distributions are allowed for AFTAPs under 100%. For new plans, the proposed regulations provide that if net assets are $0, the FTAP and AFTAP are 0%, so the plan will not be able to make these payments until at least the second plan year. There are several outstanding questions that need to be addressed related to the accelerated payment restrictions, and Enrolled Actuaries are anxiously awaiting further guidance.

Ongoing Accruals

A plan’s ongoing benefit accruals must be frozen if the AFTAP is below 60%. Once the AFTAP reaches 60%, accruals automatically resume prospectively unless the plan provides otherwise. Accruals may be lifted retroactive to the beginning of the plan year if the plan sponsor makes contributions to increase the AFTAP to 60%. The plan may provide that missed accruals are automatically restored, but if accruals were suspended for more than 12 months, automatic restoration is subject to plan amendment restrictions.

Notice Requirements

The new ERISA 101(j) notice is required within 30 days after the plan becomes subject to a UCEB or accelerated distribution restriction, or within 30 days of the valuation date when the AFTAP is under 60% for the accrual restriction. This notice may be written or provided in a “reasonably accessible” electronic form. The penalty for a late notice is up to $1,000 per day per violation. Further guidance is needed on content, timing, and distribution of the notice. There is no notice requirement for the plan amendment restriction. The ERISA 101(j) notice satisfies the 204(h) notice requirements.

Ways to Avoid Restrictions

Restrictions may be avoided with careful consideration of all funding options and their ramifications. Plan sponsors can waive the COB or PFB, make additional contributions for the prior or current year, or post security in the form of a surety bond or escrow account. Enrolled actuaries have a significant challenge to both understand these rules and help evaluate each plan sponsor’s individual situation.