Pension Reform Legislation

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November 07, 2005

The Administration, the House (the Pension Protection Act of 2005) and the Senate (the National Employee Savings and Trust Equity Guaranty Act of 2005) have proposed legislation affecting qualified retirement plans and, in particular, the funding of defined benefit pension plans. Effective dates are for the 2006 or 2007 plan year depending on the proposal. While there are significant differences in these proposals, the following common themes exist:

Accelerated Funding for Defined Benefit Pension Plans

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Accelerated Funding Rules. Currently, plans are not subject to accelerated funding requirements unless plan assets are less than 90% of a plan’s accrued liabilities. Under all three proposals, plans will be subject to accelerated funding rules if plan assets are less than their accrued liabilities. Proposed legislation institutes a 100% funding target which would be phased in over two, five or seven years depending on the proposal. Under the House Bill, if the plan’s funding ratio is less than 60%, the plan must use different actuarial assumptions which will accelerate the plan sponsor’s funding obligations.

Financial Status of Plan Sponsor Impacts Minimum Funding Obligations. Under present law, the financial condition of the plan sponsor is not taken into account in determining the plan sponsor’s funding obligations. Under the Administration’s proposal and the Senate Bill, if the employer is “at risk”, its funding obligation is increased. For public companies, “at risk” means a bond rating of below Baa for five years.

Smoothing Techniques Eliminated. Plans are now permitted to use the “actuarial value” of plan assets to calculate plan funding obligations. The actuarial value may be higher than the market value, thereby reducing the plan sponsor’s required contributions. Continued use of the smoothing technique is prohibited under all three proposals.

Modified Interest and Mortality Assumptions. Each of the proposals modifies the interest rate assumptions that may be used in funding. The new interest rate assumptions may result in accelerated funding obligations. Two out of the three pension reform proposals also require the use of a mortality assumption that would increase a plan sponsor’s funding obligations.

Credit Balances Restricted. Under current law, plan contributions that exceed the minimum required contribution for the plan year create a credit balance that can reduce future funding obligations. Each of the proposals either eliminates entirely or restricts the utility of credit balances.

Higher PBGC Premiums. Flat rate PBGC premiums will increase from $19.00 per participant to $30.00 per participant. The proposals also index the premium to the rate of growth in employee wages. Variable rate PBGC premiums would also increase.

Benefit Increases Restricted and Benefit Accrual Freeze Required. Under current law, plans cannot be amended to increase participant benefits without granting security if the plan’s funding ratio is less than 60%. Each pension reform proposal either prohibits or limits the ability of a plan sponsor to amend the plan to increase participant accrued benefits if the plan’s funding ratio is less than 80%. Plans that do not have sufficient funding levels would also be prohibited from making lump-sum distributions to participants. Two proposals require the freezing of benefit accruals if a plan’s funding ratio is less than 60%.

Practical Implications and Recommended Action. If enacted, pension reform legislation will significantly impact a plan sponsor’s funding obligations under its defined benefit pension plans. Tougher funding rules and higher PBGC premiums may adversely affect a plan sponsor’s cash flow and financial statements. The results will vary from plan sponsor to plan sponsor. Additional disclosure requirements will also increase plan costs and human resource department time and expense.

Plan sponsors may wish to have their actuary run projections showing the result of the legislation on their plans. The harsh impact of the pension reform legislation may be reduced or postponed by amending plans now to decrease or freeze benefit accruals or by accelerating plan funding for the current year.

Cash Balance Plans

Some courts have held that a lump sum distribution from a cash balance plan must be calculated by (a) projecting the participant’s current account balance in the plan to normal retirement age using the plan’s interest crediting rate, and (b) then discounting that amount back to the distribution date using a different interest rate. When the plan’s interest crediting rate is higher than the discount rate, the lump sum amount is greater than the participant’s account balance. This is referred to as the “whipsaw” effect. Another court has held that cash balance plans result in age discrimination.

Under the House version of the proposed legislation, cash balance plans would be deemed not to violate the restrictions against age discrimination and the whipsaw effect would be eliminated. Similarly, the Senate version would eliminate the whipsaw calculation requirement. Nonetheless, the Senate version makes “no inference” as to the legality of cash balance plans under current law (age discrimination), and imposes certain minimum “grandfather” requirements that would essentially provide participants over a certain age with the better of the two options upon the conversion of a traditional defined benefit pension plan to a cash balance plan.

Non-Qualified Deferred Compensation Plans

Under the Administration and Senate versions, company assets may not be transferred to a non-qualified deferred compensation arrangement, such as a Rabbi Trust, when the plan sponsor’s investment rating is below Baa and the defined benefit pension plan’s funding ratio is below 80 percent. These restrictions would, however, apply only to a plan sponsor’s CEO and top four highest paid officers. The House version provides that assets may not be transferred to a non-qualified deferred compensation arrangement when the defined benefit pension plan’s funding ratio is below 60 percent.

Defined Contribution Plans – Investment Guidelines and Advice

The Senate Bill requires that basic investment guidelines be provided to participants on an annual basis. The guidelines would be in the form of a model notice prepared by the Internal Revenue Service in consultation with the Department of Labor.

The House and Senate Bills both provide a safe harbor that shield employers from liability for certain investment advice given by investment fiduciaries.

If the safe harbor is satisfied, the investment advisor, rather than the plan sponsor, would be responsible for investment advice given to plan participants. However, the plan sponsor would remain responsible for prudent selection and periodic review of the investment advisor.

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