IRS Gives Wiggle Room on Pension Costs

Companies that still sponsor defined-benefit pension plans have won some subtle but significant relief in funding requirements, and more may be coming. But the provisions require companies to do some quick, careful analysis and make some short-term choices that could have significant long-term implications.

The Internal Revenue Service recently issued final interpretive guidance on how to fund pensions under the Pension Protection Act of 2006, which was then modified in 2008 by the Worker, Retiree and Employer Recovery Act of 2008. The guidance doesn’t set policy directly, but it does provide some sponsor-friendly interpretations that will let companies smooth over losses from last year’s stock market crash that decimated pension-plan assets.

Waidmann

Anne Waidmann, a director with the human resources services practice for PricewaterhouseCoopers, warns that final regulations from the IRS are extensive. “It answers a lot of questions, but it’s very complicated,” she says. “It provides some relief, but there are more hoops to jump through.”

The stock market plunge in 2008 took a big toll on defined benefit plans. James Gannon, manager of consulting and investment services for Russell Investments, says his firm’s clients were well-funded at the start of 2008, but collectively stumbled to only 75 percent funded by the start of 2009. That means plans on average had only 75 percent of the funds they needed to meet the actual liability.

Rosenthal

Craig Rosenthal, a principal at Mercer, says he has been tracking 874 pension plans in 2009, and determined that 20 percent of them will need to increase their cash contributions by more than half from last year’s levels.

In March, Rosenthal says, the IRS signals that it wouldn’t object if companies made some plan-friendly choices in selecting an interest rate to use as they tallied up their 2009 cash contribution requirements. That stance has been preserved in the recent final guidance. The IRS gave companies some flexibility to look back further than usual to pick the interest rate they would use to calculate their minimum contribution requirement—which let them to look back as far as October 2008, when corporate bond rates peaked.

“It gives plan sponsors the ability to use higher interest rates, which translates to lower liabilities,” Rosenthal says. That, in turn, minimizes the amount of cash companies will be required to contribute to plans in 2009 to make up for the 2008 setback.

Karbon

The IRS also said it will allow companies to waffle a bit on whether they use an interest rate at a point in time, or a rate that represents a 24-month average. Typically companies are required to pick one approach and stick with it, and most prefer an average rate to minimize volatility, says Bill Karbon, vice president at CBIZ. But the ability to look back to the October 2008 spike combined with the permission to change the approach is a rare opportunity to ratchet down the liability and provide some breathing room.

Final IRS regulations provide “some relief, but there are more hoops to jump through.”

—Anne Waidman,

Director With Human Resources Services,

PricewaterhouseCoopers

Companies also have more flexibility around whether to use a fair-market value of plan assets on a valuation date or an average value of the assets, Karbon says. Again, historically companies have had to adopt one approach and stick with it, but the IRS has granted companies a one-time dispensation to change methods. That also gives companies some latitude to close the funding gap by choosing the method that produces the best outcome.

Choose Wisely

Waite

While that added flexibility might sound appealing, tweaking your pension calculations will have consequences, says Jon Waite, chief actuary for SEI’s Institutional Group. In selecting an interest rate for 2010, for example, companies will have to stick with one approach or the other, and interest rates under either approach aren’t expected to be as favorable.

“Plan sponsors will be back to a more long-term normal valuation of liabilities,” he says. Companies will make quarterly payments in 2010 based on their 2009 year-end funding requirements, but then they’ll have to make a 2010 year-end catch-up payment, he adds. “They can expect a big jump in that final payment,” he says. “They can expect it and they should plan for it.”

Even further, companies must pay close attention to benefit restrictions, says Mike Archer, chief actuary at consulting firm Towers Perrin. Generally, he says, if a plan’s funding level falls below 80 percent, some restrictions on paying certain benefits kick in—and if it falls below 60 percent, the restrictions get worse.

PENSION PLANS GLOBALLY

Almost half (44 percent) of all global participants said the recent market turmoil has increased the likelihood the

organization will take steps to terminate the pension plan as soon as possible. Here is a breakdown of the

current status of pension plans around the world:

Status

Percentage

Active and open to new hires:

52%

Closed to new hires:

35%

Closed to new hires and accruals are frozen:

13%

Source

SEI Institutional Solutions Release on Pensions.

“The benefit restrictions ended up not being a huge deal for companies this year, but it could become much more important over the next year or two,” he says. “If my liability calculation is lower now that will help some, but sooner or later the benefit restrictions are going to apply.”

Pension experts across the board say companies with pension plans should be doing lots of modeling with their actuaries to see how various scenarios would play out, so they can make some important year-end choices. Those choices mapped out in the IRS guidance “give companies some fresh ability to look at what is the right long-term answer for them,” Archer says. “They need to determine the best long-term answer, then a short-term tactical plan that responds to the changes. They need to balance the two and be nimble in how they respond to the change in conditions.”

Pomeroy

On the horizon, companies may also get some further funding relief from Congress. Reps. Earl Pomeroy, D-N.D., and Pat Tiberi, R-Ohio, have introduced a bipartisan measure to give companies more time to catch up on 2008 market losses. Companies are currently required to cover shortfalls within seven years; Pomeroy and Tiberi propose extending that to as long as 15 years.

Another measure in the legislative pipeline proposes to let companies to do more smoothing of assets, Archer says. That would let them widen the gap between the current value of assets and the amount companies would need to contribute to the plan in a given year.

ALTERNATIVE STRATEGIES

More than half (53 percent) of the poll participants said the organization currently invests in alternatives in

the pension portfolio. Of the group using alternatives, the most popular products are real estate (46

percent) followed closely by hedge funds (43 percent). Here is a breakdown of the alternative asset

classes currently being used in global pension investments:

Alternative Strategy

Percentage

Real Estate:

46%

Hedge Funds:

43%

Private Equity:

34%

Derivatives:

21%

Commodities:

13%

Portable Alpha:

11%

130/30 Strategies:

4%

Source

SEI Institutional Solutions Release on Pensions.

PwC’s Waidmann warns that such reforms might not come soon, since Congress is so busy with healthcare reform. “Once that gets done, they will turn to other things,” she says. “This is one of the things they will turn to.”

Companies began freezing defined-benefit pension plans in 2006, as they tallied the long-term burden of a defined-benefit obligation in the new economic environment. The Pension Benefit Guaranty Corp. says 17 percent of defined-benefit plans are in a “hard freeze,” meaning benefits are no longer accruing and new members are not being admitted to the plan. The Bureau of Labor Statistics says as many as 20 percent of participants in single-employer defined-benefit plans are affected by a frozen plan.

That trend has stabilized, Waite says, with little freezing taking place in the past 18 months. Companies are not likely to freeze underfunded plans now because they still must meet the funding requirements even if the plan is frozen, and they presumably would still have to replace the plan with some other retirement offering for employees.

“There might not be a strong tradeoff there,” Waite says. “You’re probably going to have the plan around for several years because of the size of the deficit. So you may keep it in force until it’s better funded and then look at freezing it or look at how to liquidate that plan.”