Insight. DB contribution timing under PPA. Scope. Two funding regimes. Calculating the FTAP and AFTAP

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Aug 13, 2009 By Brian Donohue, Senior Vice President, Aon Consulting In the wake of PPA and its new funding rules, both practitioners and plan sponsors have found it more difficult to get their arms

1 Aug 13, 2009 By Brian Donohue, Senior Vice President, Aon Consulting In the wake of PPA and its new funding rules, both practitioners and plan sponsors have found it more difficult to get their arms around the timing of required contributions as well as the timing of the calculations that may affect those contributions. In this article, we walk you through the process with stops along the way to better understand the mechanics and the timing. In this article we review the timing of contributions under the new Pension Protection Act (PPA) defined benefit plan funding rules. "Timing of contributions" may be too narrow a description here our topic is not just "when do you put the money in," but also when key calculations are made and the interaction of the timing of contributions and the timing of calculations. Much of this may seem like "course level 101" material, but we have found some timing issues problematic, or at least not especially intuitive, and so we provide this review as a resource. Scope Let's begin by defining the scope of the discussion. We will assume for all purposes we are dealing with a calendar year plan; so we will not be discussing fiscal year plan year timing issues. And we will assume we are dealing with a frozen plan, so we won't be considering, for example, the calculation of normal cost. Finally, we're going to use, as an example, contribution timing for the 2009 year. Two funding regimes As we have discussed in the past, there are actually two funding regimes applicable under PPA. First, "regime one," a new set of rules that requires the amortization of asset-liability shortfalls over seven years. And second, "regime two," a set of rules benefit restrictions, at-risk rules and a limitation on funding of executive compensation that, in effect, punishes a sponsor for allowing a plan to drop below specific funding thresholds generally 60% or 80%. Calculating the FTAP and AFTAP Under both regime one and regime two, contributions for any year are generally a function of the plan's assets-to-liabilities funding ratio. For regime one funding purposes, that ratio is generally called the funding target attainment percentage (FTAP). For some regime two purposes, in particular benefit restrictions, it's the adjusted funding target attainment percentage (AFTAP). The "adjustment" here usually involves certain annuity purchases, which we are going to disregard, so we will use terms interchangeably, noting where differences may be important. August 2009 page 1

2 Both regime one and regime two funding ratios are calculated based on asset and liability values as of the end of the prior year. So the FTAP for 2009 is determined as of December 31, At the risk of belaboring this point, what this means is that the funding ratio for 2009 which will drive 2009 regime one contributions is based on assets in the plan as of the end of the 2008 plan year. A final, and somewhat tricky, point a plan's FTAP and any shortfall are generally determined based on "beginning-of-the year" values. Those values are the prior year's endof-year values. So, plan assets and liabilities for 2009 are based on assets and liabilities in the plan as of the end of Thus, if you want to affect, for instance, the 2009 FTAP, you must make a contribution "for" We will discuss in more detail below how/when that may be done. Regime one timing Generally under PPA, the sponsor must make a contribution each year adequate to pay off the shortfall the gap between assets and liabilities over seven years. As we have done in the past, in making calculations, our rule of thumb is that year one funding equals about onesixth of the shortfall. Why not one-seventh? We need to adjust for interest on the shortfall. So, under regime one, you calculate your FTAP (end-of-prior-year asset-liability shortfall) and (more or less) contribute one-sixth of that to the plan. When must that contribution be made? No quarterly contribution obligation Generally, if there is no quarterly contribution obligation, contributions for the current year (assuming applicable extensions) must be made on or before September 15 of the following year. So, for 2009, the contribution may be made on or before September 15, Quarterly contribution rules generally The challenge of making quarterly contributions, and managing their payment, has increased for two reasons. First, in a change of the rules, under PPA credit balances are subtracted from assets before determining whether the plan must make quarterly contributions. Second, late 2008 asset losses have put more plans in an underfunded status. So let's review how the PPA quarterly contribution rules work. Plans that have a funding shortfall for the prior year are required to make quarterly contributions for the current year. As we said above, funding shortfalls are determined as of the beginning of the year (here, the beginning of the prior year). Thus, the requirement to make quarterly contributions in 2009 is based on January 1, 2008, assets and liabilities, which are in fact the plan's December 31, 2007, values. To connect the last dot: the latest a sponsor may affect this amount the amount of the prior year shortfall is September 15 of the prior year. So, a sponsor that wished to avoid August 2009 page 2

3 quarterly contributions for 2009 had until September 2008 to eliminate the applicable prior year shortfall (by making a contribution for the 2007 plan year). Doing the math here, late 2008 asset losses won't affect quarterly contribution obligations until the 2010 plan year. And sponsors have until September 15, 2009, to make 2008 contributions affecting 2009 FTAP. Quarterly contributions must be made on or before April 15, July 15, October 15 of the current year and January 15 of the following year. The amount of each quarterly contribution is equal to 25% of the lesser of (1) 90% of the minimum required contribution for the current plan year and (2) 100% of the minimum required contribution for the preceding plan year. To the extent not met by quarterly contributions, the plan's minimum funding obligation for the current year is due (assuming applicable extensions) not later than September 15 of the following year. Thus, for 2009, quarterly contributions would be due April 15, July 15 and October 15 of 2009 and January 15, 2010; and any final ("true-up") contribution would be due September 15, Regime two timing Let's begin with the fact that timing is more critical for regime two funding because, generally, any shortfall (relative to the regime two threshold, for example, 80%) must be made up in the current year. For most plans, the most significant regime two "incentive" is avoiding PPA benefit restriction rules, so let's review briefly how the timing of the application of those rules works. Generally, benefit restrictions in the current year are based on the plan's current year AFTAP. As discussed above, that is a beginning-of-year value, which is in fact based on prior year end-of-year values. So, for 2009, the AFTAP = assets divided by liabilities as of December 31, The benefit restrictions work like an on-off switch. Generally, while the AFTAP is below one of the key thresholds (e.g., 80%), the restriction applies. Once you get above the threshold, the restriction lifts. And, depending on the flow (and timing) of contributions to the plan and the actuary's certification, the AFTAP can change during the year so the switch can go on and then off during the year. The switch is "fixed" (unchangeable) for the year once an actuarial certification of the plan's AFTAP is made. Generally, AFTAP values must be certified by an actuary before October 1 August 2009 page 3

4 of the current year (e.g., for 2009, October 1, 2009). Until certification, certain presumptions apply, as follows: 1. For January-March of the current year (e.g., January-March 2009), the 2009 AFTAP is presumed to be the same as it was in the prior year. So, if the 2008 AFTAP was 85% (note, this ratio would be determined as of December 31, 2007), the plan's 2009 AFTAP for the period January-March 2009 would be presumed to be 85%. 2. As of April 1 of the current year (e.g., April 1, 2009), the presumed AFTAP, based on the prior year, gets a 10% haircut. So, if the 2008 AFTAP is 85%, then the plan's 2009 AFTAP is presumed to be 75% as of April 1, 2009, triggering, for example, restrictions on lump sum payments. 3. Before October 1 of the current year (e.g., October 1, 2009), the plan's actuary must certify what the plan's 2009 AFTAP actually is. That number is based on end-of-prior-year values; in other words, assets and liabilities as of December 31, For all of these purposes, contributions made for 2008 by September 15, 2009, may be included in the December 31, 2008, assets, affecting the 2009 AFTAP. Please note: for 2009 and later years, the actuary certifying the plan's AFTAP may not take into account contributions that have not actually been made. So, a contribution made on September 15, 2009, may not count as December 31, 2008, assets, affecting the 2009 AFTAP, with respect to an actuarial certification made before that date. Example This is all complicated, so let's work through an example. As of the end of 2007, a plan's assets-to-liabilities ratio is 85%, so its 2008 AFTAP is 85%. The actuary certifies that ratio before October 1, (We are going to ignore 2008 PPA transition issues in this example.) Those are beginning-of-2008 values. Because of last quarter asset losses, the end-of-2008 funding ratio is actually 70%. For the period January-March 2009, the plan's 2009 AFTAP is presumed to be 85% and no restrictions apply. As of April 1, 2009, the "10% haircut" applies, the plan's 2009 AFTAP is presumed to be 75% and certain restrictions (e.g., restrictions on the payment of lump sums) apply the benefit restriction switch flips on. As of September 15, 2009, the sponsor makes a contribution for 2008 sufficient to increase the end-of-2008 funding ratio up to 80% (from 70%). September 15, 2009, is the latest date that contribution may be made. August 2009 page 4

5 Before October 1, 2009, the actuary certifies that the plan's beginning-of-2009 AFTAP is 80%, and the restrictions lift the switch flips off. Regime one + regime two Regime two contributions in our example, the contribution the sponsor made as of September 15, 2009 (for 2008) are, of course, made in addition to regime one contributions, and the interaction of the two is complicated and not particularly intuitive. As we see, a sponsor that has a regime two funding problem in the current year generally must make a contribution "for" the prior year to fix it. That regime two contribution will also have a (somewhat marginal) effect on the regime one contributions for the current year. For example, the September 15, 2009, regime two contribution described above (made for 2008) affects 2008 end-of-year funding specifically, the numerator of the 2009 FTAP and thus will affect the regime one contribution for * * * Let's now turn to an illustration of the foregoing principles. Example "ordinary" timing of regime one funding Let's begin with an illustration of a straightforward approach to the timing of funding, focusing for the moment just on regime one. Let's assume our plan has $76 million in assets and $100 million in liabilities as of December 31, After passage of the "Worker, Retiree, and Employer Recovery Act of 2008" (WRERA), the transition funding target for 2009 is 94%. Our example plan is in real terms 76% funded ($76 million in assets divided by $100 million in liabilities). But it has a shortfall for 2009 of just $18 million ($76 million in assets versus a $94 million transition funding target). Our funding rule of thumb is that year one funding equals about one-sixth of the shortfall. So, under these assumptions, this plan will have a 2009 regime one contribution requirement of $3 million ($18 million divided by six). If the quarterly contribution rules do not apply, that $3 million may be contributed as late as September 15, 2010, ignoring any interest adjustments. But, let's assume the quarterly contribution rules do apply. Thus the sponsor must contribute the lesser of 100% of the 2008 minimum required contribution, or 90% of the 2009 minimum, in four payments on April 15, July 15 and October 15, 2009, and January 15, Let's assume that the 2008 minimum contribution was $2 million, so the lesser quarterly August 2009 page 5

6 contribution is one-fourth of 100% of $2 million. Under these assumptions, the sponsor will have to make contributions as follows: Date April 15, 2009 July 15, 2009 October 15, 2009 January 15, 2010 September 15, 2010 Total Contribution $1.0 million $3.0 million The September 15, 2010, contribution of $1 million is the "true-up" of the $3 million required contribution minus the $2 million in quarterly payments. (In fact, under PPA, the final contribution will be closer to $1.2 million due to interest, but we are ignoring this to avoid overcomplicating the analysis.) Regime two timing That's the simple version under regime one. Now let's assume that the sponsor wants to conform to regime two funding requirements and thus wants to get its 2009 AFTAP up to 80%. To do that the sponsor must make a contribution by September 15, 2009, for 2008, of $4 million ($76 million plus $4 million equals $80 million; $80 million divided by $100 million equals 80%). That contribution will change the 2009 FTAP for regime one funding purposes. There's another $4 million in the numerator; the numerator is now $80 million, and the 2009 shortfall is only $14 million ($80 million in assets versus a $94 million transition funding target). Onesixth of $14 million is about $2.3 million. So, with those numbers in mind, here, again, is a straightforward approach to the timing of funding: Date April 15, 2009 July 15, 2009 September 15, 2009 (made for 2008) October 15, 2009 January 15, 2010 September 15, 2010 Total Contribution $4.0 million $0.3 million $6.3 million August 2009 page 6

7 To be clear about what's going on here: the sponsor is still making the same quarterly contributions, based on one-fourth of 100% of its 2008 minimum required contribution of $2 million. It's also contributing, on top of those amounts, another $4 million, to get the plan's 2009 AFTAP (based on end-of-2008 values) up to 80%. That additional 2008 contribution reduces the 2009 contribution from $3 million to $2.3 million. By September 15, 2010, the sponsor has to contribute whatever balance of the 2009 contribution that hasn't been covered by quarterlies. When it was only conforming to regime one, that balance was $1 million ($3 million owed minus $2 million in quarterlies). When it puts in $4 million, for 2008, to conform to regime two requirements, the balance goes down to $0.3 million ($2.3 million owed minus $2 million in quarterlies). Accelerating contributions We'd now like to describe an accelerated contribution schedule that provides one clear benefit reduced Pension Benefit Guaranty Corporation (PBGC) premiums. Let's go back to our simple regime one table, but let's make all $2 million in quarterlies before April 15, for Date Contribution April 14, 2009 $2.0 million (made for 2008) April 15, 2009 $0 (apply credit balance) July 15, 2009 $0 (apply credit balance) October 15, 2009 $0 (apply credit balance) January 15, 2010 $0 (apply credit balance) September 15, 2010 $1.0 million Total $3.0 million Let's start with the mechanics of this approach first; then we'll explain why you might do it. Under this funding approach, the sponsor contributes all $2 million of the quarterlies before April 15 [(it could literally be made on April 15, but it's easier to explain this way)], for That entire contribution is in excess of the minimum contribution owed and already contributed for 2008 and thus creates a $2 million credit balance. That credit balance is then used to satisfy the 2009 quarterly contribution obligations. August 2009 page 7

8 Now, why? Assuming interest rate effects wash out (that is, the company's cost of borrowing is the same as the interest rate under the plan), getting the $2 million in for 2008 increases December 31, 2008, assets, reducing the plan's 2009 unfunded liability and saving PBGC premiums on unfunded liabilities (by 0.9% of $2 million, or about $18,000 in this example). In real life, that is a pure savings to the enterprise. PBGC premiums aren't like contributions contributions above the minimum will still reduce the sponsor's obligation. They are a fee once you pay them, you can't get them back, and you get no added benefit. Not all companies will want to employ this strategy. It will not be particularly appealing to companies under cash stress. But for those with ready access to capital, it is, at the margin at least, money-saving. And the ability to accelerate contributions is not just limited to quarterlies the "true-up" contribution (which in our examples is made on September 15, 2010) could also be accelerated (to September 15, 2009), with a concomitant reduction in 2009 PBGC premiums. In addition, contributions that are accelerated to April 30 and considered as being made for 2008 can be counted as assets and thereby reduce the unfunded liability shown on the new PPA funding notice. That notice, which goes to employees, has raised concerns among some sponsors, especially in the context of late 2008 asset losses. Without walking through the regime two example, we note that similar benefits (reduced PBGC premiums, increased assets on participant notices) are available to plans operating under regime two that accelerate 2009 required contributions. Asset strategy and regime two contributions As a general matter, under PPA, all plans will have to be brought up to full funding (ignoring PPA transition issues) over seven years. So, as they say, you will either have to "pay now or pay soon." Timing of contributions can generally only be manipulated over the short term. One "benefit" of regime one is that it adds assets to the trust, to make up the shortfall, incrementally, over seven years. So, to some extent at least, market timing issues can be disregarded. If the sponsor must conform to funding regime two, however, funding is accelerated. You don't pay more (adjusting for the time value of money), you just pay sooner. But the sponsor does put a significant piece of the plan's shortfall into the first year. In our example, the total shortfall the total amount to be funded over seven years was $18 million. Under regime one, only $3 million of that went into the first year. Under regime two (which is really regime two + regime one), $6.3 million went into the "first" year (technically, $4 million of that amount went into the prior year). Here's the point: putting that much into the plan "all at once" raises market timing issues. They will matter more in some situations than others, but it is worth considering, if you are conforming to regime two, what is the right asset strategy for the "extra" assets you are putting into the plan. This is particularly an issue right now, because plan shortfalls August 2009 page 8

9 especially for are likely to be large, and a sponsor funding to a regime two threshold may be putting a lot of money into their plan. * * * We have purposely ignored, in this discussion of contribution timing, complications facing plans that maintain significant credit balances, with the exception of balances that are created and spent almost immediately to satisfy current year quarterly requirements. Consideration of these issues will be the subject of our next article on the subject. Finally, the issues discussed here are merely tactical, not strategic. But we have found that, in discussing the impact on sponsor cash resources of PPA DB funding demands, an understanding of when calculations are made, when contributions must/may be made and how contributions affect calculations can add incremental value. Thus, we provide this material as a resource for our discussion of truly pressing issues e.g., determining how much money a sponsor must contribute for 2009 or ##### For more strategies on retirement programs, contact Brian Donohue at or brian.donohue@aon.com. August 2009 page 9

The use of a "standing election" to apply credit balances against minimum funding requirements.

The use of a standing election to apply credit balances against minimum funding requirements. Nov 12, 2009 By Brian Donohue, Senior Vice President, Aon Consulting The IRS recently released a copy of final defined benefit funding regulations that indicate changes made by PPA. In this article, we