Carryover and Prefunding Balances Post-PPA

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1 Carryover and Prefunding Balances Post-PPA Stephen Parks, EA, MSPA, Chief Actuary, Retirement Systems of California, Inc. Stephen R. Parks, EA, MSPA, Chief Actuary, Retirement Systems of California, Inc. Steve is the Chief Actuary for Retirement Systems of California, Inc.; a third party retirement plan administration firm located in Woodland Hills, California. Steve earned his Bachelor of Arts degree in Economics from California State University, Northridge. He began working in the pension industry in Steve became an enrolled actuary in 1989 and worked for several years as a consulting actuary, providing actuarial services to numerous pension administration firms around Southern California. In addition to providing actuarial services to defined benefit pension plans, Steve also provided other technical expertise including IRS audit calculations and strategy, the design and compliance of more complex plan designs, divorce valuations and has acted as an expert witness in a number of court proceedings. He has also spoken on actuarial topics at numerous seminars.

2 Stephen R. Parks, EA, MSPA, Chief Actuary, Retirement Systems of California, Inc. In addition to being an Enrolled Actuary under ERISA, Steve is a Member of the American Society of Pension Professionals & Actuaries. He currently serves on the Leadership Council for the ASPPA College of Pension Actuaries and has served on the Conference Committee for the Los Angeles Benefits Conference. Prefunding Balances Topics: The difference between a Carryover Balance (COB) and a Prefunding Balance (PFB) Why maintain balances? How much should you bank? When balances work against you Deemed reductions and the inclusive presumed AFTAP Elections to add to or apply PFB, including standing elections Adjustments when used to satisfy quarterly contributions

3 Prefunding Balances Differences between a COB and a PFB A Carryover Balance (COB) can only exist if: The plan was around before the initial year for PPA funding (YB 2008), and It had a Credit Balance in the Funding Standard Account at the end of the 2007 year (COB created automatically). A Prefunding Balance (PFB) only exists if: Contributions have been made in excess of the minimum on behalf of years subject to PPA funding, and The Plan Sponsor elected to add this excess to the PFB. Prefunding Balances Differences between a COB and a PFB When electing to apply balances to satisfy the funding requirement, the COB must be applied first and completely exhausted before applying any of the PFB. Excess contributions can only be added to the PFB. When performing various calculations, sometimes the assets are reduced by both the COB and PFB; other times they are reduced by only the PFB.

4 Prefunding Balances Differences between a COB and a PFB Instances where the assets are reduced by both the COB and PFB: Calculating the amount of assets in excess of the Funding Target used to reduce the Target Normal Cost in determining the Minimum Required Contribution (MRC). Determining the funding shortfall when either: An election is made to apply the PFB. Any amount; even if not needed to satisfy MRC, or The assets (unreduced by balances) < FT. Calculating the AFTAP (if assets < FT). Prefunding Balances Differences between a COB and a PFB Instances where the assets are reduced by only the PFB: Determining whether a new shortfall amortization base must be created when there is no election to apply PFB to satisfy the MRC. Determining the prior year s funding percentage. Determining whether the plan is subject to the quarterly contribution requirement.

5 Prefunding Balances Differences between a COB and a PFB For purposes of this discussion: The focus will primarily be on Prefunding Balances (PFBs). It has been eight years since the passage of PPA. If a plan still maintains a Carryover Balance (COB), there is a good chance the plan sponsor doesn t really need it. Prefunding Balances Why maintain balances? Only one reason: To provide a lower contribution requirement, possibly eliminating or reducing an unpaid minimum required contribution when the sponsor has a bad year. However, use of a balance to meet minimum funding should be considered a red flag. Unless it is just a one-time issue for the sponsor, its use may indicate that the plan is too costly and in need of amendment.

6 Prefunding Balances How much should you bank? Never an amount that will create a prior year s funding percentage below 80%. This must be anticipated. What you do now will not affect you currently, but may in a future year. If the plan is sufficiently funded, you may want to limit the amount of PFB such that the quarterly contribution requirement is not triggered. Even for an extremely well-funded plan, there is probably no need to maintain balances in excess of 2 years worth of MRC (my personal rule-of-thumb). Prefunding Balances When balances work against you Adds to the administrator s workload sometimes significantly. Requires timely and carefully drafted elections by the sponsor. If prior year s funding percentage is < 80%, the MRC will most likely increase and balances cannot be used to offset. May trigger the quarterly contribution requirement in a plan that would not otherwise be subject.

7 Prefunding Balances Maintaining a PFB imposes on the plan: A requirement to determine any deemed burns as of the first day of the plan year if a plan is under 80% funded in the prior year; and as of the first day of the 4th month of the plan year if a plan is under 90% funded in the prior year (assuming the current year AFTAP has not already been certified at over 80% by that date). Prefunding Balances Example Plan s 2013 AFTAP is 85% Its 2014 AFTAP has not yet been certified as of 4/1/14 As of 4/1/14 there is a required calculation of the 2014 inclusive presumed AFTAP to determine any deemed burn as of that date. Even if an actual certified AFTAP calculation as of 4/2/14 determines that the actual 2014 AFTAP is over 80% and no burn was necessary, the calculation as of 4/1 is required and any deemed burn as a result of that calculation happened and is irreversible.

8 Prefunding Balances Time Travel A deemed burn as of the first day of the 4th month of the next plan year can increase the absolute minimum required contribution for the prior plan year. Prefunding Balances Time Travel Example The 1/1/2013 valuation is done for a plan in early 2013, and the MRC is $100,000, and there is a PFB of $50,000 so you communicate to the client that their absolute minimum for 2013 assuming they use the PFB to reduce the MRC is $50,000 The client decides to fund $50,000 for 2013, but won t be making the contribution until later in 2014 and has not signed a specific election to use the balance to reduce the 2013 minimum Plan s 2013 AFTAP is 85% Its 2014 AFTAP has not yet been certified as of 4/1/14 because the client has not yet provided the 12/31/13 data.

9 Prefunding Balances Time Travel As of 4/1/14 there is a required calculation of the 2014 inclusive presumed AFTAP to determine any deemed burn as of 4/1 (the deemed burn is to increase the presumed AFTAP of 75% to 80% to avoid a restriction). You determine that the deemed burn is $25,000. The regs. require backward time travel and the burn as of 4/1/14 is considered to have happened as of 12/31/13 so the PFB as of 12/31/13 has been reduced by $25,000. Even if an actual certified AFTAP calculation as of 4/2/14 determines that the actual 2014 AFTAP is over 80% and no burn was necessary, that $25,000 burn happened and is set in concrete. You have to tell the client they now have to increase their 2013 contribution by $25,000. Prefunding Balances Time Travel How do you manage this situation? When you provided the 2013 contribution details to the client, you should have looked ahead to 4/1/14 and advised them of the potential of the burn and of the potential of the higher contribution. Or, you must have the client sign a specific election prior to 4/1/14 to use the balance to reduce their 2013 minimum. Or, you make sure the client knows they must get you the 2013 data by early 2014 and must make their 2013 contribution before 4/1/14 so that you can certify the higher 2014 AFTAP before 4/1/14. Oh and good luck getting them to do either of these things!

10 Prefunding Balances A PFB cannot be used to reduce its MRC if the prior year funded ratio is under 80%. For this purpose, the PFB is subtracted from the plan assets. So a well funded plan with a PFB may not be able to use its PFB to reduce its MRC. Prefunding Balances Yes, they could voluntarily burn some of the PFB to increase the prior year funded ratio to 80% but this election must be made before the end of the plan year to which it applies. So this is impractical if you are looking at a plan in 2014, and you realize that the sponsor should have burnt some of its PFB in 2013 so that their 2013 funded ratio for this purpose was over 80%.

11 Prefunding Balances If you run a BOY val, it s easy to look ahead at this scenario and advise the client to do a voluntary burn by the end of the year so that their funded ratio for this purpose is 80%. But given that many clients will not decide their contribution until after the end of their year, you may have advised them to burn part of their PFB that was not necessary to burn. Deemed Reductions Automatic (non-discretionary) reductions in balances (deemed burns) These may occur on the first day of the following plan year and 1 st day of the 4 th month of that year (if AFTAP not yet certified). If reducing a balance on either of these days would result in the elimination of a benefit restriction (i.e. get the funding up to 60% or 80%). Only occurs if: the balances are large enough to reach the applicable threshold, and a benefit restriction would actually be eliminated. As with all other applications of balances, the COB must be completely exhausted before reducing the PFB.

12 Deemed Reductions Some unique terms The interim value of adjusted plan assets for determining the balance reduction as of the 1 st day of the following year The value of the plan assets as of the 1 st day of the following year, reduced by the COB and PFB, including contributions already made on behalf of the current year, and reflecting balance elections already made. Deemed Reductions Some unique terms The interim value of adjusted plan assets for determining the balance reduction as of the 1 st day of the 4 th month of the following year The value of the plan assets as of the 1 st day of the following year, reduced by the COB and PFB, reflecting BOY reductions, if any, including contributions already made on behalf of the current year, and reflecting balance elections already made even if made for the following year.

13 Deemed Reductions The presumed adjusted funding target A calculated value determined by: dividing the interim value of adjusted plan assets by the presumed AFTAP It s a complete fabrication The inclusive presumed AFTAP The presumed AFTAP reflecting deemed reductions in balances. Deemed Reductions Requirement #1: The balances must be large enough to reach the applicable threshold Example 1 The presumed AFTAP as of 1/1/2014 is 55% On that date the COB = 0 and the PFB = 75,000 The interim value of adjusted plan assets = 625,000 The presumed adjusted funding target = 1,000,000

14 Deemed Reductions Example 1 Without a deemed reduction, the presumed AFTAP would remain at 55% {(625,000 75,000) / 1,000,000}. But if the assets were not reduced by the PFB, the presumed AFTAP would be 62.5% {625,000 / 1,000,000}. Since this result is above the 60% threshold, we know that some amount of balance reduction will get us to exactly 60%. We can solve for the balance reduction as follows: (1,000,000 * 60%) (625,000 75,000) = 50,000 The PFB is now 25,000 {75,000 50,000}, and The inclusive presumed AFTAP is now 60% {(625,000 25,000) / 1,000,000} Deemed Reductions Example 2 Same facts as Example 1, except the PFB = 25,000, and The interim value of adjusted plan assets = 575,000

15 Deemed Reductions Example 2 Without a deemed reduction, the presumed AFTAP would remain at 55% {(575,000 25,000) / 1,000,000}. If the assets were not reduced by the PFB, the presumed AFTAP would be 57.5% {575,000 / 1,000,000}. Since this result is still below the 60% threshold, we know that no amount of balance reduction will get us up to the threshold. The balance remains at 25,000. Deemed Reductions Requirement #2: A benefit restriction would actually be eliminated Example The presumed AFTAP as of 1/1/2014 is 75% On that date the COB = 0 and the PFB = 75,000 The interim value of adjusted plan assets = 825,000 The presumed adjusted funding target = 1,000,000 The plan does not allow for accelerated benefit payments (e.g. lump-sums) Although reducing the PFB could increase the inclusive presumed AFTAP to 80%, no benefit restriction currently applies. Since reducing the PFB would not eliminate a restriction, no reduction occurs.

16 Election to use part of the PFB to reduce the minimum An election (or standing election) to use the PFB to satisfy the MRC may also cause the sponsor to lose the exemption from setting up a shortfall amortization base. If no PFB is used to satisfy the MRC, then in determining if a shortfall amortization base is established the PFB is not subtracted from the assets. But if it is used, then the PFB gets subtracted from the assets to determine if there is a shortfall. This could cause the amount required to satisfy the MRC to increase. Election to use part of the PFB to reduce the minimum Ironically, it can also cause the amount required to satisfy the MRC to decrease. Occurs when the sum of the present values of prior shortfall amortization payments is larger than the current shortfall after reducing assets by the PFB. When this happens, the shortfall balance and amortization payment for the current year are negative. In our office, this occurred in many of our 2012 valuations when MAP-21 segment rates drastically reduced the Funding Target amounts. In those situations where we wanted to preserve as much PFB as possible, we had them elect to apply $1 of PFB even when not necessary to satisfy the MRC.

17 Election to use part of the PFB to reduce the minimum Using or not using the COB has no effect on this, as the exemption is based on the assets less the PFB only. Important Note: Elections should refer to funding balance instead of PFB. IRS has indicated that if you elect to waive or use $5000 of PFB, they take that to mean waive or use all of COB and $5000 of PFB. The election should refer to Funding balance and the ordering rules will take it in the right order. Another option would be to specify the amount that is meant to be waived or used from each. But, as always, remember that you must waive or use all of the COB before even $1 of PFB can be waived or used. Election to use part of the PFB to reduce the minimum Example Assets = 100,000 Funding Target = 90,000 PFB = $20,000 MRC = $50,000 If the sponsor does not use any PFB to satisfy the MRC then the PFB does not get subtracted from the assets and this plan is exempt from establishing a shortfall amortization base. But if the sponsor does use any part of the PFB to satisfy the MRC then the PFB does get subtracted from the plan assets and this plan would not be exempt from establishing a shortfall amortization base. So the MRC cannot be determined until you know whether the employer is going to use the PFB to reduce the MRC creating a circular result.

18 Balance or no balance? Questions: Do we establish them for new plans? If we already created them on existing plans, do we have clients voluntarily burn them to minimize the administrative hassle? Unfortunately the decision to not create, or to eliminate a PFB, can end up requiring clients to make higher contributions in certain plan years. Credit Balance Elections Credit Balance Elections The plan sponsor elects whether or not to maintain the COB/PFB. The election to maintain the COB in 2008 was automatic. The existence of a PFB depends on the sponsor electing to add excess contributions to it each year.

19 Credit Balance Elections This election must be made by the due date of contributions for the plan year. This is the case even though it is not reported to the IRS until the following year s Schedule SB. So for calendar year plans, this election must be made by September 15th after plan year end. This is problematic because often the client does not communicate their contribution amount to the actuary until after 9/15. If the sponsor wants the max added to the PFB each year and typically won t be signing the funding election by 9/15, then it would be recommended to use a standing election. Credit Balance Elections Example Sponsor makes contribution on 9/15, actuary gets data on September 22. Actuary completes valuation and determines that there are $40,000 of excess assets for prior year that are eligible to be added to the PFB. But it s too late now to add this because it s after 9/15 unless there is a standing election in place.

20 Credit Balance Elections Sponsor may voluntarily elect to reduce the Carryover Balance (COB) or Prefunding Balance (PFB) This election applies for all purposes under code sections 430 and 436, and can help to increase the funding ratio for the plan. Credit Balance Elections For example, you run the 1/1/14 valuation in November 2014 and the 2014 AFTAP is 130%. Assets = $130,000 Funding Target = $100,000 COB = $0 PFB = $55,000 The COB is $0, but there is a large PFB, so the FTAP for purposes of whether you can use the PFB in later years is only 75%. The plan sponsor can elect to waive part of the PFB to increase the FTAP for 2014, which will then allow the sponsor to use the PFB to offset the MRC in 2015.

21 Credit Balance Elections Cannot elect to reduce PFB until all of COB is gone. So if the plan only needs PFB waived in order to get FTAP above 80% (to allow the use of the PFB in a future year), then all of the COB must first be waived. Must be a written notice to the actuary and plan administrator. Election must use specific dollar amounts and cannot be conditional or formula-based. Can t just state in notice that sponsor will waive sufficient for plan to be 80% funded. It would be nice, but can t do that. Credit Balance Elections Election to reduce balances must be made before the end of the plan year. This election is deemed to occur as of the valuation date for the plan, and therefore takes precedence over other elections. So if an election is made in December of 2014 to reduce the COB, this takes effect as of 1/1/14 (the valuation date). But if an election was also made earlier in the year to apply the COB to the 4/15/14 quarterly contribution and the voluntary reduction eliminates the COB, then the quarterly contribution is deemed to have been missed. If the plan is subject to PBGC coverage, than you ll need to notify them as soon as possible (unless small plan exception applies). However, this election is not retroactively deemed to apply prior to an election to use the COB/PFB to satisfy the MRC for a prior plan year. (1.430(f)-1(d)(1)(ii)(B)) That s good, otherwise OUCH!

22 Credit Balance Elections If this election is made after AFTAP for the year has already been issued, then it could cause a material change in the AFTAP for the year. Grey book illustrates that whether or not a change is material is a functional test. Dropping below a threshold is not material unless a restriction would have actually applied. Credit Balance Elections The plan sponsor may elect to use COB or PFB to satisfy the MRC for the year. Must be made by the due date for the contribution for the year. The date of the election matters, because there is an order to the elections made and if an election is made to use (or deemed to be used) in the subsequent plan year before this election to offset the MRC in the prior year, then there may not be as much available to use

23 Credit Balance Elections Example (Based on example 9 of 1.430(f)-1). Plan sponsor makes two elections: Elects on August 1, 2015 to use COB/PFB to satisfy the 2014 MRC But due to a finalized 2015 AFTAP on July 1, 2015 there was a deemed reduction of the COB/PFB as of 1/1/15 to increase the 2015 AFTAP. Since the July reduction occurs before the August reduction then this takes precedence, even though the August election is for the prior year. Credit Balance Elections Plan sponsor can also elect to have the quarterly contributions satisfied by the COB/PFB. If the election is made before the due date of the quarterly contribution, the balance is accumulated from the valuation date to the election date at the effective interest rate to determine the amount available to offset the required installment. Then the amount used is discounted back from the election date to the BOY using the effective interest rate to determine the amount remaining. (See 1.430(f)-1(b)(5)(i))

24 Credit Balance Elections Example The quarterly installment due April 15, 2014 is $20,250. The effective interest rate is 6%. The sponsor makes an election on April 1 to use the COB to satisfy the quarterly payment. The amount from 1/1 needed to generate 20,250 on 4/15 is 19,909: / 1.06^(3.5/12) = $19,909 But if the election is made two weeks early (on 4/1) to reduce the 1/1 credit balance by 19,909, you won t meet the quarterly, because you only get interest credit to the election date): 19,909 * (1.06^(3/12)) = 20,201 Leaves a $49 missed quarterly To fix this, the sponsor may have to elect more than what is necessary to cover the quarterly, or only make the election on the actual date due. Credit Balance Elections If the election to offset the quarterly installment is made after the due date, then a penalty rate of 5% is applied to the balance, reducing it by more than just the amount applied to the quarterly contribution requirement. For example, the quarterly installment due April 15, 2014 is $20,250. The effective interest rate is 6%. The sponsor makes an election on July 1 to use the COB to satisfy the quarterly payment. The amount used to offset the minimum required contribution for the year is: / 1.11^(2.5/12) / 1.06(3.5/12) = $19,481 The COB is reduced by a greater amount (discounted without the penalty): / 1.06(6/12) = $19,669 (See 1.430(f)-1(d)(1)(B)) The IRS has not yet released guidance as to how elections are made and their effect for EOY valuation dates.

25 Credit Balance Elections If the election to offset the quarterly installment by a balance is made after the due date, then the value entered in line 8 on the Schedule SB may not agree with the brief label on the form. Line 8 reads: Portion elected for use to offset prior year s funding requirement (line 35 from prior year). In the previous example, $19,481 would be entered in line 35 on the 2014 Schedule SB. However, $19,669 would be entered in line 8 on the 2015 Schedule SB (assuming the form stays the same). Credit Balance Elections The election to use the COB/PFB to offset the MRC can be revoked to the extent the election was in excess of the amount needed to satisfy the MRC. But the revocation needs to happen prior to the end of the plan year for BOY valuations or by the deadline for making contributions if the valuation date is EOY. This is a bonus for EOY valuations, and is hardly practical for BOY valuations since most plan sponsors in my experience don t finalize their contributions until after the end of the plan year once they know their tax situation.

26 Credit Balance Elections If not revoked in time (or at all), then the COB or PFB is decreased by the amount elected even if not needed but it s not that big of a deal as we will see. Since the excess COB or PFB is elected to be used, it does not simply get added to the PFB and accumulated at the effective rate, but gets accumulated at the actual rate of return similar to an existing PFB. Credit Balance Elections Example (See example 4 of 1.430(f)-1 regulations) Plan s MRC is $100,000, and employer contributes $150,000. Even with a discount this is more than enough to meet the minimum. But employer also elects to apply $15,000 of PFB to meet the minimum. Since the $15,000 wasn t needed, it is increased to the next year s valuation date using actual investment experience and not the effective rate. However, the excess from the contribution that is added to the PFB is increased based on the effective rate. This treatment in effect puts the plan in the same situation it would have been had the election not been made, as you will end up with the same total for the credit balances.

27 Credit Balance Elections The election to use the COB/PFB to meet the MRC can also be done by standing election, and is discussed below An election (or standing election) to use the PFB to satisfy the MRC may also cause the sponsor to lose the exemption from setting up a shortfall amortization base. Standing Elections A plan sponsor can make a Standing Election for two purposes: To use COB or PFB to extent necessary to satisfy minimum required contribution (MRC), and/or To add maximum amount to the PFB.

28 Standing Elections The good thing about standing elections is that they do NOT have to be for specific dollar amounts. Specific elections are very difficult to use in small plans since we often don t know the contribution amount the sponsor decided to make until after the due date of the election. So there are no worries about whether the sponsor elected enough or too much to satisfy the MRC. There are no worries about whether the full excess contributions were elected to be added to the PFB. And there are no worries about getting the elections done in time. But you may have to worry about getting them overridden! Standing Elections A standing election cannot be used to apply the COB or PFB to satisfy quarterly contributions A separate election is required for each quarterly contribution requirement at this time. This may change in future regulations whenever they get around to issuing them.

29 Standing Elections If a standing election is used, then the election is deemed to be made as of the last day applicable for that purpose, which is 8 ½ months after plan year end for both purposes. This can have drawbacks for the election to satisfy the MRC. Since the standing election does not take effect until the last day for funding, then elections (or deemed elections) made during the subsequent plan year can have the effect of using the COB/PFB before they can be applied to that prior plan year. Standing Elections Example There is a standing election in 2014 to use the COB/PFB to the extent necessary to satisfy the MRC. The 2014 MRC is $100,000. The 2014 PFB is $15,000. The employer contributes $100,000 on 2/15/2015 (which is not sufficient to satisfy the MRC due to the interest discount) and wants the balance satisfied by the PFB. The actuary determines at this time that there is sufficient PFB to finalize the Schedule SB and sends it to the employer. However, because the plan s presumed AFTAP as of April 1, 2015 is under 80% there is a deemed election on April 1, 2015 to reduce the PFB by $14,000 in 2015 for the 2015 AFTAP. According to the regulations, this deemed election occurs prior to the usage of the PFB for the 2014 MRC even though the SB for 2014 was already signed. Now there isn t enough PFB to satisfy the 2014 MRC. The 2014 SB will have to be amended and the employer will need to contribute additional amounts to avoid a funding deficiency for 2014.

30 Standing Elections How can we then use a standing election to satisfy the MRC for a year without waiting until after 9/15 of the following year to certify the Sch SB for the year? (See grey book ) You could also do an election for the specific amount of the COB/PFB used on the SB. This will then make the election effective immediately instead of at 9/15, and will take precedence over later deemed elections. But I would still recommend having the standing election in place to protect those employers that don t fund until the last minute. Standing Elections Should you use a standing election to add the max to the PFB each year? Pros: If the employer often delays making their contribution until the funding deadline or if the actuary often doesn t get the information until after the funding deadline (or the actuary is just a bum and doesn t get the valuation done until after the funding deadline), then the standing election will automatically add the max to the PFB so that no election needs to be done by 9/15.

31 Standing Elections Should you use a standing election to add the max to the PFB each year? Cons: Adding the max to the PFB each year could inadvertently result in bad consequences for the employer. If the PFB grows large enough that the FTAP is now less than 80%, then there is this huge credit balance but it can t be used. It would increase the funding required for the plan, without allowing the employer to use the PFB to satisfy this larger MRC. Standing Elections Should you use a standing election to add the max to the PFB each year? Recommendation: Try to have more control in this area. Try to complete the next year s valuation at the time you finalize the prior valuation (if at all possible, that way you don t have to remember 6 months later what is going on with the plan), that way you can judge the effect of adding to the PFB and make a recommendation to the plan sponsor. In my opinion, this standing election is generally not a good idea. The risk of creating a large, unusable PFB that works against the client far exceeds the benefits.

32 Standing Elections Standing elections stay in effect until revoked or there is a change in actuary Must revoke by notice to actuary and administrator prior to the date the election was deemed to have occurred. If there is a change in actuary, can issue new standing election to name the new actuary prior to the due date of the Form Prefunding Balances Questions?