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 review new provisions not previously covered in our articles and summarize the new funding and benefit restriction rules. On October 7, 2009, the Internal Revenue Service released a pre-publication copy of final defined benefit funding regulations reflecting changes made by the Pension Protection Act (PPA). This article summarizes the new regulations. We begin with a brief summary of "what's new" and follow with summaries of the new funding and benefit restriction rules. What's new Short answer not much. There are several important changes to the proposed regulations, but the really important ones have already been published in some other form. So, as it were, here's what's old: Per the "Worker, Retiree, and Employer Recovery Act of 2008" (WRERA), 24-month asset averaging now takes into account expected returns on plan assets (actuarial "smoothing"). Per announcements in the IRS newsletter, calendar year plans may use October 2008 spot rates for 2009 valuations and may switchback to 24- month average segment rates for 2010. The final regulations contain a number of technical changes with respect to the calculations and the "chronology" of calculations of both the basic funding requirements and the application of the benefit restriction rules. In addition, we would identify the following features of the final regulations as "new:" The use of a "standing election" to apply credit balances against minimum funding requirements. Allowing sponsors that apply a credit balance to minimum funding requirements and then "over-contribute" for the year to use the excess to "replenish" their credit balances. Elimination of a requirement in the proposed regulations that plans offer participants the right to defer payment of the restricted portion of a prohibited payment even where the plan did not otherwise provide for such a deferral. Clarification of the rules for the calculation of the prohibited portion of an accelerated payment that will allow payment of Social Security level income benefits in many cases. Not yet answered: Can a standing election be used to apply credit balances against quarterly contribution requirements? And how are "plan-related" investment expenses to be treated? November 2009 page 1

The regulations are generally effective for years beginning in 2010. Sponsors may rely on the proposed regulations for prior years. Final regulations the two funding regimes As we have written in the past, PPA generally provides for two funding regimes: First, a requirement that plan shortfalls (generally, plan liabilities minus assets) be funded over seven years. And, second, a set of penalties/limitations/restrictions (e.g., on the payment of lump sums and the funding of deferred compensation) that apply when plan funding falls below certain levels (generally 80% or 60%). Funding under the second regime is not mandatory, but sponsors that comply with the second regime generally must fund up shortfalls (e.g., to get the plan to 80% funding) immediately rather than over seven years. The final regulations provide general rules for the determination of funding obligations under regime one and rules for the determination and application of benefit restrictions probably the key set of rules under regime two. With respect to regime one, the final regulations detail how key elements of regime one funding calculations are to work. Key element of the funding calculation funding target attainment percentage Many funding requirements key off of a plan's funding target attainment percentage (FTAP). The FTAP is generally plan assets divided by liabilities. Since the IRS's initial proposals, questions have come up, and, for the most part been resolved, with respect to both the numerator and denominator of the FTAP. Determination of the numerator value of assets Generally, the numerator of the FTAP is the fair market value of plan assets on the valuation date, but the sponsor may (and in most cases is likely to) elect to use an "average" value of assets. Asset values may be averaged over up to 24 months. Reflecting changes made by WRERA, the final regulations provide that the "average" value of assets is adjusted for expected earnings. As provided by PPA, asset averaging is limited by a 90% to 110% fair market value corridor. Generally, the value of plan assets is reduced by the value of plan credit balances. Determination of the denominator value of liabilities Generally, the denominator of the FTAP is equal to plan liabilities. Liabilities are generally determined based on a simplified corporate bond-based yield curve with three "segment rates" short- (0-5 years), medium- (6-20 years) and long-term (over 20 years). Segment rates are generally based on a 24-month average, with the 24-month period ending with the month immediately preceding the valuation month. So, for a calendar year plan, the 24- month period for the January 2009 valuation month ends December 2008. Sponsors may, however, alternatively elect to use one of four lookback alternatives e.g., for a calendar November 2009 page 2

year plan for the January 2009 valuation, any of the 24-month periods ending with August, September, October, or November 2008. A sponsor may elect to use "spot rates" (i.e., "un-smoothed rates" averaged over one month, not 24) and a full yield curve (i.e., no segmenting). There was a controversy over whether sponsors electing to use "spot rates" could also pick from five different measurement months. The proposed regulations provided that sponsors using spot rates could only use rates from the month preceding the valuation month. We discuss this issue in our article 2009 DB funding Impact of IRS's interest rate guidance. As indicated in an IRS newsletter published in March 2009, the final regulations provide that for 2008 and 2009 a sponsor using spot rates may pick from any of the five valuation months available for plans using segment rates. For 2010 and after, sponsors using spot rates must use rates from the month preceding the valuation month. A related issue was whether plans that used spot rates for 2009 could switchback to smoothed rates for 2010. Generally such a change would require specific approval by the IRS. This issue is discussed in our article IRS will permit switchback to smoothed interest rates for 2010. Again, as indicated in a September 2009 IRS newsletter, the final regulations provide that such a switchback will be automatically approved for 2010. Application of credit balances As noted, credit balances are generally subtracted from plan assets in making funding calculations. Sponsors may elect to waive credit balances (thereby increasing the plan's asset numerator) or to apply credit balances against their minimum funding requirement. The final regulations provided detailed guidance with respect to these elections. Generally: Elections must be made by providing written notification of the election to the plan's enrolled actuary and the plan administrator, setting forth the relevant details of the election, including the specific dollar amount involved in the election. The final regulations add a feature allowing "standing elections." A plan sponsor may provide a standing election in writing to the plan's enrolled actuary to use credit balances to offset the minimum required contribution for the plan year. Elections with respect to credit balances must be made no later than the last date for making the minimum required contribution for the plan year. However, an election to reduce credit balances for a plan year (for example, in order to avoid or terminate a benefit restriction) must be made by the end of the plan year to which the election relates. Elections with respect to credit balances are irrevocable. The final regulations provide for one exception to this rule: an election to use a credit balance to offset the minimum required contribution can be revoked to the extent it exceeds the minimum required contribution, provided the revocation is, generally, made by the end of the plan year. (Note that the regulations defer the deadline for making this revocation for November 2009 page 3

the first plan year beginning in 2008 until the due date (including extensions) of the Schedule SB of Form 5500.) Credit balances are generally adjusted for the actual rate of return on plan assets. We discuss PPA credit balance rules in detail in our article Credit balances and contribution timing under PPA. The final regulations provide a number of rules for, e.g., the ordering of additions to and reductions of credit balances, adjustments for interest and actual rate of return on plan assets and other technical issues raised by PPA credit balance rules. Rules for plans in at-risk status The final regulations make no significant changes to the rules for plans in at-risk status. To summarize: Plans with an FTAP for the preceding year of less than 80% (using regular valuation assumptions) and less than 70% (using at-risk assumptions) must use at-risk liability valuation assumptions for determining the current year FTAP. Under at-risk liability valuation assumptions, you must assume that all participants eligible to commence benefits under the plan in the current plan year, or the next 10 plan years (that's 11 years in total), will terminate at the earliest possible date and will take the most valuable benefit available to them under the plan (e.g., a lump sum or subsidized early retirement). In addition, plans that have been in at-risk status two of the four preceding years must add a loading factor equal to $700 per participant plus 4% of total liabilities; normal cost of these plans is also increased by 4%. A couple of transition rules apply. First, the "80% test" is phased-in as follows: In 2008 65% In 2009 70% In 2010 75% Thus for the 2010 plan year, a plan is at-risk if the FTAP for the 2009 plan year was less than 75% using regular assumptions and less than 70% using at-risk assumptions. Second, generally plans in at-risk status for less than five years (not taking into account pre- 2008 years) have their at-risk liability valuation phased-in at a rate of 20% per year. The final regulations do offer some added flexibility relative to the proposed regulations. When a plan is coming out of at-risk status, the proposed regulations would have required IRS approval to return to the not-at-risk actuarial assumptions; the final regulations generally provide automatic approval. * * * November 2009 page 4

Final regulations benefit restrictions In what follows, we are going to discuss, in summary, the PPA benefit restriction rules as articulated in the final regulations. Let's begin with the basics. The following chart summarizes PPA funding-based benefit restrictions. Event Restriction Unpredictable No benefit payable where adjusted funding target attainment contingent event percentage (AFTAP) is less than 60% or would be less than 60% (e.g., plant taking into account the occurrence of the event. shutdown) Plan amendment May not increase benefits where AFTAP is less than 80% or would be less than 80% taking into account the amendment. (An exception applies for non-pay related plans for certain increases not in excess of pay increases.) Accelerated payments (e.g., lump sums) May not pay at all where AFTAP is less than 60% (or where the sponsor is in bankruptcy proceedings and the certified AFTAP is less than 100%); restricted to the lesser of 50% or the present value of the maximum PBGC guarantee where AFTAP is between 60% and 80%. No restriction where the plan has had no benefit accruals on or after September 1, 2005. Accruals Must be frozen where AFTAP is less than 60%. Key element of the funding calculation adjusted FTAP The application of PPA benefit restriction rules depend on a plan s adjusted funding target attainment percentage (AFTAP). Generally (and oversimplifying somewhat), the AFTAP is: Actuarial value of the plan's assets minus credit balances divided by The plan's funding target (ignoring at-risk calculations) This number is adjusted for certain annuity contract distributions. AFTAP for "fully funded" plans There is one special AFTAP calculation rule: if your plan is "fully funded," that is assets without subtracting credit balances are at least 100% of your funding target, you are exempt from having to subtract credit balances when determining the AFTAP. That "fully funded" rule transitions in, as follows: November 2009 page 5

For year Fully funded means assets (without subtracting credit balances) divided by funding target is 2008 92% 2009 94% 2010 96% 2011 and after 100% To be eligible for the transition percentage in any year you have to have met the transition target in prior years. So, to use the 96% target in 2010, you have to have met the 94% target for 2009 and the 92% target for 2008. If you didn't, then "fully funded" means 100%. The rules for plans that don't "fully fund" If you don't qualify for the fully funded "exemption," you must: 1. Calculate yearly, and in some cases more than once a year, what your AFTAP is. 2. Determine the extent to which your AFTAP status restricts benefits. 3. Decide whether to mitigate any restriction. The regulations go into elaborate detail as to how all this works. In what follows, we will review the more significant elements of this process. Calculating AFTAP In the abstract, a plan's AFTAP is a pretty simple number. Basically, it's just beginning of the year assets divided by beginning of the year liabilities. The calculation of the AFTAP under the benefit restriction rules is, however, complicated by special rules concerning: (1) a required actuarial certification of the plan's AFTAP and presumptions that apply prior to that certification; and (2) the treatment of reductions in credit balances. Actuarial certification of AFTAP Generally, a plan's AFTAP is whatever the plan's actuary certifies it to be. Remember that the AFTAP is calculated as of January 1 of the current year. In a perfect world, where all data were instantly available, this calculation would be simple. But in the real world, funded status has to be retroactively derived. Asset and liability values are determined after January 1, as data for January 1 is accumulated and crunched. Generally, you can derive your asset value (unless you have significant illiquid assets) fairly quickly. But liability values, based on a snapshot of a plan s employees as of January 1, are typically not determined until several months into the year. So both sponsors and regulators have to deal with a "calculation/data lag" problem. The IRS rejected requests for a "roll-forward" rule, under which the benefit restriction rules would be based on prior year actuarial results with appropriate adjustments for subsequent November 2009 page 6

changes. Instead, timing issues are accommodated by PPA presumptions and the range certification rule included in the proposed regulation. Presumptions In the ordinary course, prior to the actuarial certification of a plan's AFTAP for the year, for calendar year plans the following presumptions apply: Presumption 1. If a benefit restriction applied to the plan on the last day of the preceding plan year, then the AFTAP for the current plan year, as of the beginning of the plan year, is presumed to be prior year's AFTAP. Presumption 2. If the prior year AFTAP was certified to be at least 60% but less than 70% or at least 80% but less than 90%, then as of April 1 the plan's AFTAP is presumed to be equal to 10 percentage points less than the prior year AFTAP. So, for instance, a 2010 AFTAP of 69% (absent certification of a 2011 AFTAP) resets to 59% on April 1, 2011. Presumption 3. If the plan's actuary has not certified the plan's AFTAP before the 10th month of the plan year, the plan's AFTAP, for the rest of the year, is conclusively presumed to be less than 60%. The regulations provide for special rules where current year actuarial certification is made on or after October 1. Generally these presumptions do not apply retroactively. And, until October 1, any applicable presumption is overcome by an actuarial certification. Finally, as under the proposal, sponsors and actuaries may use an interim "range" certification (i.e., the AFTAP is at least 60%, 80% or 100%). The range certification supersedes any presumption. After a range certification is made benefit restrictions are applied based on an assumed AFTAP at the bottom of the range. A "real" certification must be provided by year end (the proposed regulations had required it by October 1), and there are significant penalties if the real certification comes in below the lower end of the range. Determining the extent to which your AFTAP status restricts benefits Again, in the abstract, the effect of your AFTAP status on your ability to pay benefits should be simple. You just look up your AFTAP and determine whether a restriction applies. But the timing of the commencement and cessation of a restriction, as well as the interaction of the presumptions and the actuarial certification, can make this a complicated process. The general rule is that benefit restrictions don't apply retroactively; they begin to apply when a certification is made or a presumption takes effect; they cease to apply when, e.g., a new AFTAP is certified. But there are exceptions to this rule. For instance, a plan that, in February 2011, did not provide an unpredictable contingent event benefit because the certified 2010 AFTAP was less than 60% would have to go back and provide the benefit if there were a certification in June 2011 that the AFTAP was 60% or greater. A similar rule applies for plan amendments. November 2009 page 7

Application of a benefit restriction For the most part the application of a benefit restriction is straightforward, e.g., during the relevant restriction period, no plant shutdown benefit may be paid, no plan amendment may be made, etc. The application of restrictions on accelerated payments where a plan's AFTAP is 60% or more but less than 80% is, however, a little more elaborate. In those circumstances (oversimplifying somewhat) a part of the benefit the lesser of 50% or the present value of the PBGC guaranteed amount is "unrestricted" and can be paid on an accelerated basis; the rest of the benefit is "restricted" and cannot be paid on an accelerated basis. As noted, the final regulations provide for a calculation of the "prohibited portion" in these circumstances that is likely to permit the payment of most Social Security level income options. Under the proposal, the plan must provide a participant with the option either to defer payment ("to the extent permitted under applicable qualification requirements") or to bifurcate the benefit into unrestricted and restricted portions. Many sponsors found this rule awkward. The final regulations provide that a deferral option must be offered only to the extent the plan otherwise allows for a deferral. Mitigating benefit restrictions There are things sponsors can do to avoid the application of benefit restrictions, and there are things they can do to, in effect, make up for benefits lost during a restriction period. Avoiding restrictions Sponsors can avoid the application of a benefit restriction through one of four techniques. The sponsor can: Reduce available credit balances and thereby increase the asset "numerator" in the AFTAP fraction. Make additional contributions for a prior plan year (within 8-1/2 months of the end of the plan year and prior to any certification reflecting such contribution). Make a specific contribution to offset the cost of unpredictable contingent event benefits, a plan amendment or ongoing accruals. Provide security as permitted under PPA. The reduction of credit balances to avoid restrictions requires some discussion. Following the statute, under the final regulations credit balances must be reduced if doing so would relieve a restriction (1) on accelerated payments in any plan or (2) relieve any of the other November 2009 page 8

restrictions (e.g., on plant shutdown benefits or a plan amendment) in a collectively bargained plan. The calculation of the reduction is tricky. There are different rules depending on whether you are above or below the applicable threshold; where a presumption applies, you have to, in effect, interpolate a funding target number to derive the adjustment; and, if on ultimate certification it turns out you didn't need to do the reduction, you can't get reductions back. Similar rules apply where the credit balance reduction is optional, e.g., to allow a plan amendment in a non-collectively bargained plan. Restoring restricted benefits The general rule is that when the underfunding stops the restriction stops. So, for instance, where a plan that had been subject to unpredictable contingent event benefit and ongoing accrual restrictions, once the plan's AFTAP is certified to be 60% or more accruals will recommence and unconditional contingent event benefits will again be paid, with respect to unpredictable contingent events subsequent to the certification. Similarly, once a limit on accelerated payments ceases, unrestricted accelerated payments may be made to participants with subsequent annuity starting dates. Once a restriction "lifts," a plan may also be amended to restore "lost" accruals. Generally, that restoration would be treated as a new amendment, subject to any applicable restrictions on plan amendments (e.g., if the plan is less than 80% funded). But such a restoration is allowed without regard to any applicable amendment restrictions where: (i) the continuous period of the accrual restriction is 12 months or less; and (ii) the plan's enrolled actuary certifies that the AFTAP for the plan would not be less than 60% taking into account the restored benefit accruals for the prior plan year. The final regulations add a new rule with respect to unpredictable contingent events and plan amendments: if an unpredictable contingent event benefit cannot be paid or a plan amendment can not take effect because of a benefit restriction but is permitted later in the plan year as a result of additional contributions or pursuant to a subsequent actuarial certification, then the unpredictable contingent event benefit or plan amendment must be given retroactive effect. * * * For those who have been following the evolution of PPA funding rules, most of the foregoing is review. Probably the biggest outstanding issue at this point is whether and how Congress will temporarily change these rules to provide additional breathing room for plan sponsors struggling in the wake of the 2008 financial crisis. We are continuing to follow that issue. Our latest article is DB funding relief bill introduced. ##### For more strategies on retirement programs, contact Brian Donohue at 312.732.2164 or brian.donohue@aon.com. November 2009 page 9