On Thursday, March 11, the president signed the American Rescue Plan Act (ARPA) into law. Sections 9701-9708 are grouped under a subtitle labeled "Pensions'' and anyone sponsoring a qualified defined benefit plan is going to be interested in what those sections have to say.
Multiemployer Plans
Multiemployer plans—plans sponsored by a union for its members, and funded by those members' employers—are subject to a different set of funding rules than single-employer plans. Multiemployer plan funding rules are the subject of sections 9701 through 9704 of ARPA, and will not be addressed further in this article.
Extended Amortization Period
Section 9705 of ARPA increases the period for amortizing funding shortfalls from 7 years (which was the period established under the Pension Protection Act (PPA) back in 2006) to 15 years going forward. This change is mandatory for all plans starting in 2022, but may be used for funding calculations as early as 2019 if the plan sponsor elects to do so. This change will generally have the effect of reducing employers' minimum required contributions.
In order to understand the impact of this change, it is important to first understand how the minimum required contribution is determined.The minimum required contribution is generally made up of two pieces: the Target Normal Cost and the Shortfall Amortization Charge. The Target Normal Cost represents the value of benefits earned during the current year. The Shortfall Amortization Charge only applies if plan assets are less than plan liabilities; the amount by which the liabilities exceed the assets is called the Funding Shortfall. Rather than having to pay the full amount of the Funding Shortfall all in one year, the amount is amortized into a number of equal installments, payable over a period of years. The Shortfall Amortization Charge for the current year is equal to the amortized installment of the current year’s Funding Shortfall, plus the amortized installments of any past years’ Funding Shortfalls. [Please note this paragraph is a vast simplification of the actual funding rules and there are many other factors which may affect a plan's minimum required contribution. However, the author believes it is sufficiently descriptive to help the reader understand the impact of the changes made by ARPA.]
For the 2022 plan year (or an earlier year if elected by the plan sponsor), if the plan is carrying any installments on prior years, those installments are reduced to zero. Any resulting Funding Shortfall after eliminating the 7-year installment payments is then amortized over 15 years, and the Shortfall Amortization Charge for that year will be equal to that single 15-year amortization installment. In the following year, any remaining Funding Shortfall will be amortized over 15 years from that date, and that amortization payment will be added to the first year's installment to get the Shortfall Amortization Charge for that year, and so on.
Because existing shortfall installments are being reduced to zero, and the Funding Shortfall is now being amortized over 15 years instead of 7, plan sponsors can expect smaller Shortfall Amortization Charges over the next several years. Eventually, however, multiple years' worth of amortization installments could be due in a single year and the total Shortfall Amortization Charge is likely to return to current levels.
Overall this change is likely to negatively impact plans' funded status. Under the original rule, a plan with a funding shortfall would be expected to become fully funded within 7 years, more or less. Now the horizon to reach full funding has been extended to 15 years, leaving plans in an underfunded and therefore riskier state for a longer period of time.
Funding Discount Rates
Section 9706 of ARPA adjusts the interest rates used to determine the minimum required contribution, as described in the previous section. The changes made by this section will result in higher discount rates, which translates into smaller Target Normal Costs and Funding Shortfalls. As a result, minimum required contributions will be smaller.
The interest rates in question are based on the yield on investment-grade corporate bonds. Those yields are grouped into three segments: the first segment is yields for a term of less than 5 years, the second segment is those with a term of at least 5 but less than 20 years, and the third segment is for those 20 years or more. A 24-month average is taken for the yields in each segment and those averages are our starting point.
Next, a 25-year average is calculated for each segment, and multiplied by an adjustment factor, which serves as a lower limit on the 24-month average. Prior to ARPA, the adjustment factor for 2020 was 90% and for 2021 was 85%. ARPA increased those to 95% for years 2020 through 2025, 90% for 2026, and reduces that by 5% each year thereafter until it reaches 70% in 2030.
Because bond yield rates have been very low for many years now, the 25 year average—which includes rates going back to the late 1990s when rates were significantly higher—will almost always be higher than the 24-month average, even after taking the adjustment factor into account. A higher discount rate means smaller Target Normal Costs and Funding Shortfalls, which means smaller minimum required contributions for plan sponsors.
Section 9706 also adds a rule that if the 25-year average is ever below 5%, then 5% will be used instead of the actual 25-year average. In other words, for the years 2020 through 2025, the segment rates will never be lower than 95% of 5%, or 4.75%.
The changes made by this section are effective in 2020, but a plan sponsor may choose to delay taking them into account until 2021 or 2022, if they wish.
This change, while it reduces the funding obligations for plan sponsors, further distances the plan's funding requirements from reality. The original intention of the rule that discount rates be based on bond yield rates was that it could reasonably represent the actual investment returns available in a real pension fund. In reality, short- and medium-term bond yields have not approached anywhere near 4.75% in many years, so allowing plans to use that as a discount rate will not encourage the plan to be adequately funded. Ultimately the responsibility will lie on the plan sponsor and the enrolled actuary to determine a funding strategy that will ensure the plan remains adequately funded into the future.
Other provisions
Section 9707 provides special funding rules for community newspaper plans. Section 9708 affects the rules determining excessive remuneration for certain employees of publicly-held corporations. Neither of these sections is likely to have an impact on sponsors of small defined benefit plans.
Overall impact of the ARPA
All of the changes made by ARPA with respect to single-employer plans have the effect of reducing minimum contribution requirements. While many plan sponsors will appreciate the flexibility this offers them, minimum contribution requirements alone do not tell the whole story. Plans which are covered by the PBGC are still required to pay a variable-rate premium which is based on the plan’s funded status and calculated using spot discount rates. PBGC premiums are expected to rise over the next several years due to the low interest rate environment, and unlike the rates used for minimum funding, the rates used for PBGC have not been adjusted or capped. Plan sponsors who take advantage of the lower minimum contribution requirements may find themselves subject to higher PBGC premiums if their plans are not well-funded.
It is important for plan sponsors to understand that merely satisfying the minimum contribution requirements is not sufficient to ensure that their plans are sufficiently funded to meet all benefit obligations. Discussing your funding objectives with an enrolled actuary or plan consultant is essential to developing a sound contribution strategy for your plan. Please don’t hesitate to contact us to talk about funding your plan.