Final DB Funding Relief Analysis

Transcription

1 We discussed the details of the new defined benefit (DB) plan funding relief legislation, signed into law on June 25, Below, we analyze how this legislation may affect different plans. For general background on ERISA DB funding rules, please see our article Three Ways to Think About DB Finance. Who Is/Is Not Affected by the New Law? It's easier to discuss this issue by focusing on who is not affected by the new law. Generally the relief may not be significant if: Your plan is overfunded, i.e., you have no current ERISA funding obligation other than (perhaps) normal cost. You must comply with what we call funding regime two i.e., to avoid certain penalties (e.g., a restriction on the ability to pay lump sums), you must get funding above 60% or 80%. The second point requires additional explanation. As we have discussed in prior artic les, ERISA, as amended by the Pension Protection Act, in effect contains two funding regimes. One is applicable to all corporate DB plan sponsors and generally requires funding of shortfalls over 7 years. The other applies certain penalties including benefit restrictions, atrisk rules, Pension Benefit Guaranty Corporation (PBGC) reporting, and a limitation on funding of executive compensation. The latter regime also places a limitation on funding executive compensation that essentially punishes a sponsor for allowing a plan to drop below specific funding thresholds generally 60% or 80%. As noted, we call that second set of rules "funding regime two." As a general matter (and with some exceptions), a sponsor does not have to conform to funding regime two requirements as long as it is willing to put up with the restrictions that apply, e.g., if funding falls below 80%. But if you do have to comply, the relief provided by the new law generally will not help; it's really only funding regime one relief. In this regard, given interest rate and asset performance to date, 2011 (based on end-ofyear 2010 values) may be a tough year for some companies and test their resolve to stay above 80%. Special Relief on Accrual Freezes and Level Income Payments There are two exceptions to this general rule. First, relief provided under the Worker, Retiree, and Employer Recovery Act of 2008 (WRERA) is extended to 2010, allowing sponsors to determine funding based on beginning-of-2008 values to determine whether the plan is less than 60% funded and therefore subject to an accrual freeze. And second, similar treatment was provided for restrictions on Social Security level income payments. July 2010 page 1

2 Thus, in these two fairly limited situations, the new law provides some funding regime two relief. In all other respects, however, the new law affects/is useful to plans that are at least 80% funded or are otherwise unconcerned about complying with funding regime two, but do have an obligation to fund a shortfall. Under the new rules, that latter obligation can effectively be stretched out. Effect of New Relief Let's illustrate the impact of the new relief with some numbers. The table below provides 1- year contribution numbers for 7-year, 2+7-year and 15-year amortization for a $100 million shortfall, using a 5% interest rate. Method 1-year payment Savings 7-year (no relief) 2+7-years (relief alternative 1) 15-year (relief alternative 2) $16.5 million $4.8 million $11.7 million $9.2 million $7.3 million So the benefit provided by the funding relief (reduced current cash cost) can be significant and should provide meaningful relief for some plans. The cost, of course, is that the missed contributions will have to be made up at some point, in subsequent years vs. 15-year Amortization For sponsors with significant current cash issues, 2+7-year amortization provides the best deal in the current year, but the amortization in year 3 will go back up (in our example, to $16.5 million). For sponsors with less immediate cash needs, 15-year amortization provides the better long-term deal. The short-term cost of using 15- rather than 2+7-year amortization in the current year for the example plan is $4.4 million. Cash Flow Rules A critical element of most companies' analyses of relief options will be applying the new law's cash flow rules, which may limit the amount a sponsor may pay out in compensation, dividends and stock redemptions (the cash flow rules are discussed in detail in our earlier article). July 2010 page 2

3 As a general matter, we note that with respect to the cash flow rules, companies can either reduce compensation (read our analysis here), dividends and/or redemptions or increase the amount of the contribution to the plan. Since the shortfall will generally have to be funded eventually, having to put more in the plan is not really a penalty, it's just a reduction in short - term cash-flow relief. Let's consider the compensation rule and then the dividend/redemption rule. Compensation Analysis of the impact of the cash-flow rules on compensation policies will require some data gathering. Obviously, sponsors will want to identify employees who are being paid more than $1 million; but there are a variety of technical rules, (e.g., excluding certain commissions and adding in certain deferred compensation arrangements), the application of which will have to be sorted out for each company and, in all likelihood, each high-paid individual. In some cases, commissioned employees earning over $1 million may have no impact on the cashflow rule, while other employees earning under $1 million may exceed the $1 million threshold when the value of deferred compensation plans are included. For companies with really big shortfalls (say, in the billions of dollars), the impact of the compensation cash-flow rule may not be that great, relative to the amount of relief provided. On the other hand, if the shortfall is only $100 million, simply paying one executive $2 million will reduce the relief by almost 10% under the 2+7-year alternative and even more under the 15-year alternative. Thus, for a significant number of companies, compliance with the compensation cash-flow rule will put stress on executive compensation policies. In some cases, top-paid executives may be asked to wait until the restriction period 3 years (where the 2+7-year alternative is elected) or 5 years (where the 15-year alternative is elected) lapses, but such a strategy faces a host of practical and legal hurdles. The shorter restriction period for the 2+7-year alternative may be a deciding factor for some companies with these sorts of compensation issues. Dividends and Redemptions Since they are so far outside of our usual bailiwick of benefits and compensation, our observations with respect to the dividend/redemption cash -flow rules are necessarily brief. Probably most important: officials of the company responsible for finance and their advisors will want to study the applicable rules in detail to determine if pension funding relief negatively affects the current financial plan. Having said that, it appears that the dividend/redemption cash-flow rule is designed to accommodate historical practices of returning money to shareholders without seriously July 2010 page 3

4 compromising meaningful pension funding relief for most companies that really need such relief. The application of these rules may be a case in which it is useful to involve both advisors who mainly look at plan liabilities and assets (e.g., the plan's actuary) and advisors who mainly look at company liabilities and assets (e.g., the company's financial officials and bankers). Picking the Right Year Unless yours is a non-calendar year plan, the relief generally is effective for the years You may elect relief for any 2 of those years, but you must elect the same method (2+7-year or 15-year amortization) for both. Remember, in discussing years here, the shortfall for any year (for a calendar year plan) is based on values as of December 31 of the prior year. So the 2009 shortfall (and contribution) is based on December 31, 2008, values. (We discuss contribution timing issues in detail in our article DB Contribution Timing Under PPA.) Which years work best will depend on each sponsor's specific circumstances. We note that, with respect to assets, 2009 (based on December 31, 2008, values) was a weak year; 2010 (based on December 31, 2009, values) was a good year; and 2011 looks like it may be another weak year. Of course, smoothing of assets and liabilities under PPA can distort some of these market observations. Generally, in a given plan year the larger the shortfall, the greater the relief. Most calendar year plans will already know the shortfalls for the 2009 and 2010 plan years and be able to reasonably estimate the shortfall for The math is straightforward: bigger shortfall = bigger relief. Another thing to consider electing relief for earlier years will provide more immediate relief (e.g., relief for the 2009 plan year may reduce required contributions due on September 15, 2010). Thus, companies urgently seeking near-term relief may lean towards including 2009 as one of the relief years. On the other hand, the phase-in of the shortfall amortization under PPA (based on 94% of the funding target for 2009 and 96% for 2010 for most plans) will tend to push more of the shortfall into 2011, tilting the incentive toward the later years Special Issues For sponsors who are considering electing relief for 2009, there are some special issues. The first and foremost is timing. If relief for 2009 is a possibility at all, the books on it (for calendar year plans) will close in September, leaving very little time for analysis. July 2010 page 4

5 With respect to the 2009 shortfall, sponsors were allowed special interest rate relief, allowing them to use (very high) October 2008 interest rates to value 2009 liabilities. In addition, asset smoothing also helped reduce the size of 2008 losses that had to be recognized. As a result, many sponsors with large end-of-2008 losses nevertheless had no shortfall for Companies that plan to take advantage of relief for 2009 may actually consider un-deflating the 2009 shortfall. That is, it may be an advantage to make the 2009 shortfall bigger by not smoothing asset values and/or not valuing liabilities using the high October 2008 interest rates. Effectively, you can decrease the 2010 shortfall by increasing the 2009 shortfall. This approach does present some issues worth considering: If increasing the 2009 shortfall takes you below a benefit restriction threshold (e.g., 80%), the consequences for essentially a material misstatement of the plan's adjusted funding target attainment percentage (AFTAP) may be prohibitive. Other PPA penalties (AFTAP presumptions, PBGC 4010 filings, at-risk status) should also be considered. Changing interest rates (e.g., from the higher October 2008 rate to the lower December 2008 rate) is likely to increase the PBGC variable premium obligation with respect to the plan. Going from smoothed to un-smoothed asset values (which, for end-of-year 2008 generally will result in a decrease in asset values) does not present the same problem, since variable premiums are typically calculated based on un-smoothed assets. Note also that, unlike funding (which pays for an obligation you will have to pay for at some point), variable premiums are like taxes they go to the PBGC, and you don't get them back. If you increase a plan's 2009 shortfall now, you may have a quarterly contribution problem; given the new, higher shortfall, quarterly contributions may have been inadequate. You will want to evaluate the consequenc es of such an under - contribution. The cash-flow rules only apply to compensation and dividends/redemptions after February 28, This rule may marginally mitigate the impact of the cash-flow rules (especially the $1 million compensation rule). With the key date having passed however, taking advantage of this rule is not something a company can plan for; application will be very fact-specific. * * * The decisions sponsors may make with respect to funding relief involve a number of very complicated calculations and some tough judgment calls. Unfortunately, because of the very July 2010 page 5

6 long time it took Congress to act on this issue, that work may have to be done very quickly, e.g., before September Finally, there are a few items to note on legislative language. The bill that passed into law was identical to the bill passed by the Senate in March, and did not reflect some clean up that was added to the House bill passed in May. As a result, at least two items that were cleaned up in the House bill are now problematic: 1. Relief on level income restrictions are retroactive. Therefore, companies that applied restrictions in these forms of payments prior to 2010 may need to revisit these calculations. 2. Technically, the legislation can be read to double count relief offsets under the cash-flow rules for plans that elect multiple years of relief. So, for instance, $2 million in excess compensation in 2011 may reduce the impact of funding relief by $4 million for some plans. While legislators have indicated that this is not the intention of the law, Treasury officials are struggling to read this intention into the statutory language. We will continue to follow this issue, as the new law is interpreted by the agencies and as companies learn, in practice, its effect. ##### For more strategies on DB funding relief, contact Brian Donohue at July 2010 page 6