Incentives to Fund; Flexibility
Sponsors should be able to fund and deduct the unfunded ABL at year-end or anytime. They should be encouraged to better fund their plans by: 1) allowing them to buildup funding margins in good years, without deductions and excise taxes; and 2) allowing them access to “super-surpluses” for other purposes, such as employee health benefits, without incurring the reversion tax.

In theory, the PPA provides significant flexibility for sponsors to contribute additional amounts in good years to create a funding balance that can be accessed in future periods when a business downturn could make large cash contributions undesirable. However, poor stock market returns in 2007–2009 and falling interest rates in recent years have effectively reduced this flexibility by eliminating previous cushions for many plans  (in some cases as the result of mandatory or voluntary funding balance waivers to avoid benefit restrictions) and increasing contribution requirements for minimum funding or to avoid benefit restrictions.

Successes

The significant increase in maximum tax-deductible contributions under the PPA (preserved under MAP-21, HATFA, and BBA) allows plan sponsors significant flexibility to contribute more in good years to serve as a cushion against increases in future years when access to cash may be limited or needed for other business purposes.

Funding balances provide contribution flexibility for plans maintaining an 80 percent funded status.

The PPA created numerous funding bases and thresholds for different purposes, including levels needed to avoid benefit restrictions or at-risk status, to preserve the ability to use funding balances, or for determining PBGC variable rate premiums. These thresholds provide powerful incentives for plan sponsors to accelerate funding.

 

Shortcomings

Excise taxes on asset reversions (generally 50 percent of the reversion amount) discourage plan sponsors from contributing to create a surplus due to the potential of that surplus becoming “trapped.”

Restrictions on the use of funding balances and mandatory waivers—as well as essentially forced voluntary waivers to avoid funding-based benefit restrictions—may discourage prefunding.

Instead of providing an incentive to fund, recent increases in PBGC premiums may provide an incentive for plan sponsors to reduce participant headcount (or even to exit the defined benefit system entirely).

Avoidance of Moral Hazards
The rules should not facilitate weak employers to improve benefits (or take large risks) at the expense of another stakeholder (e.g., PBGC, its premium payers, U.S. taxpayers, or current and future employees).

The benefit restriction provisions in the PPA significantly restrict the ability of plan sponsors to improve or accelerate the payment of benefits in underfunded plans, while providing mechanisms for those plans to avoid restrictions by contributing to improve a plan’s funding level.

 

Successes

Shorter amortization periods and funding-based benefit restrictions ensure past service amendments are funded more quickly.

Limiting the payment of accelerated distributions from poorly funded plans helps to maintain benefit security for the remaining plan participants (especially the restriction on payments for benefits in excess of the PBGC guarantee level).

Restricting very poorly funded plans from providing additional benefit accruals or paying unpredictable contingent event benefits inhibits the growth of funding deficits.

Eliminating the “guaranteed” return on funding balances in favor of realized rates of return on plan assets prevents plans from maintaining artificially inflated funding balances based on book value accumulations of prior excess contributions.

The HATFA provision specifically exempting the use of the 25-year average rate for determining the applicability of the accelerated payment restriction during a bankruptcy period preserves protections for PBGC and other participants in the situation of a bankrupt employer during a low-interest period.

Shortcomings

A plan sponsor’s ability to dictate when the plan actuary issues a funded-status certification introduces significant discretion into plan operations that may delay or extend the application of benefit restrictions.

Current benefit restrictions may limit the payment of some accelerated distribution forms that do not pose a significant risk to a plan, such as the Social Security Level Income Option, certain death benefits, and periodic benefits payable at a retroactive annuity starting date.

The PPA benefit restrictions could induce some plan sponsors to intentionally underfund their plans to avoid paying benefits negotiated in good faith through a collective bargaining process.

MAP-21 changes have diluted the effectiveness of some of the PPA’s protections against moral hazard by overstating    a plan’s funded status relative to current market conditions, permitting a plan to avoid restrictions on accelerated distributions, and allowing the payment of lump-sum benefits determined at historically low market interest rates (which are more advantageous to participants). The eight-year extension of the corridor phase-out under HATFA/BBA delays the return to a market-based measure of the plan’s funded status and increases the risk exposure to the PBGC. Ultimately, this will lead to a more rapid deterioration of a plan’s funded status as assets paid out as a lump sum will exceed the liability released as a result of the distribution unless the plan is funded on a basis that takes into account these lump-sum distributions.

Highly complicated rules provide incentives for plan sponsors to seek loopholes.

Transparency
Users of the information provided (e.g., employees, employers, investors, and the PBGC) should be able to understand the financial position of the pension plan and its effect on their sponsor.

Plan participants and other key stakeholders are provided with more frequent disclosure of information intended to improve their understanding of a plan’s financial health.
However, the confusing nature of much of the information presented in the disclosures may compromise their effectiveness.

Successes

The PPA prescribes a single funding method, with limited variations available for the selection of interest rate and asset valuation method. This makes contribution information more comparable across plans.

The required PPA annual funding notice (AFN) includes more detail on plan assets, liabilities, and funding levels than the pre-PPA notices (Summary Annual Report and Notice of Plan Underfunding), indicating how a plan’s funded status changes year over year.

The Department of Labor posts Form 5500 Schedule SB filings on its website, and plan sponsors also are required to post Schedule SB on a company-sponsored intranet site (if their intranet is used for providing benefits-related information).

Shortcomings

Using a 24-month average of segment rates and asset values decreases transparency compared to the (monthly basis) yield curve and market value of assets. MAP-21 creates the potential for greater distortion compared to market rates   for liability calculations over the near-term, and the extension of the MAP-21 relief via HATFA and BBA perpetuates this distortion for an additional eight years.

The PPA defines an array of funded-status measures for various purposes, making it difficult for stakeholders to understand the plan’s financial condition.

The use of different bases for calculating beginning and end-of-year funded status in the AFN creates confusion for plan participants and employers.

Simplicity
The rules should be easier to use and understand.
 
Lack of simplicity may be the PPA’s largest failure. Taken at face value, the liability method, amortization rules, and contribution requirements appear straightforward but other provisions, such as the at-risk rules and the rules around funded-status certifications, make valuations and plan administration much more complex. Subsequent funding-relief provisions (provided via WRERA, PRA, MAP-21, HATFA and BBA) add further complexity.

Successes

Plans all use the same actuarial liability method with limited variations available for the selection of interest rate and mortality tables. Investment and demographic gains and losses, assumption changes, changes in plan provisions, and changes in asset valuation method are combined and amortized based on a single amortization period.

Shortcomings

Extremely complicated rules related to funding balance elections, deemed reductions to funding balances, and offsets to plan assets for various funded status measurements greatly complicate plan management while adding little or no value in terms of benefit security.

Benefit restriction rules, including the presumption rules in effect prior to the issuance of the plan’s funded-status certification, complicate the benefit administration process for sponsors and participants without demonstrating a beneficial result.

As noted in the Transparency section, having multiple measures of plan funded status for different purposes can be difficult for participants and sponsors to understand. The introduction of MAP-21’s 25-year average segment rates for some—but not all—measurement purposes adds another set of funded-status measures and introduces even more complexity.

At-risk rules complicate the valuation process considerably without adding commensurate value.

Requiring that plan contributions be discounted to reflect the actual date paid adds unnecessary complexity.

Transition
Sponsors need smooth transitions, including adequate time to implement new rules.

Although the PPA included numerous provisions to aid plan sponsors during the transition period, those special rules proved to be of limited effect in the difficult economic environment that followed.

Successes

The PPA included a number of temporary provisions and phase-in rules relating to funding segment interest rates, at-risk percentages, and funding shortfall amortizations.

Subsequent funding-relief legislation has helped sponsors cope with economic and capital market downturns in recent years, providing additional time to fund unanticipated funding shortfalls.

Shortcomings

The PPA’s increase in the target funding level from 90 percent to 100 percent affected plan sponsors at a particularly bad time—at the onset of an extreme period of economic and capital market dislocation.

Delays in the regulatory approval process have left plan sponsors without guidance on several critical issues, such as corporate transactions. The timing of guidance that has been released often has given sponsors little time to act before the rules are effective.

Even when funding-relief provisions have been enacted, the last-minute timing put significant pressure on plan sponsors to react quickly and make decisions with little time to consider longer-term consequences.

Possible Approaches to Improve PPA Funding Requirements

The PPA’s existing structure can be modified to better meet overall objectives, i.e., to make the rules more effective and support the sustainability of the system. We do not believe that a major system overhaul is necessary.
 
As noted in the PPA Scorecard section, many of the temporary fixes and funding-relief provisions, particularly the MAP-21, HATFA, and BBA changes, did not seek to balance the long-term principles of funding reform. However, the effects of these laws will gradually diminish over the next several years. Allowing that to happen naturally is consistent with the smooth transition principle and may be a reasonable approach if reform efforts are focused instead on permanent, long-term solutions that better balance the key principles.

The Academy’s Pension Committee has identified significant opportunities for improvement in three general areas. While each proposal, if implemented, individually could improve a particular aspect of the current PPA rules, we acknowledge that it may be impractical, and even undesirable, to implement the full set of proposals as outlined. Funding rules represent a complex system, with many interacting parts; changes to one aspect of the rules often will affect the operation in other areas. Finding an appropriate balance should be a primary consideration.
 
We further suggest that any changes include voluntary transition provisions to provide plan sponsors time to adjust to new requirements. Other sponsors may be permitted to adopt rule changes more quickly if desired.

Proposal 1: 
Increase Incentives to Fund

The overriding goal of pension-funding legislation is to establish a minimum level of required funding. Nevertheless, plans that are well funded today often achieved that status as a result of past contributions made in excess of minimum requirements. Although plan sponsors should not be permitted to funnel unlimited amounts into their pension plans on a tax-advantaged basis, a reasonable amount of prefunding should be encouraged.
 
Possible ways to encourage prefunding include:

• Ease funding balance forfeitures: Some inequities result from the current framework in regard to mandatory funding balance waivers. For example, a pension plan that pays lump sums is required to waive funding balances to the level necessary to avoid restrictions on accelerated payments, if possible. But there is no connection between the amount of balance waived and the amount of lump sums that will be paid, so a plan might be required to waive $10 million of funding balance to protect a lump-sum feature that will pay only $1 million in lump sums. As an alternative, a plan could be required to waive funding balances equal to the amount of lump sums that will be paid or a plan sponsor could be permitted to add contributions equal to the lump-sum amounts.
• Reduce the excise tax imposed on supersurpluses:⁸ The excise tax rules on asset reversion could be relaxed to allow plan sponsors access to super-surpluses, while including restrictions on the use of funds for non-benefit purposes. For instance, a sponsor could be permitted to withdraw a portion of surplus each year (e.g., 5 percent of the value of assets or obligations). There also could be an additional restriction on reversions within a specified period of time following a change in corporate ownership where accessing a super-surplus may be adverse to the interests of plan participants or restrictions on the uses of withdrawn surplus (e.g., require withdrawn excess to be used for other deductible employee benefit plan costs).
• Determine Adjusted Funding Target Attainment Percentage (AFTAP) without a reduction for funding balances: Funded status for purposes of the funding-based benefit restrictions could be measured using plan assets unreduced by funding balances.
• There is no strong rationale for penalizing a well-funded plan sponsor because funds were contributed earlier than required (i.e., because the sponsor has the ability to employ those balances to reduce future required contribution amounts). Should the plan sponsor elect to use those balances in the future and the funded percentage then falls below 80 percent as a result, benefit restrictions would more reasonably be applied at that time.
• Revising rules that create illogical outcomes: Complex rules and restrictions regarding the establishment of funding shortfall amortization bases sometimes give rise to situations where having a lesser funded position results in a lower required contribution. For example:
  • A plan whose assets exceed the funding target by $1 may be prohibited from setting up a (negative) amortization base such that the minimum required contribution could be larger than the amount that would have been required if the plan was instead $1 underfunded.
  • The sponsor of a plan that falls below 80 percent funded by $1 more than the plan’s existing funding balances (such that a deemed waiver would not return the plan to 80 percent funded) will likely be required to contribute significantly less than if the plan first falls below 80 percent by $1 less than the amount of available funding balances—and is thus forced to waive to avoid benefit restrictions.

• PBGC premium incentives to prefund: PBGC premiums (both the  flat-rate  premium paid by all plans and the variable-rate premium paid only by underfunded plans) have increased significantly since the PPA was enacted.⁹ The recent increases in the variable premium rate will result in many plans paying the maximum variable-rate premium, which creates more of an incentive to reduce headcount through voluntary cashouts and annuity purchases than it does to increase funding levels.¹⁰ A reduction in PBGC premiums for plans that take voluntary action to progress toward solvency would provide sponsors an increased return on contribution dollars and might provide a compelling rationale for prefunding. For example, a tiered premium structure could allow sponsors paying more than the minimum to pay a lower variable-rate premium than those who pay only the minimum required amount.

These changes would support solvency by providing employers with new incentives to fund in advance of minimum requirements. Eliminating highly complex rules that are often counterintuitive in their effects simplifies the system and reduces moral hazard by making the underlying restriction rule set more manageable, thereby reducing the future need for temporary relief that has the result of weakening the effectiveness of the rules.
 

Proposal 2: 
Enhance Contribution Predictability

For plan sponsors choosing a minimum contribution strategy, large year-to-year increases in contribution requirements were a critical problem in the initial years under the PPA funding regime. The Great Recession of 2008– 2009¹¹ and the decline in interest rates since then led to substantial increases in minimum required contributions and the adoption of special funding relief that deferred to later years a portion of the minimum contributions otherwise required under the PPA. These funding-relief measures provided plan sponsors with an opportunity to plan for the higher contribution requirements that eventually would come due. However, the cost of this increased contribution flexibility was an acceptance of decreased solvency and benefit security for plan participants.
 
Employers have the ability under existing rules to create more stable contribution patterns by funding at a level in excess of the minimum required. Additional changes may further support those sponsors not able to, or choosing not to, fund in excess of the minimum required. To achieve more stable contribution patterns, either or both of the first two of the following features could be added to the funding rules as options. The second option removes an inconsistency between the valuation of plan assets and liabilities for plan sponsors that implement an investment strategy to hedge against interest rate changes that affect the determination of the funding target liability.

• Output (rather than input) smoothing: The funding rules could be reworked to employ strict market-based inputs for asset values and interest rates; the resulting calculated minimum contribution and benefit restriction percentage could then be smoothed/averaged over a period of years. Amortization of the funding shortfall is one example of output smoothing with which many people are familiar. Another form of output smoothing would limit the change in the minimum required contribution or AFTAP to a specified corridor around the prior year’s value, which would be particularly helpful for sponsors that fund to avoid the benefit restriction “cliffs.” With output smoothing, minimum contributions would not increase as much immediately following “bad” years and would not decrease as much immediately following “good” years. It should be noted that significant elements of this approach easily could be implemented on a sponsor-by-sponsor basis by plan sponsors that want to contribute according to a funding policy that exceeds the minimum requirement.
• End-of-year yield curve: For plan sponsors that decide to pursue a hedging investment strategy, the inability to use interest rates as of the valuation date is an obstacle. Permitting the use of spot yield-curve rates based on information as of the last day of the plan year aligns the discount rate with interest rates implicit in fixed income pricing.

Output smoothing would allow the minimum funding requirements to accommodate a desired level of contribution predictability without impairing the transparency of the fundamental liability and asset measurements that occurs when interest rates or asset values are smoothed (input smoothing). Input  smoothing  methods can accomplish a similar result in terms of contribution predictability, but they tend to obscure the measure of solvency and may result in decision-making that is adverse to the ultimate goal of ensuring benefit security. Allowing the use of the end-of-year yield curve facilitates hedgeability and contribution predictability for those plans that hedge by matching the point in time of the interest rates that are used to measure the liability with the point in time measure of plan assets.
 
Care must be taken to ensure an appropriate balance between predictability and solvency, as changes to improve one of these principles are often a trade-off with the other. To the extent that contribution predictability is enhanced by methods other than hedging the liabilities or contributions in excess of the minimum required amount, there is increased risk to plan participants and the PBGC.
 
If output smoothing is not deemed appropriate by policymakers, more input smoothing may be needed to improve contribution predictability. One potential change that provides additional input smoothing, particularly in the most volatile market conditions, is to broaden the asset corridor from 10 percent to 20 percent. While the shortened smoothing period of two years implemented under the PPA improved solvency, the 20 percent corridor allowed under prior law was more effective at smoothing the effect of extreme capital market fluctuations than the current 10 percent corridor. In the event of extreme market events, an additional moderate amount of asset smoothing may provide a brief reprieve for a sponsor to recover and plan for the higher contribution requirements needed to return the plan to its prior funded status. However, it might also mean that an already financially distressed employer would be permitted to further delay funding.
 

Proposal 3:
Reduce Regulatory Burden

Defined benefit plans are complex structures by their nature. However, in the years since the PPA was enacted, the degree of difficulty in administration and compliance has grown substantially, placing greater burden on plan sponsors and making defined benefit plans less appealing. Simplifying the funding and regulatory structure would reduce a substantial disincentive to plan sponsorship.

Some specific areas where regulatory simplification might be possible include:

• Discontinue current at-risk rules: Consideration should be given to discontinuing the burdensome at-risk calculations. These add substantially to administrative cost and complexity while seemingly adding little value in terms of promoting plan solvency.

Making at least some of the suggested modifications would help to enhance simplicity and make compliance easier by encouraging plan sponsors to comply and addressing instances of substantial noncompliance.

Conclusion

The Academy’s 2005 analysis of pension reform options noted that there is one major objective that pervades all discussions affecting retirement security, including funding reform—meeting the financial needs of retirees—and the defined benefit system is uniquely effective in doing this.
 
As defined benefit plans become underfunded, the amount of benefits paid to participants is not changed, but the security of promised benefits may be reduced. Funding rules should encourage a healthy defined benefit system and one that employers will find appealing in which to participate. But sponsors faced with sometimes unnecessary financial and administrative burdens will choose to move away from defined benefit plans.
 
The PPA represented a significant step forward in a number of ways, but issues that have arisen with its implementation indicate that further progress is needed. As it exists today, the single-employer defined benefit funding system (including the funding-based benefit restrictions) is far too complex. Simplification of the rules is essential to creating and maintaining a system in which plan sponsors are willing to participate.

Removing obstacles to the creation of new plan designs that better correlate the behavior of funding liabilities and the assets used to finance those liabilities or that provide for a greater sharing of risk between sponsors and participants will encourage continued defined benefit plan sponsorship. The funding rules should support plan sponsors in structuring their investment and funding strategies to effectively manage defined benefit plan risks.
 
The Academy Pension Committee has proposed specific legislative and regulatory modifications that we believe will help support a robust defined benefit system by:

• Creating incentives for plan sponsors to fund their plans toward solvency;
• Rewarding sponsors that fund in excess of the minimum;
• Increasing participant engagement; and
• Appropriately reducing the administrative burdens of compliance.

We encourage the legislative and regulatory communities to consider these suggestions with an eye toward achieving a better balance among the seven key principles of single-employer pension funding: solvency, predictability, flexibility, avoidance of moral hazards, transparency, simplicity, and smooth transitions. Defined benefit plans can effectively support the objectives of both plan sponsors and participants when operated within a reasonable regulatory framework—one that discourages detrimental practices while limiting unnecessarily complex administrative requirements.