DB contribution timing under PPA

Insight
Aug 13, 2009
DB contribution timing under PPA
By Brian Donohue, Senior Vice President, Aon Consulting
In the wake of PPA and its new funding rules, both practitioners and plan sponsors have
found it more difficult to get their arms around the timing of required contributions as well as
the timing of the calculations that may affect those contributions. In this article, we walk you
through the process with stops along the way to better understand the mechanics and the
timing.
In this article we review the timing of contributions under the new Pension Protection Act
(PPA) defined benefit plan funding rules. "Timing of contributions" may be too narrow a
description here – our topic is not just "when do you put the money in," but also when key
calculations are made and the interaction of the timing of contributions and the timing of
calculations. Much of this may seem like "course level 101" material, but we have found
some timing issues problematic, or at least not especially intuitive, and so we provide this
review as a resource.
Scope
Let's begin by defining the scope of the discussion. We will assume for all purposes we are
dealing with a calendar year plan; so we will not be discussing fiscal year plan year timing
issues. And we will assume we are dealing with a frozen plan, so we won't be considering,
for example, the calculation of normal cost. Finally, we're going to use, as an example,
contribution timing for the 2009 year.
Two funding regimes
As we have discussed in the past, there are actually two funding regimes applicable under
PPA. First, "regime one," a new set of rules that requires the amortization of asset-liability
shortfalls over seven years. And second, "regime two," a set of rules – benefit restrictions,
at-risk rules and a limitation on funding of executive compensation – that, in effect, punishes
a sponsor for allowing a plan to drop below specific funding thresholds – generally 60% or
80%.
Calculating the FTAP and AFTAP
Under both regime one and regime two, contributions for any year are generally a function of
the plan's assets-to-liabilities funding ratio. For regime one funding purposes, that ratio is
generally called the funding target attainment percentage (FTAP). For some regime two
purposes, in particular benefit restrictions, it's the adjusted funding target attainment
percentage (AFTAP). The "adjustment" here usually involves certain annuity purchases,
which we are going to disregard, so we will use terms interchangeably, noting where
differences may be important.
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Both regime one and regime two funding ratios are calculated based on asset and liability
values as of the end of the prior year. So the FTAP for 2009 is determined as of December
31, 2008. At the risk of belaboring this point, what this means is that the funding ratio for
2009 – which will drive 2009 regime one contributions – is based on assets in the plan as of
the end of the 2008 plan year.
A final, and somewhat tricky, point – a plan's FTAP and any shortfall are generally
determined based on "beginning-of-the year" values. Those values are the prior year's endof-year values. So, plan assets and liabilities for 2009 are based on assets and liabilities in
the plan as of the end of 2008. Thus, if you want to affect, for instance, the 2009 FTAP, you
must make a contribution "for" 2008. We will discuss in more detail below how/when that
may be done.
Regime one timing
Generally under PPA, the sponsor must make a contribution each year adequate to pay off
the shortfall – the gap between assets and liabilities – over seven years. As we have done in
the past, in making calculations, our rule of thumb is that year one funding equals about onesixth of the shortfall. Why not one-seventh? We need to adjust for interest on the shortfall.
So, under regime one, you calculate your FTAP (end-of-prior-year asset-liability shortfall)
and (more or less) contribute one-sixth of that to the plan. When must that contribution be
made?
No quarterly contribution obligation
Generally, if there is no quarterly contribution obligation, contributions for the current year
(assuming applicable extensions) must be made on or before September 15 of the following
year. So, for 2009, the contribution may be made on or before September 15, 2010.
Quarterly contribution rules –generally
The challenge of making quarterly contributions, and managing their payment, has increased
for two reasons. First, in a change of the rules, under PPA credit balances are subtracted
from assets before determining whether the plan must make quarterly contributions. Second,
late 2008 asset losses have put more plans in an underfunded status. So let's review how
the PPA quarterly contribution rules work.
Plans that have a funding shortfall for the prior year are required to make quarterly
contributions for the current year. As we said above, funding shortfalls are determined as of
the beginning of the year (here, the beginning of the prior year). Thus, the requirement to
make quarterly contributions in 2009 is based on January 1, 2008, assets and liabilities,
which are in fact the plan's December 31, 2007, values.
To connect the last dot: the latest a sponsor may affect this amount – the amount of the prior
year shortfall – is September 15 of the prior year. So, a sponsor that wished to avoid
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DB contribution timing under PPA
quarterly contributions for 2009 had until September 2008 to eliminate the applicable prior
year shortfall (by making a contribution “for” the 2007 plan year).
Doing the math here, late 2008 asset losses won't affect quarterly contribution obligations
until the 2010 plan year. And sponsors have until September 15, 2009, to make 2008
contributions affecting 2009 FTAP.
Quarterly contributions must be made on or before April 15, July 15, October 15 of the
current year and January 15 of the following year.
The amount of each quarterly contribution is equal to 25% of the lesser of (1) 90% of the
minimum required contribution for the current plan year and (2) 100% of the minimum
required contribution for the preceding plan year.
To the extent not met by quarterly contributions, the plan's minimum funding obligation for
the current year is due (assuming applicable extensions) not later than September 15 of the
following year.
Thus, for 2009, quarterly contributions would be due April 15, July 15 and October 15 of
2009 and January 15, 2010; and any final ("true-up") contribution would be due September
15, 2010.
Regime two timing
Let's begin with the fact that timing is more critical for regime two funding because,
generally, any shortfall (relative to the regime two threshold, for example, 80%) must be
made up in the current year. For most plans, the most significant regime two "incentive" is
avoiding PPA benefit restriction rules, so let's review briefly how the timing of the application
of those rules works.
Generally, benefit restrictions in the current year are based on the plan's current year
AFTAP. As discussed above, that is a beginning-of-year value, which is in fact based on
prior year end-of-year values. So, for 2009, the AFTAP = assets divided by liabilities as of
December 31, 2008.
The benefit restrictions work like an on-off switch. Generally, while the AFTAP is below one
of the key thresholds (e.g., 80%), the restriction applies. Once you get above the threshold,
the restriction lifts. And, depending on the flow (and timing) of contributions to the plan and
the actuary's certification, the AFTAP can change during the year – so the switch can go on
and then off during the year.
The switch is "fixed" (unchangeable) for the year once an actuarial certification of the plan's
AFTAP is made. Generally, AFTAP values must be certified by an actuary before October 1
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of the current year (e.g., for 2009, October 1, 2009). Until certification, certain presumptions
apply, as follows:
1. For January-March of the current year (e.g., January-March 2009), the 2009 AFTAP is
presumed to be the same as it was in the prior year. So, if the 2008 AFTAP was 85% (note,
this ratio would be determined as of December 31, 2007), the plan's 2009 AFTAP for the
period January-March 2009 would be presumed to be 85%.
2. As of April 1 of the current year (e.g., April 1, 2009), the presumed AFTAP, based on the
prior year, gets a 10% haircut. So, if the 2008 AFTAP is 85%, then the plan's 2009 AFTAP is
presumed to be 75% as of April 1, 2009, triggering, for example, restrictions on lump sum
payments.
3. Before October 1 of the current year (e.g., October 1, 2009), the plan's actuary must
certify what the plan's 2009 AFTAP actually is. That number is based on end-of-prior-year
values; in other words, assets and liabilities as of December 31, 2008.
For all of these purposes, contributions made for 2008 by September 15, 2009, may be
included in the December 31, 2008, assets, affecting the 2009 AFTAP.
Please note: for 2009 and later years, the actuary certifying the plan's AFTAP may not take
into account contributions that have not actually been made. So, a contribution made on
September 15, 2009, may not count as December 31, 2008, assets, affecting the 2009
AFTAP, with respect to an actuarial certification made before that date.
Example
This is all complicated, so let's work through an example. As of the end of 2007, a plan's
assets-to-liabilities ratio is 85%, so its 2008 AFTAP is 85%. The actuary certifies that ratio
before October 1, 2008. (We are going to ignore 2008 PPA transition issues in this
example.)
Those are beginning-of-2008 values. Because of last quarter asset losses, the end-of-2008
funding ratio is actually 70%.
For the period January-March 2009, the plan's 2009 AFTAP is presumed to be 85% and no
restrictions apply.
As of April 1, 2009, the "10% haircut" applies, the plan's 2009 AFTAP is presumed to be
75% and certain restrictions (e.g., restrictions on the payment of lump sums) apply – the
benefit restriction switch flips on.
As of September 15, 2009, the sponsor makes a contribution for 2008 sufficient to increase
the end-of-2008 funding ratio up to 80% (from 70%). September 15, 2009, is the latest date
that contribution may be made.
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Before October 1, 2009, the actuary certifies that the plan's beginning-of-2009 AFTAP is
80%, and the restrictions lift – the switch flips off.
Regime one + regime two
Regime two contributions – in our example, the contribution the sponsor made as of
September 15, 2009 (for 2008) – are, of course, made in addition to regime one
contributions, and the interaction of the two is complicated and not particularly intuitive.
As we see, a sponsor that has a regime two funding problem in the current year generally
must make a contribution "for" the prior year to fix it. That regime two contribution will also
have a (somewhat marginal) effect on the regime one contributions for the current year. For
example, the September 15, 2009, regime two contribution described above (made for 2008)
affects 2008 end-of-year funding – specifically, the numerator of the 2009 FTAP – and thus
will affect the regime one contribution for 2009.
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Let's now turn to an illustration of the foregoing principles.
Example –"ordinary" timing of regime one funding
Let's begin with an illustration of a straightforward approach to the timing of funding, focusing
for the moment just on regime one.
Let's assume our plan has $76 million in assets and $100 million in liabilities as of December
31, 2008. After passage of the "Worker, Retiree, and Employer Recovery Act of 2008"
(WRERA), the transition funding target for 2009 is 94%. Our example plan is in real terms
76% funded ($76 million in assets divided by $100 million in liabilities). But it has a shortfall
for 2009 of just $18 million ($76 million in assets versus a $94 million transition funding
target).
Our funding rule of thumb is that year one funding equals about one-sixth of the shortfall. So,
under these assumptions, this plan will have a 2009 regime one contribution requirement of
$3 million ($18 million divided by six).
If the quarterly contribution rules do not apply, that $3 million may be contributed as late as
September 15, 2010, ignoring any interest adjustments.
But, let's assume the quarterly contribution rules do apply. Thus the sponsor must contribute
the lesser of 100% of the 2008 minimum required contribution, or 90% of the 2009 minimum,
in four payments on April 15, July 15 and October 15, 2009, and January 15, 2010. Let's
assume that the 2008 minimum contribution was $2 million, so the lesser quarterly
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contribution is one-fourth of 100% of $2 million. Under these assumptions, the sponsor will
have to make contributions as follows:
Date
April 15, 2009
July 15, 2009
October 15, 2009
January 15, 2010
September 15, 2010
Total
Contribution
$0.5 million
$0.5 million
$0.5 million
$0.5 million
$1.0 million
$3.0 million
The September 15, 2010, contribution of $1 million is the "true-up" of the $3 million required
contribution minus the $2 million in quarterly payments. (In fact, under PPA, the final
contribution will be closer to $1.2 million due to interest, but we are ignoring this to avoid
overcomplicating the analysis.)
Regime two timing
That's the simple version under regime one. Now let's assume that the sponsor wants to
conform to regime two funding requirements and thus wants to get its 2009 AFTAP up to
80%. To do that the sponsor must make a contribution by September 15, 2009, for 2008, of
$4 million ($76 million plus $4 million equals $80 million; $80 million divided by $100 million
equals 80%).
That contribution will change the 2009 FTAP for regime one funding purposes. There's
another $4 million in the numerator; the numerator is now $80 million, and the 2009 shortfall
is only $14 million ($80 million in assets versus a $94 million transition funding target). Onesixth of $14 million is about $2.3 million. So, with those numbers in mind, here, again, is a
straightforward approach to the timing of funding:
Date
April 15, 2009
July 15, 2009
September 15, 2009
(made for 2008)
October 15, 2009
January 15, 2010
September 15, 2010
Total
August 2009
Contribution
$0.5 million
$0.5 million
$4.0 million
$0.5 million
$0.5 million
$0.3 million
$6.3 million
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To be clear about what's going on here: the sponsor is still making the same quarterly
contributions, based on one-fourth of 100% of its 2008 minimum required contribution of $2
million. It's also contributing, on top of those amounts, another $4 million, to get the plan's
2009 AFTAP (based on end-of-2008 values) up to 80%. That additional 2008 contribution
reduces the 2009 contribution from $3 million to $2.3 million.
By September 15, 2010, the sponsor has to contribute whatever balance of the 2009
contribution that hasn't been covered by quarterlies. When it was only conforming to regime
one, that balance was $1 million ($3 million owed minus $2 million in quarterlies). When it
puts in $4 million, for 2008, to conform to regime two requirements, the balance goes down
to $0.3 million ($2.3 million owed minus $2 million in quarterlies).
Accelerating contributions
We'd now like to describe an accelerated contribution schedule that provides one clear
benefit – reduced Pension Benefit Guaranty Corporation (PBGC) premiums. Let's go back to
our simple regime one table, but let's make all $2 million in quarterlies before April 15, for
2008.
Date
April 14, 2009
(made for 2008)
April 15, 2009
July 15, 2009
October 15, 2009
January 15, 2010
September 15, 2010
Total
Contribution
$2.0 million
$0
(apply $0.5 million credit balance)
$0
(apply $0.5 million credit balance)
$0
(apply $0.5 million credit balance)
$0
(apply $0.5 million credit balance)
$1.0 million
$3.0 million
Let's start with the mechanics of this approach first; then we'll explain why you might do it.
Under this funding approach, the sponsor contributes all $2 million of the quarterlies before
April 15 [(it could literally be made on April 15, but it's easier to explain this way)], for 2008.
That entire contribution is in excess of the minimum contribution owed and already
contributed for 2008 and thus creates a $2 million credit balance. That credit balance is then
used to satisfy the 2009 quarterly contribution obligations.
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Now, why? Assuming interest rate effects wash out (that is, the company's cost of borrowing
is the same as the interest rate under the plan), getting the $2 million in for 2008 increases
December 31, 2008, assets, reducing the plan's 2009 unfunded liability and saving PBGC
premiums on unfunded liabilities (by 0.9% of $2 million, or about $18,000 in this example). In
real life, that is a pure savings to the enterprise. PBGC premiums aren't like contributions –
contributions above the minimum will still reduce the sponsor's obligation. They are a fee –
once you pay them, you can't get them back, and you get no added benefit.
Not all companies will want to employ this strategy. It will not be particularly appealing to
companies under cash stress. But for those with ready access to capital, it is, at the margin
at least, money-saving. And the ability to accelerate contributions is not just limited to
quarterlies – the "true-up" contribution (which in our examples is made on September 15,
2010) could also be accelerated (to September 15, 2009), with a concomitant reduction in
2009 PBGC premiums.
In addition, contributions that are accelerated to April 30 and considered as being made for
2008 can be counted as assets and thereby reduce the unfunded liability shown on the new
PPA funding notice. That notice, which goes to employees, has raised concerns among
some sponsors, especially in the context of late 2008 asset losses.
Without walking through the regime two example, we note that similar benefits (reduced
PBGC premiums, increased assets on participant notices) are available to plans operating
under regime two that accelerate 2009 required contributions.
Asset strategy and regime two contributions
As a general matter, under PPA, all plans will have to be brought up to full funding (ignoring
PPA transition issues) over seven years. So, as they say, you will either have to "pay now or
pay soon." Timing of contributions can generally only be manipulated over the short term.
One "benefit" of regime one is that it adds assets to the trust, to make up the shortfall,
incrementally, over seven years. So, to some extent at least, market timing issues can be
disregarded. If the sponsor must conform to funding regime two, however, funding is
accelerated. You don't pay more (adjusting for the time value of money), you just pay
sooner. But the sponsor does put a significant piece of the plan's shortfall into the first year.
In our example, the total shortfall – the total amount to be funded over seven years – was
$18 million. Under regime one, only $3 million of that went into the first year. Under regime
two (which is really regime two + regime one), $6.3 million went into the "first" year
(technically, $4 million of that amount went into the prior year).
Here's the point: putting that much into the plan "all at once" raises market timing issues.
They will matter more in some situations than others, but it is worth considering, if you are
conforming to regime two, what is the right asset strategy for the "extra" assets you are
putting into the plan. This is particularly an issue right now, because plan shortfalls –
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especially for 2010-11 – are likely to be large, and a sponsor funding to a regime two
threshold may be putting a lot of money into their plan.
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We have purposely ignored, in this discussion of contribution timing, complications facing
plans that maintain significant credit balances, with the exception of balances that are
created and spent almost immediately to satisfy current year quarterly requirements.
Consideration of these issues will be the subject of our next article on the subject.
Finally, the issues discussed here are merely tactical, not strategic. But we have found that,
in discussing the impact on sponsor cash resources of PPA DB funding demands, an
understanding of when calculations are made, when contributions must/may be made and
how contributions affect calculations can add incremental value. Thus, we provide this
material as a resource for our discussion of truly pressing issues – e.g., determining how
much money a sponsor must contribute for 2009 or 2010.
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For more strategies on retirement programs, contact
Brian Donohue at 312.732.2164 or [email protected].
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