By Zorast Wadia CFA, FSA, EA, MAAA CFA, FSA, EA, MAAA - Principal, Consulting Actuary at Milliman
Nine considerations for corporate plan sponsors after the passage of the American Rescue Plan Act of 2021
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The COVID-19 pandemic has caused tremendous hardships for people and businesses alike. Plan sponsors of defined benefit (DB) pension plans certainly were not spared from the business and financial impacts of COVID-19. They simultaneously had to deal with burgeoning cash contribution requirements as interest rate relief provisions were scheduled to wear away starting in 2021. With financial markets declining rapidly in the first quarter of 2020 and many businesses ceasing normal operations, it appeared that plan sponsors were headed toward the eye of the perfect storm.
Fast forward to nearly 12 months later: with the passage of the American Rescue Plan Act of 2021 (ARPA) on March 11, 2021, plan sponsors were extended a new lifeline. The rules of pension funding for single employer pension plans as we had all become accustomed to for nearly the last decade and a half have undergone a complete overhaul. Just as the U.S. economy hit the financial reset button and came out of 2020 with a record recovery, corporate pension plan sponsors now get to revitalize their pension funding—the key difference being that the corporate defined benefit plan funding resurrection is expected to last through the rest of this decade!
It is important to appreciate how ARPA brings about landmark changes to pension funding for corporate plan sponsors. Much flexibility in the application of ARPA is available to plan sponsors, and the impacts of the funding relief and timing of the start of the relief should be examined. What is also of significance are the peripheral effects of ARPA on pension plan accounting, Pension Benefit Guaranty Corporation (PBGC) insurance premiums, asset allocation, and pension risk management strategies. This article summarizes nine considerations for corporate plan sponsors in light of the passage of ARPA.
ERISA funding and plan sponsor elections
To understand the impact on ERISA funding, we need to first examine how the rules changed. The two main funding relief components of ARPA were an extension of interest rate smoothing and a restart and extension of funding shortfall amortization bases. This is further summarized below.
Interest rate smoothing
ARPA provides for the use of higher segment interest rates used to calculate pension liabilities for minimum funding purposes and benefit restrictions. It preserves the stabilization effects of interest rate smoothing as follows:
- The 10% interest rate corridor surrounding the use of the 25-year average segments rates under prior law is reduced to 5%, effective in 2020.
- A 5% floor would be placed on each of the 25-year segment interest rate averages.
- The phase-out of the 5% interest rate corridor is delayed until 2026, at which point the corridor would increase by five percentage points each year until it attains 30% in 2030, where it would stay.
Extension of funding shortfall amortization bases
ARPA will lower plan sponsor costs as follows:
- All current shortfall amortization bases for prior plan years (and all shortfall amortization installments determined with respect to such bases) shall be reduced to zero (“fresh start”).
- All new shortfalls would be amortized over 15 years, rather than seven years under the prior law.
For starters, it is worth noting that the interest rate smoothing provisions under ARPA are more expansive than the previous interest rate smoothing provisions allowed under the Moving Ahead for Progress in the 21st Century Act passed in 2012 due to the compression of the interest rate corridor. Also, the interest rate floor in particular is meant to ensure stability and predictability on a longer-term basis, so that interest rate variations do not create excessive volatility. The higher interest rates under ARPA will lower the resulting plan liability and normal cost used in minimum funding requirement calculations. Moreover, with respect to the funding relief related to amortization bases, not only did ARPA more than double the amount of time that plan sponsors have to fund their shortfalls (the excess of accumulated liabilities over plan assets), but they now get to restart their efforts. All prior amortization bases that were established on a seven-year amortization schedule are eradicated under ARPA.
Besides the intrinsic relief attributes of ARPA, there are more plan sponsor privileges in terms of an inception date. Plan sponsors get the opportunity to retroactively apply the relief provisions of ARPA dating back as far as the 2019 plan year; one year earlier than the onset of the COVID-19 pandemic! Employers may have reasons to first apply ARPA at a later point in time than 2019 such as for the 2020, 2021, or 2022 plan year. Pros and cons of these options will have to be laid out alongside multiyear cost projections in many cases. The final plan sponsor elections will likely be based on consultation and guidance from various sources including plan actuaries.
The combined effect of interest rate and amortization shortfall relief is expected to be profound for many plan sponsors, especially those with plans facing current funding shortfalls. The retroactive start applications of ARPA will allow plan sponsors to “go back in time” and revise historical 2019 and/or 2020 actuarial valuations. A plan sponsor may choose this approach in order to lower its prior minimum required contributions. The reduction in minimum required contributions may be recaptured by the plan sponsor through the creation of prefunding balances. These prefunding balances can be accumulated to the present 2021 year, reflecting the favorable investment performance of 2020, and then be used to further reduce required cash contributions in 2021 and future years.
Besides the potential for immediate cash relief, many plan sponsors will find that their contribution projections are significantly lower during the next several years relative to what they were under prior law. The minimum contribution reduction effects are even more resonant for frozen plan sponsors, who could see their requirements decrease by more than 50% over the short term. Furthermore, by the time interest relief under ARPA begins its wear-away period in the year 2026, the effect for many plans could be muted given the potential for asset build-up over the next five years, assuming that plans meet their return expectations over this period.
Unintended prefunding balance consequences
Retroactive application of ARPA certainly can bring about benefits for plan sponsors. However, care must also be exercised so as to not be left with unintended consequences. Based on good faith interpretation of the relief under ARPA—Internal Revenue Service (IRS) regulations have not yet been issued—it is thought that excess contributions can be used to create prefunding balances. But these balances may not necessarily be available for immediate use in an intended year if the plan does not meet an adjusted funded ratio of at least 80%. Also, while it is possible to create a larger prefunding balance by revising the 2019 plan year valuation, the resulting balance available for the 2021 plan year may not be as large as initially envisioned if a plan sponsor is required to forgo some of the balance.
Mandatory forfeitures are required for plans that have accelerated forms of distribution and the ability to reach 80% funding by writing off some or all of the existing prefunding balance. In addition, by creating a larger prefunding balance based on retroactive application of ARPA, it is possible for a plan to trigger the requirement for a PBGC 4010 filing. This is because the PBGC 4010 filing threshold test requires plan assets to be offset by a plan’s prefunding balance. This would certainly be an undesirable consequence for a plan that had previously cleared the exemption threshold for the PBGC 4010 filing under application of the prior law.
Lastly, as long as a plan has a funded status below 100%, the existence of a prefunding balance actually serves to increase its minimum funding contributions due to the technical rules that must be adhered to in setting up shortfall amortization bases. Therefore, plan sponsors will want to work in concert with their pension actuaries to carefully determine the optimal starting point for the application of ARPA relief (2019, 2020, 2021, or 2022).
Cash contributions and tax deductibility
Funding ratios and projected minimum cash contribution requirements are just one aspect of this multifaceted coin. Clearly, plan sponsors that will strictly fund their plans to the level of minimum cash requirements will not get the benefit of higher tax deductions relative to funding beyond minimum cash requirements. While many plan sponsors have been accustomed to only funding minimum cash requirements in the years leading up to ARPA, due to business or other cash flow constraints, they should reevaluate their funding strategies now given the newly minted relief provisions.
In addition, some plan sponsors may want to redouble their contribution pledges should federal tax policy change. While a record stimulus package was passed under the Biden presidency, there is consternation about how the relief provisions will exactly be afforded. Should U.S. fiscal policy result in corporations being more heavily taxed than under current law, some plan sponsors may choose to begin making larger cash contributions to capitalize on the tax deductions. In fact, we saw this behavior in response to the Tax and Job Cuts Act of 2017 passed during the Trump regime, when plan sponsors accelerated cash contributions just prior to the application of lower corporate tax rates. For reference, Milliman's 2021 Corporate Pension Funding Study reported a plan sponsor contribution spike of $61.8 billion during 2017 compared to $34.6 billion in 2020 for the plans of the largest 100 U.S. publicly traded corporations.1
Benefit restrictions and other triggers
While ARPA did not necessarily change the cost of pension plan funding, it did alter contribution timing. The new funding rules allow longer periods of time for plan sponsors to make up funding deficits. Relative to prior law, this means that pension plan funded percentages will take longer to improve over time on average. Certain funded status thresholds have key importance under pension funding rules and plan sponsors may want to adjust their funding strategies accordingly as they near these thresholds.
For example, plans that are funded below 60% are required to freeze benefit accruals. The changes to interest rate smoothing with ARPA mean that plans that are funded below this mark now have the opportunity get over this hump sooner and with the potential of contributing less than needed under the prior law. The same logic can be applied to plans that are below the 80% and 100% funded status thresholds. Getting above 80% can help plans to avoid imposition of benefit restrictions on accelerated forms of payment such as lump sums. Payment of lump sums can be an important feature in a plan sponsor’s overall de-risking strategy as is discussed later. Funding over 80% could also allow for usage of prefunding balance in lieu of cash contributions in a year where cash funding may present a particular sponsor difficulty. Furthermore, not meeting the 80% funding threshold also carries other consequences. At-risk valuations, for example, could accelerate funding requirements.
Lastly, the 100% funding threshold could be an important consideration when determining a plan’s shortfall amortization base, a key component of a plan’s minimum required contribution, as noted above. The takeaway here is that there may be opportune times for plan sponsors to make contributions above ARPA minimum requirements as their plans near certain key funded status thresholds. Again, this should be highlighted by the plan’s actuary.
PBGC insurance premiums consist of a flat dollar premium and a variable rate premium (subject to a cap). The variable rate premium is based on a plan’s funded status, without the reflection of smoothed interest rates as allowed under ARPA. This means that if a plan sponsor chooses to make lower contributions (as allowed under ARPA) then they will often be required to pay a larger PBGC premium. Plan sponsors will need to weigh reduced minimum funding requirements under ARPA with increased PBGC insurance premiums. Under ARPA, plan sponsors have roughly double the time to making up for underfunding relative to prior law, but this would result in paying higher PBGC premiums for longer. Irrespective of the higher insurance premiums, plan sponsor contributions overall will be lower under ARPA, assuming of course that plans meet their annual return expectations. For plans paying PBGC premiums out of plan assets, the premiums are already a factored component of the plan’s minimum required contribution calculation.
Another mitigating factor to consider is the application of the PBGC variable rate premium cap, which is a function of the total number of plan participants. For significantly underfunded plans, as long as the variable rate premium cap applies, plan sponsors are protected from the larger variable rate premiums that would otherwise apply. As a plan’s funded status improves and the plan is no longer subject to the variable rate premium cap, the plan sponsor may want to consider accelerating its funding to lower the overall insurance payment. A common tactic for plan sponsors near full funding on a PBGC basis is to evaluate the benefits of additional funding in order to completely avoid paying a variable rate premium.
Pension accounting expense
While investment returns sharply rebounded and ended the year well ahead of expectations in 2020, discount rates fell sharply. That resulted in a mixed bag for plan sponsors for purposes of determining pension expense in 2021. For plans with longer durations and more cash flows sensitive to interest rates, the drop in the pension discount rates will likely result in a pension expense increase in 2021 relative to 2020. On the other hand, plans with shorter durations may find their liability losses offset by their asset gains in 2020 and thus may experience a reduction in 2021 pension expense compared to 2020. Either way, the one variable component of 2021 pension expense that plan sponsors can still influence is the expected return on assets.
Plan sponsors may want to consider making voluntary contributions in 2021 in order to increase the expected return on assets component of pension expense, thereby lowering the pension expense impact in 2021. Higher pension contributions in 2021 will also help to boost pension funded status as measured at the end of the 2021 fiscal year, which is a determinant for the 2022 fiscal year pension expense. Of course, the reduced funding requirements under ARPA will generally result in an increase in pension expense for sponsors who contribute less cash and/or use prefunding balances. For plan sponsors concerned about the long-term impact on pension expense as a result of the lower projected cash funding requirements under ARPA, multiyear accounting projections should be examined in addition to funding projections.
The passage of ARPA also necessitates the reexamination of pension risk management strategies. The remaining considerations will focus on popular pension risk transfer techniques, which have been rising in frequency over the past decade. Pension de-risking via asset allocation and glide path techniques will also be discussed.
Incentives for de-risking via window programs
Window programs have been used by plan sponsors for decades to accomplish human resource objectives during various business cycles and to meet long-term plan sponsor risk objectives. Windows are required to be voluntary and compliant with nondiscrimination requirements, and they are often executed over a short period of time such as 45 or 60 days (although the entire window administration process will take much longer depending on the extent of employee communications, data quality, and plan complexity). A couple of window strategies that are worth plan sponsor consideration include early retirement incentive windows and lump sum windows.
The COVID-19 pandemic can affect retirement patterns in different ways, including accelerating early retirement in some cases and contributing to delayed retirement in other cases. Employers in certain industries may be facing aging workforces who tend on average to defer retirement to later ages. The pension plan combined with an early retirement window can be used by a plan sponsor as a workforce management tool. Early retirement windows may include pension benefit incentives such as granting additional years of service or lower reduction factors applicable for earlier benefit commencement. Current IRS funding rules under the Pension Protection Act state that if a plan is funded below 80% at the time an amendment is adopted, any additional costs related to that amendment will require immediate funding (instead of amortizing the cost over 15 years as allowed under ARPA). With the extension of interest rate smoothing and the retroactive application of ARPA, the 80% funding threshold may be more in reach for plan sponsors now than ever before to execute window offerings.
Lump sum window offerings also continue to be widely used by plan sponsors in transferring longevity risk onto plan participants, and they don’t come with the hefty premiums associated with third-party liability transfers to insurance companies. In order for plans to pay lump sums without any benefit restrictions, they need to be funded above the 80% level. Similar to the early retirement window narrative, plans may now be in a better position to execute these strategies with the passage of ARPA and the associated higher funding levels.
Another added benefit of window strategies is that they reduce a plan’s participant count, which could result in PBGC premium savings for plans where the variable rate premium is limited by the per participant premium cap. With the slower funding progression expected under ARPA, plans could be limited by premium caps longer than under prior law. Thus, incentive windows can be explored that would bring about additional cash savings to plan sponsors under ARPA.
With ARPA bringing about transformational funding relief for plans, it is a good idea for plan sponsors to revisit their plan asset allocations to make sure their funding and investment policies are in sync. The relaxed minimum contribution requirements under ARPA allow plan sponsors to take longer-term views toward pension de-risking. As such, plan sponsors may want to take on less risky investments and consider the adoption of liability-driven investment strategies, if they have not done so already. Prior to ARPA, many plan sponsors had significant funded status deficits, and with interest rates steadily declining in 2019 and 2020, the possibility of shifting assets from equities to fixed income may have not have been palatable. Plan sponsors would not want to lock in underfunding by taking on greater fixed income positions, given the cascade of upcoming required contributions that they would have faced prior to ARPA.
With funded ratios immediately improving under ARPA and minimum required contributions significantly muted over the next several years, shifting asset allocations from equities into fixed income seems like a viable alternative again. Many plan sponsors had already been doing this via glide path strategies adopted well before the passage of ARPA. For those plan sponsors, further progression down the glide path toward full funding is very likely to continue.
Pension buyouts and plan termination
Even with the business disruptions caused by COVID-19, pension buyout activity continued to occur in 2020. In fact, the 2021 Corporate Pension Funding Study revealed that pension risk transfers (including pension buyouts and lump sums) for the largest 100 U.S. plan sponsors of defined benefit plans totaled $15.8 billion in 2020, which represented an increase from the $13.5 billion recorded for 2019. While the passage of ARPA will not affect the costs of annuity purchases and plan terminations, the general improvement in ERISA funded status may cause some plan sponsors to reevaluate their pension risk transfer strategies.
With the costs of maintaining a frozen plan significantly decreasing over the next several years due to lower minimum required contributions, some plan sponsors may decide to choose a plan hibernation strategy over annuity purchases and plan termination. Continuing along the pension glide path to full funding and letting the plan run its natural course by paying out benefits to retired pensioners over time can offer cost savings to plan sponsors relative to third-party risk transfer strategies. After the ERISA full funding threshold is crossed, immunization investment strategies can lock in surplus sufficient for the elimination of contributions and the minimization of PBGC premiums. Upon this juncture, a plan sponsor can decide to further ride out its pension plan naturally once the ongoing costs are essentially covered, or terminate the plan depending on its risk and financing preferences. Terminating a pension that is already in a position of funding surplus will certainly be less costly than doing so for a plan with a funding shortfall.
In conclusion, despite the current uncertainty caused by the COVID-19 pandemic, there is renewed hope for defined benefit pension plan sponsors. This article touches on the numerous considerations and pathways for plan sponsors to follow going forward under the passage of ARPA. Every plan sponsor has its own unique set of circumstances to examine under the lens of ARPA. Ultimately, the decisions on whether to proceed with further pension de-risking will depend upon what level of risk is appropriate, including a plan sponsor’s risk tolerance and expectation for the future. We know that the future is a whole lot brighter for plan sponsors now with the passage of unprecedented funding relief under the American Rescue Plan Act of 2021.
This article first appeared May 18, 2021 on Milliman's website at https://us.milliman.com/en/insight/defined-benefit-pension-funding-resurrection#
1Wadia, Z., Perry, A.H., & Clark, C.J. (April 2021). 2021 Corporate Pension Funding Study. Milliman White Paper. Retrieved May 9, 2021, from https://us.milliman.com/en/insight/2021-corporate-pension-funding-study