On June 25, President Obama signed the Preservation of Access to Care for Medicare Beneficiaries and Pension Relief Act (the Act) into law, thereby making further funding relief available to defined benefit (DB) plans. To advance discussions in the pension community, this analysis projects aggregate regulatory funded status and minimum required contributions for single-employer DB plans both with and without this latest relief.[1]
The projections reflect financial and economic conditions and outlooks as of May 31, 2010. Without this relief, DB plan funding obligations would be expected to increase sharply. The funding relief significantly eases financial pressures for at least two years, but after that, sponsors should be prepared for funding obligations to trend upward (absent significant changes in asset markets or interest rates).
Our model incorporates the main provisions of the Pension Protection Act of 2006 (PPA), the Worker, Retiree and Employer Recovery Act of 2008 (WRERA), and March and October 2009 IRS guidance and regulations. The PPA establishes the general seven-year schedule for funding shortfall amortization, and the WRERA clarifies and improves the use of smoothed asset values. For minimum funding purposes, plan sponsors can measure pension liabilities using either the full yield curve (a one-month average of interest rates) or the 24-month-average segment rates. The March 2009 IRS guidance allows sponsors to choose the most favorable interest rate for valuing 2009 liability. Under the October IRS regulations, sponsors can switch to a different interest rate and asset valuation method for plan year 2010 without seeking IRS approval first. Plans may also switch from segment rates for 2010 to the yield curve for 2011 or a later plan year. Subsequent changes will require IRS approval.
Under the Act, underfunded DB plans may elect either the 2+7 rule or the 15-year amortization rule for any two years between 2008 and 2011. Under the 2+7 rule, the sponsor makes interest-only payments for two years followed by regular seven-year amortization. Under the 15-year rule, the sponsor amortizes the funding shortfall over 15 years. The two relief years need not be consecutive, but the same relief method must apply to both years (a mix of the 2+7 and 15-year rules is not allowed). Also, plans that were at least 60% funded in the 2008 plan year need not freeze benefit accruals for 2009 and 2010.[2] This lookback provision only applies to 2009 under prior relief.
Under the Act’s so-called cash flow rule, relief recipients must make higher contributions if they pay “excess” employee compensation, declare extraordinary dividends or redeem company stock in excess of certain thresholds. The restriction period is three years under the 2+7 rule and five years under the 15-year rule. The extra contributions must equal the excess payments over the restriction period but are capped at the relief amount. Our analysis does not model this cash flow rule because we cannot project how it will affect a sponsor’s funding choice (see “Pension Funding Relief Will Affect Executive Pay Design”). Also, the analysis excludes 2008 as a relief year — it is long past and no longer relevant for most plans.
This analysis updates the funding projections for capital market conditions as of May 31, 2010, segment rates and composite corporate bond rate (CCBR, as a proxy in the model for the yield curve) recently published by the IRS, and newer forward-looking assumptions for 2011-2013.[3] The Appendix outlines the projection methodology, and Figure A-1 lists the financial and economic assumptions.
The results appear in Figures 1 and 2. Under pre-Act provisions, average funded status on a regulatory basis would be 87% for plan year 2010, 79.8% for 2011, 78.8% for 2012 and 81.9% for 2013. The minimum required contributions for these years in aggregate for single-employer DB plans would be $78.4 billion, $130.9 billion, $159 billion and $158.5 billion, respectively. These required contributions, which are substantial and rapidly rising — particularly compared with 2007-2009 levels — thus subject sponsors to continued financial pressures. Some plan sponsors would also have to make extra contributions, as shown in Figure A-2 in the Appendix, to avoid the benefit restrictions imposed on plans whose funded status falls below 80%. (The new pension relief does not address lump-sum restrictions.)
The Act’s funding relief reduces required contributions by $19 billion to $63 billion, summing all reductions and later reversals over 2009-2013. Using the 2+7 rule for 2009 and 2010 delivers the least relief over this period for two reasons: The relief vanishes — and reverses — as early as plan year 2012, and earlier relief made the 2009 shortfall base relatively small. Using 15-year amortization for 2010 and 2011 shortfalls maximizes the relief, increasing contributions gradually over the five-year horizon.
To maximize relief for the 2010 and 2011 plan years, sponsors can take advantage of the interest-only provision in the 2+7 option, thereby reducing minimum required contributions by about $47 billion for these two years. Once the relief expires in 2013, however, these sponsors will have to contribute roughly $11 billion more than they would without the relief. By contrast, opting for 15-year amortization reduces contributions by about $29 billion in 2010 and 2011. So the 2+7 rule may be the better choice for those sponsors more concerned with immediate cash flow. Otherwise, the 15-year amortization rule gives more and smoother relief.
Although the Act is generally good news for plan sponsors, it presents new complexities along with potential relief. In considering whether to opt for relief, sponsors must consider the effects of the cash flow rule, including the linkage with executive compensation/corporate governance.
Figure 1
Measured funded status under pre-Act provisions and the Act (%)
Pre-Act provisions
2+7 amortization
15-year amortization
Plan year
2009 & 2010
2010 & 2011
2009 & 2011
2009 & 2010
2010 & 2011
2009 & 2011
2007
95.9
95.9
95.9
95.9
95.9
95.9
95.9
2008
96.7
96.7
96.7
96.7
96.7
96.7
96.7
2009
96.6
96.6
96.6
96.6
96.6
96.6
96.6
2010
87.0
86.9
87.0
86.9
86.9
87.0
86.9
2011
79.8
78.9
79.1
79.6
79.4
79.4
79.7
2012
78.8
77.3
76.6
77.7
77.9
77.5
78.1
2013
81.9
80.7
79.2
80.1
80.5
79.8
80.6
Source: Towers Watson.
Figure 2
Required minimum contributions under pre-Act provisions and the Act ($ billion)
[1] The series of prior studies on the DB plan funding problem and relief efforts appear in the January, April, June, October and November 2009 and March 2010 issues of Insider, available at www.towerswatson.com/research/insider.
[2] Fiscal year is identical to calendar year in our model. The lookback rule in the Act generally applies for plan years beginning on or after October 1, 2008, and before October 1, 2010.
[3] We have updated and modified our model since the March 2010 projections. Equity return for 2010 is lower than the previous expectation of 9.2%. Bond returns are now proxied by the Barclays Capital Long Government/Credit Bond Index because it better represents pension investment practice, replacing the Dow Jones Corporate Bond Index. This new index makes the historical 2009 bond return lower but expected returns in 2010-2013 higher. For a better alignment with the reality of slow economic recovery, CCBRs for 2011-2013 are set lower than in prior analyses based on projected yields on high-quality corporate bonds. With these changes, funded status is about two percentage points higher and minimum contribution is roughly $12 billion lower for plan year 2011 under pre-Act law. The funded status for 2012-2013, however, is about seven percentage points lower and the required contribution is about $40 billion higher than our prior estimates.
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