The American Rescue Plan Act of 2021 (the “ARPA”), which President Biden is expected to sign, provides additional funding relief to sponsors of single-employer defined benefit pension plans.
Valuation of Plan Benefit Obligations
A plan’s goal is to have sufficient assets to equal the present value of all benefits accrued or earned under the plan. If the present value of those benefit obligations is greater than the value of plan assets, then the plan is underfunded and the employer may be required to make a minimum required contribution to help further fund the plan.
Determining the value of the plan benefits for this purpose is complex and involves certain actuarial assumptions. One important assumption is the interest (or discount) rate that is used to convert the future benefits that the plan will pay to participants or beneficiaries into a single-sum present value amount -- which in turn permits a comparison of the plan’s assets to its benefit obligations. For purposes of determining minimum required contributions, the pension rules mandate the use of certain interest rate assumptions.
These pension plan rules generally contemplate that the value of plan benefits will be determined based upon relatively current interest rates reflecting the average corporate bond yields over only a 24-month period (the “Current Rate”). However, interest rates (and corporate bond yields) have been at historically low levels since the 2008 financial crisis, and the low rates significantly affect the pension funding calculation. The present value of a plan’s benefit obligation bears an inverse relationship to the interest rate. The higher the interest rate, the lower the value of the plan’s benefit obligation; but conversely, the lower the interest rate, the higher the value of the plan’s benefit obligations. And, of course, the higher the value of the plan’s benefit obligation, the more likely that the plan is unfunded and that greater employer contributions will be required.
Because these low Current Rates required employers to increase their plan contributions, Congress originally provided relief in 2012 (referred to as “MAP-21 Relief”) when it amended the pension funding rules to introduce a 25-year average interest rate (“25-Year Rate”) into the equation. The 25-Year Rate forms the basis for establishing a minimum and maximum interest rate for purposes of calculating required minimum contributions. For example, for 2020, the minimum and maximum boundaries were set at 90% and 110% of the 25-Year Rate. Under this methodology, the Current Rate applies if it falls between the minimum and maximum boundaries. However, if the Current Rate is less than the minimum boundary established by reference to the 25-Year Rate, then the minimum boundary rate is used; similarly, if the Current Rate exceeds the maximum boundary established by reference to the 25-Year Rate, then the maximum boundary rate is used.
Under prior law, the minimum and maximum percentages widened over several years until, by 2023, the minimum would be 70% of the 25-Year Rate and the maximum would be 130% of the 25-Year Rate (as compared to the 2020 corridor of 90% to 110%). Widening of the minimum and maximum corridors has the effect of making more plans subject to the Current Rates, i.e., it would cause the minimum required contribution to be determined under the original rules.
The ARPA extends the corridor protections by continuing the 25-Year Rate methodology but implementing a revised schedule of minimum and maximum rates that will not reach the 70% minimum/130% maximum thresholds until 2030, as follows:
Further, the ARPA adds a new special minimum interest rate rule whereby if for any year the 25-Year Rate would otherwise be less than 5%, the 25-Year Rate is set at 5% for that year.
These rules are effective for plan years beginning after December 31, 2019, but a plan sponsor can elect to not have these rules apply until plan years beginning on or after January 1, 2022.
Amortization of Funding Shortfalls
In general, the minimum required contribution that a plan sponsor is obligated to make with respect to any plan year is the sum of:
- The target normal cost for the plan year; and
- The shortfall amortization charge.
The target normal cost reflects the amount required to fund the value of benefits which are expected to be earned (and the amount of plan-related expenses expected to be paid) during the current plan year. The shortfall amortization charge is an amount attributable to plan underfunding with respect to prior periods. A plan might become underfunded for any of several reasons, including unfavorable investment experience, and a decrease in interest rates (which, as discussed above, can increase the plan’s benefit obligations on a present value basis).
The sponsor of an underfunded plan is not required to make up a funding shortfall in a single year. Prior to the ARPA, the funding rules generally contemplated that the funding shortfall attributable to any year be made up (or amortized) over seven plan years. The ARPA changes the amortization period from seven to 15 years (and converts prior funding shortfalls that had been subject to the seven year rule to a new 15 year amortization schedule). By providing plan sponsors with a longer period to make up funding shortfall amounts, the near-term minimum required contribution should decrease.
The ARPA permits plan sponsors to apply this new 15-year amortization schedule for plan years beginning after 2018, 2019, 2020 or 2021.
What this Means for Plan Sponsors
Plan sponsors of pension plans should contact their actuaries to determine the effect that these rules will have on the plan sponsor’s funding obligations, and the pros and cons of making the elections permitted by the ARPA to apply (or not apply) these new rules to earlier plan years.