Pension Funding: Threading the PPA Minefield

Global equity markets stumbled badly in the first weeks of this year and pension plans took a big hit, losing $110 billion of their value as compared with December 2007, according to consulting firm Mercer. Funding levels dropped by 7 percent to 8 percent by the end of January. "It is a big decrease," says Jonathan Barry, a member of Mercer's financial strategy group. "Fortunately the liabilities side has stayed relatively stable; interest rates haven't been going too crazy, at least for the kind of interest rates used to value pension liabilities. But the equity market has been hit hard."

The dip comes at a time when many plan sponsors are scrambling to bring funding levels up to those required the Pension Protection Act (PPA) of 2006. "Generally speaking, [PPA] requires companies to fund up their pension plans to 100 percent over a period of about seven years," Barry explains. "So to the extent that you're underfunded, you have to make up that gap, whatever it might be. And that's quite a bit faster than under the old rules. In fact, the old rules didn't require you to be 100 percent funded; they were generally geared to being 90 percent funded."

Plan sponsors that fall behind this accelerated funding curve may face problems. Under provisions of the PPA that kicked in on January 1 of this year, the ability of a plan to pay certain benefits is tied to its funding level as of the first day of the plan year. For example, if funding is determined to be 80 percent or lower at that time, plan sponsors can't pay out more than 50 percent of the value of the benefit as a lump sum payment. If funding is 60 percent or lower, plan sponsors are required to freeze benefit accruals for current participants, and lump sum distributions are prohibited.

It's important to note, though, that it's the funding level as of that first day of the plan year -- January 1, for most plans -- that's crucial. If the markets recover before the next plan year begins, the current turmoil will have no effect on plans' funding status with respect to PPA, notes Robert McAree, senior vice president at Sibson Consulting. But "if the current volatility continues and if the markets continue to underperform for the rest of 2008, it means that the funding levels of plans -- most of which are on a calendar-year basis -- as of January 1, 2009, are going to be depressed. And that could result in some significant issues for plan sponsors to deal with, especially with regard to the benefit restrictions that are imposed under PPA."

Companies that haven't yet completed the required measurement of their plan's funding level -- a calculation called the adjusted funding target attainment percentage, or AFTAP -- should do so within the next couple of months. "If you've got a plan where the funding ratio clearly is in excess of [90 percent], you might not feel as much pressure to conduct this analysis in January, February and March," says McAree. "But if that's not the case, it's critical that you establish what the AFTAP is as of January 1, 2008, as quickly as possible."

Failure to do so before April 1 might have serious consequences. While the law provides that plan sponsors can operate under a presumed AFTAP after that date, "you have to make the presumption that the percentage is 10 percent less than what that calculation showed as of January 1, 2007," says McAree.

That wouldn't be a problem if your funding was up around, say, 95 percent last year -- you would still be presumed to be above the 80 percent level at which restrictions kick in. "Where it would have a more significant impact would be if your percentage was something less than 90 percent, and you don't determine the target percentage as of January 1 by April 1," says McAree. "Then the presumption is that you're going to be below 80 percent and possibly below 60 percent, in which case you're going to have to impose the restrictions until such time as you actually calculate the 2008 percentage and prove it to be something different."

Put it off till October, and the presumption becomes even more onerous. "For all plans, if you haven't determined your target percentage by October 1 of 2008, you're automatically presumed to be under 60 percent, and all of the restrictions are imposed," McAree says.

Barry sees the value of the PPA's provisions in ensuring that companies don't let themselves become too under-funded. "It's forcing you to throw the money back into the plan quickly once you've lost it," he notes. "But having said that, there still will be a decent number of plan sponsors that potentially could be hit by these benefit restrictions."