In August of 2006
President Bush signed the Pension Protection Act of 2006 (PPA) into
law primarily to address the financial security of the defined
benefit plan system. Generally, the changes to the funding
requirements for defined benefit plans brought about by this new law
are effective for plan years commencing in 2008.
PPA attempts to improve the financial security of the defined
benefit system by focusing on the funding adequacy of a plan on a
plan termination basis rather than addressing the funding
sufficiency at the time a participant reaches retirement age.
Generally, the pre-PPA funding requirements intended to create a
level funding of a participant’s benefit over their working
lifetimes. The PPA rules attempt to ensure that benefits accrued to
date are fully funded based on current market interest rates.
Further, as a result of PPA, a great deal of flexibility has been
taken away from the enrolled actuary. The funding method as well as
the mortality table and interest rates used to determine a plan’s
minimum funding requirement is now dictated by the Internal Revenue
Code’s minimum funding requirements.
As this article will address in detail, plans that are not
adequately funded on a plan termination basis may be subject to
restrictions on benefit accruals and distributions as well as
limitations on the ability to amend the plan to improve benefits. In
addition, as described below, PPA has significantly revised the
method of calculating a participant’s lump sum benefit.
Basic Funding Requirements
Prior to PPA, the actuary for a defined benefit plan was able to
choose from a variety of different funding methods as well as choose
the appropriate mortality table and interest rate in determining a
plan’s minimum funding requirement. PPA now mandates the single
funding method as well as the mortality table and interest rates to
be used for minimum funding purposes.
Generally, PPA’s funding method determines the minimum funding
requirement by adding the present value of the benefits accrued in
the current year by all plan participants, called the normal cost,
to the payment required to pay down the plan’s underfunding over a
seven year period called the shortfall amortization payment. The
valuation liabilities, known as the target liability, are determined
by calculating the plan’s termination liability based on current
market interest rates. An underfunding exists to the extent that
plan assets are less than the target liability.
In determining the plan liabilities for actuarial valuation
purposes, the plan’s actuary is required to use three different
interest rates, known as segment rates, that are based on investment
grade corporate bond rates. Applicable interest rates vary based on
the length of time until a benefit is payable.
The above funding requirements will be subject to transitional
rules that may eliminate the need to pay the shortfall amortization
payment if the plan assets are close to the target liability.
Further, plan assets and contribution requirements must be adjusted
for the credit balance. The credit balance, which represents the
accumulation of contributions exceeding minimum funding
requirements, has become more complex under PPA. Credit balances
based on contributions prior to the effective date of PPA are
treated differently than post PPA contributions.
Basis for Limits and Restrictions
Each year a plan’s funding ratio, known as the Adjusted Funding
Target Attainment Percentage (AFTAP), must be certified by the plan
actuary. Generally, the AFTAP is determined by dividing the plan
assets by the plan’s target liability. To the extent that these
liabilities fall below ratios specified in the new law, limitations
are imposed on:
- Benefit increases;
- Benefit accruals;
- Distributions in a form other than an annuity; or
- Shutdown benefits.
In determining the plan’s AFTAP, plan assets must be adjusted for
certain credit balances.
Limitation on Benefit Increases
A plan cannot be amended to increase benefits if the AFTAP is
below 80% or would be under 80% if the amendment was adopted by the
plan. An employer desiring to increase plan benefits with an AFTAP
below 80% would be required to make a contribution (or provide
security) which would bring the AFTAP up to 80%.
Plan amendments subject to this restriction include improvements
to the benefit formula as well as any other amendment increasing the
value of plan benefits, such as an improvement in the plan’s vesting
schedule. The funding based restriction on plan amendments is not
applicable in the first five years of a newly established plan.
Restrictions on Benefit Accruals
A plan is required to cease benefit accruals if the AFTAP is less
than 60%. The restriction on benefit accruals will continue until
the plan’s funding ratio improves and the AFTAP exceeds 60%.
Once the AFTAP exceeds 60%, the plan document does not need to be
amended to restore lost benefit accruals if the accrual restrictions
were in place for less than 12 months. However, if the accrual
restrictions were in place for more than 12 months, an amendment
will be required to restore the benefits that were lost during the
time that the AFTAP was less than 60% and benefits were frozen. As
detailed above, such an amendment restoring lost accruals could only
be executed if the AFTAP increases to more than 80%.
Once again, the funding based restriction on benefit accruals is
not applicable in the first five years of a newly established plan.
Restrictions on Benefit Distributions
If a plan’s AFTAP is less than 60%, distributions may only be
made in the form of a life annuity. Therefore, plans that permit
distributions in the form of a lump sum or installment payments
would be prohibited from offering these forms until their AFTAP
reached the 60% level. Plans would be required to provide that
participants affected by this restriction have the ability to defer
payment or elect another form of payment.
If the plan’s AFTAP is between 60% and 80%, payments in a form
other than a life annuity will be restricted. Plans within this
funding range may only make payments to the extent that their value
does not exceed:
- One-half of the payment that could be made absent any
- The present value of the maximum benefit guaranteed by the
Pension Benefit Guaranty Corporation which is currently $4,312
In other words, a plan which permits lump sum distributions would
be restricted to paying out one-half of the lump sum if the plan’s
AFTAP was between 60% and 80%. In this situation, the plan would be
required to defer payment or elect another form of payment. Although
not required by law, the plan could permit the payment of one-half
of the lump sum and allow the participant to defer payment of the
remaining lump sum until such time as there is no funding based
How is the Plan’s AFTAP Certified?
The plan’s enrolled actuary is required to certify the plan’s
AFTAP in writing. The timing of such certification is critical in
determining the applicable AFTAP. Generally, the AFTAP should be
certified by the first day of the fourth month of the plan year. If
the actuary is unable to certify the AFTAP by this deadline, the
AFTAP is the prior year’s AFTAP less 10%.
For example, let’s assume that the plan year is the calendar year
and the AFTAP for 2007 was 85%. The applicable AFTAP for 2008 must
be determined by April 1, 2008. If the AFTAP is not determined by
that date, as of April 1, 2008 the AFTAP becomes the 2007 AFTAP less
10% or 75%. As the AFTAP is now less than 80%, the plan may not be
amended to improve benefits, and plans permitting lump sum
distributions may only pay one-half of the lump sum otherwise
payable to a terminated participant.
Further, let’s assume that on July 1, 2008 the actuary certifies
the 2008 AFTAP to be 88%. As of July 1, 2008 the above restrictions
are no longer applicable. If the actuary was able to complete the
certification by April 1, 2008, these restrictions would not have
been applicable at any point during the year.
If the actuary is unable to certify the AFTAP by the first day of
the tenth month of the plan year, the AFTAP is automatically deemed
to be 60% and all of the restrictions addressed in this article will
become applicable. These restrictions will remain in place for the
remainder of the year regardless of when the actuary ultimately
certifies the AFTAP.
Let’s go back to our example above. However, let’s now assume
that the actuary does not complete the AFTAP certification until
October 15, 2008. Under this scenario, the applicable AFTAP for 2008
would be as follows:
- January 1, 2008 through March 31, 2008 the AFTAP will be
equal to the 2007 AFTAP which was 85%, and there would be no
applicable limitations or restrictions.
- From April 1, 2008 through September 30, 2008 the applicable
AFTAP would be 75%, which is the 2007 AFTAP less 10%.
- From October 1, 2008 through December 31, 2008 the
applicable AFTAP would be 60%.
The above highlights the importance of the timing of the
actuary’s certification of the plan’s AFTAP for a particular year.
The actual AFTAP determined by the actuary was 88% which would not
have imposed any limitations or restrictions if it was certified by
April 1. However, since the certification was not completed until
October 15, the adjusted 2007 AFTAP resulted in the application of
certain restrictions as of April 1 and all restrictions and
limitations as of October 1.
In order to avoid the unnecessary imposition of any restrictions
or limitations, it is imperative that the sponsor of a defined
benefit plan provide the plan actuary with the necessary census and
asset information as soon as possible so that the actuary has the
opportunity to calculate the plan’s AFTAP within the first three
months of a plan year.
Lump Sum Distributions
Effective for plan years commencing in 2008, PPA has
significantly changed the interest rate and mortality table used to
determine the lump sum distribution payable to plan participants.
Prior to PPA, the applicable 30-year Treasury rate was used to
determine a participant’s lump sum benefit. This rate is replaced by
what PPA calls a three-segment rate approach, which varies based on
the length of time until the benefit is payable or expected to be
paid. These segment rates are based on a yield curve using
investment-grade corporate bonds, which typically carry higher
yields than treasuries and will ultimately result in lower lump sum
To mitigate the immediate impact on plan participants, the
segment rates are phased in over the next four years. During this
transition period, lump sums will be determined using a blend of the
30-year Treasury rate and the new segment rates.
PPA has made dramatic changes to the funding rules and the
determination of lump sum benefits for defined benefit plans.
Further guidance is forthcoming to deal with the many nuances in the
law that may impact the application of the new rules to a specific
The sponsor of a defined benefit plan needs to work closely with
the plan’s actuary to monitor the plan’s funded status in order to
avoid the imposition of unintended restrictions or limitations on
the plan. To facilitate this process, which requires the actuary to
determine the funded status on a timely basis, the plan sponsor must
diligently respond to any requests for census data and plan
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