Modifying Pension Minimum Funding Requirements For Policymakers

How do recent changes impact different stakeholders?

WASHINGTON—A new issue brief from the American Academy of Actuaries offers public policymakers a concise, actuarially informed look at the complex considerations involved in modifying minimum funding requirements for single-employer defined benefit plans.

“These rules have changed numerous times in the past, and changing them requires weighing the possible impacts on different stakeholders,” said Grace Lattyak, vice chairperson of the Academy’s Pension Committee, which developed the issue brief, Public Policy Considerations for Changing Single Employer Pension Plan Funding Rules. “This new resource draws on actuarial expertise to provide policymakers with key factors to evaluate the different available options for modifying the requirements, and to understand the interests, needs, and potential impacts on plan participants, sponsors, taxpayers, shareholders, and the Pension Benefit Guaranty Corporation.”

Among the public policy considerations are the volatility of minimum required contributions to plans in light of the countercyclical effect of funding requirements, and changes to the smoothing rules. The brief makes the point that the total amount that must ultimately be contributed to pension plans is relatively unaffected if the plan is to be maintained indefinitely. “Evaluation of any proposals should consider this dynamic even if the scoring methodology applied to proposed legislation does not,” said Lattyak.

Stakeholders and Their Priorities

Although sponsorship of a defined benefit pension plan may appear to be simply an agreement between an employer and employees covered by the plan, the reality is considerably more complicated. Various stakeholders have either direct or indirect involvement with the pension plan, and each has an interest in the standards applied to plan funding. Analysis of alternative pension funding rules should consider the potential impact on all affected stakeholders for purposes of sustainability.

Summary of Current Funding Rules

The current framework for minimum contribution requirements was established by the Pension Protection Act of 2006 (PPA). Although this issue brief does not include many details, PPA generally determines minimum funding requirements using the following steps:

• Calculate a normal cost (called the “target normal cost” by PPA), which is the value of pension benefits participants are expected to earn in the current year.
• Calculate the liability for benefits earned as of the beginning of the current year (called the “funding target”).
• Compare the funding target to the fund’s asset value to derive a net shortfall or surplus.
• Calculate an annual amortization payment of any shortfall.
• Calculate the minimum required contribution as the target normal cost plus the amortization of shortfall.
• If contributions in excess of the minimum have been made in prior years, the “prefunding balance” so created can be applied against the minimum requirement.

These calculations include mechanisms that moderate the volatility of results, providing a degree of predictability and stability. Using these mechanisms is typically called “smoothing.” Modification of the degree of smoothing or its manner of application is often included in proposals to change minimum funding rules.

Countercyclicality

Plan funding rules generally increase minimum contribution requirements when the markets experience a downturn and decrease contributions when markets are performing well, assuming everything else is equal. This phenomenon results in increased funding requirements when plan sponsors’ core business may be struggling and could be experiencing cash constraints. This dynamic, sometimes called “countercyclicality,”
is challenging for plan sponsors. An unexpectedly large increase in contribution requirements when a company has limited access to funding can have severe adverse consequences.

The Evaluation of Proposals for Change

To encourage understanding and support from various stakeholders, policymakers might consider linking any pension funding proposals to relevant analysis of its effects, including both short-term effects as well as longer term effects that may play out over many decades.

Evaluating the cost of such proposals is also necessary. Plan sponsors are entitled to deduct contributions from taxable income—thus taxpayers subsidize single-employer qualified defined benefit plans. The cost or savings of modifying the system derive from changes to these deductions. Higher contributions generate greater tax deductions when made and reduce general revenue; contribution reductions have the immediate effect of lowering deductions and increasing revenue.

Conclusion

To achieve optimal results benefiting various stakeholders, the minimum contribution requirements for pension plans must strike a sustainable and appropriate balance. Potential objectives can include benefit security, the efficient use of corporate capital, and the predictability of future requirements.

Managing the volatility of minimum required contributions is critically important, particularly in light of the inherent countercyclical nature of these requirements. Although plan sponsors can contribute in excess of minimum requirements to establish a prefunding balance, smoothing can also be used. Some variations of this technique directly smooth market observations, such as interest rates or asset values. By doing so, these input smoothing approaches reduce the transparency and usefulness of important information about pension plan funded status. Alternative approaches would use output- smoothing techniques. These can be deployed in a manner that can achieve the desired volatility management without distorting measurements of liability, assets, or funded status. They also provide greater clarity about the approach used to achieve the desired stability.

Read the issue brief and learn more under the public policy section of the Academy’s website.

About the American Academy of Actuaries

The American Academy of Actuaries is a 19,500+ member professional association whose mission is to serve the public and the U.S. actuarial profession. For more than 50 years, the Academy has assisted public policymakers on all levels by providing leadership, objective expertise, and actuarial advice on risk and financial security issues. The Academy also sets qualification, practice, and professionalism standards for actuaries in the United States.