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Qualified Retirement Plans in a Tough Economy | Chiesa Shahinian & Giantomasi PC - New Jersey | New York | Full-Service Law Firm
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Law360, New York (October 13, 2009) -- Given the current state of the United States economy, many employers are struggling to fund their qualified retirement plans. Employers are facing difficulties with both their defined benefit pension plans and defined contribution plans (such as 401(k) [1] plans), due in part to the plummeting stock market and ensuing recession.
In addition, new funding rules enacted by the Pension Protection Act of 2006 increased the burden on employers sponsoring pension plans by creating stricter funding guidelines.[2]
There are, however, options available to employers who are looking to lower costs through changes to their qualified plans. Following is an overview of the requirements and potential implications that employers should consider before moving forward with any changes to their qualified plans.
As noted, pension plans are facing stricter funding requirements as well as shrinking asset bases. Employers looking to reduce costs may consider freezing their pension plan or, if necessary, terminating their pension plan in its entirety.
Employers who sponsor 401(k) plans, on the other hand, share none of the risk of a drop in plan assets because the employees solely bear the ultimate risk of market fluctuations in these types of plans.
Nevertheless, sponsors of 401(k) plans are still looking for ways to lower their costs through a reduction or suspension of matching contributions and discretionary employer contributions.
Proposed regulations were recently published that provide additional flexibility for employers with safe harbor 401(k) plans to reduce or suspend non-elective safe harbor contributions.[3]
However, with the current rate of saving for retirement in the United States so low, there is a controversy surrounding an employer’s decision to reduce matching or non-elective contributions.
Finally, employers may also ease their employees’ economic burden by providing for participant loans and hardship distributions to the extent their plans do not already permit such distributions, thus, allowing employees access to their account balances.
Minimum Funding Rules Post PPA
The PPA significantly changed the funding rules for pension plans for plan years beginning after 2007 and has the greatest impact on underfunded pension plans.[4]
The general purpose of the minimum funding rules are to require employers to make minimum contributions to pension plans to ensure the plan will have sufficient plan assets to make benefit payments when due.
Generally, before the PPA, an unfunded balance could be amortized up to 30 years. After the PPA, unfunded balances must generally be amortized over seven years, creating a larger burden on sponsors of pension plans.
In addition, plans that have a funding ratio below a certain percentage will be subject to benefit restrictions, which can include freezing benefit accruals.
Under the new rules, a plan’s actuary must annually certify the plan’s adjusted funding target attainment percentage (“AFTAP”). This measurement determines whether restrictions are applied to the plan under the Internal Revenue Code.
Employers sponsoring pension plans who cannot meet the plan funding requirements as discussed above have a few options to evaluate. Employers may consider amending plan benefit formulas to reduce benefit accruals, freezing their plans or terminating the plan.
Reduce Benefit Formulas
Employers may consider reducing future benefit accruals subject to certain restrictions, proper notice to participants and other technical requirements.
Another option to reduce employer costs is to freeze the pension plan. The effect of a freeze is that benefit accruals will cease from the date of the implementation of the freeze provided that the freeze is implemented before any employee accrues 1,000 hours of service, or a lesser amount if the plan provides, and that all participants have been given the required advance notice under the Employee Retirement Income Security Act of 1974. It is possible that a frozen plan be amended again to provide for future benefit accruals.
Terminate the Plan
If a plan is fully funded, it may be terminated so that there are no future accruals or contributions. If a plan is underfunded and the plan sponsor is in financial distress, the pension plan may be terminated or even taken over by a governmental entity called the Pension Benefit Guaranty Corp., which was created under ERISA.
Generally, there are two ways to terminate underfunded pension plans[5]: (1) a distress termination, and (2) an involuntary termination.
1) Distress Termination
In a distress termination the plan administrator starts the termination process by filing a notice with the PBGC and affected parties.[6] In order to qualify for a distress termination the plan sponsor must meet one of the following three requirements:[7]
- liquidation in bankruptcy or insolvency, where a petition for liquidation is filed with a bankruptcy court or in a similar state court;
- reorganization in bankruptcy or insolvency proceeding, where a petition for reorganization is filed with the bankruptcy court under Title 11 of the United States Code, or under any similar state law, where such court determines if the plan is not terminated, then the sponsors of the plan will not be able to pay its debts pursuant to the plan of reorganization and continue in business outside the reorganization process; or
- plan termination is required so that the plan sponsor may pay its debts and stay in business or to avoid unreasonably burdensome pension costs caused by a declining workforce.
Once the required notices are issued then the plan administrator generally is restricted from making loans to plan participants.[8] In addition, plan benefit payments may be reduced to guaranteed levels established by the PBGC annually.[9]
2) Involuntary Termination
This process must be initiated by the PBGC rather than the plan administrator. The PBGC may generally initiate a proceeding to terminate a plan where it determines that:[10]
- the plan has not met the minimum funding standard required under Section 412 of the Internal Revenue Code of 1986, or has been notified that a notice of deficiency has been issued for an excise tax for failing to pay required minimum contributions;
- the plan will not be able to pay benefits when due;
- a “reportable event” where certain covered distributions under the plan to a “substantial owner” occurred; or
- the long-run loss to the PBGC for the plan may “reasonably be expected to increase unreasonably if the plan is not terminated.”
PBGC Guarantee of Benefits
As noted above, the PBGC, which is partially funded by employer-paid premiums, provides a certain level of guaranteed benefits for covered pension plans. Once the PBGC takes over the plan, it will begin to pay benefits up to the maximum guaranteed amounts.
This maximum amount is adjusted each year and for plans with a 2009 termination date, the maximum guarantee is $54,000 a year for a single annuity beginning at age 65, with the amount of the guarantee being reduced for each year the participant is younger.
In the year 2008, it is estimated that the PBGC paid about $4.3 billion in benefits to participants in terminated pension plans.[11]
Safe Harbor Defined Contribution Plans (401(k))
Even though the employer shares none of the risks of market fluctuations, 401(k) sponsors may still seek ways to reduce expenses by suspending discretionary company contributions. IRS-proposed regulations were recently issued that allow employers to suspend safe harbor nonelective contributions to 401(k) plans.[12]
While 401(k) plans are generally required to satisfy nondiscrimination requirements using mathematical tests called Actual Deferral Percentage/Actual Contribution Percentage (“ADP/ACP”) tests, a safe harbor 401(k) plan will be treated as automatically passing the ADP/ACP tests as long as the employer makes certain nonelective or matching contributions for non-highly compensated employees.
Before the issuance of the proposed regulations, an employer could not cease making safe harbor contributions mid-year and an employer’s only option was to terminate the plan.[13]
However, the proposed regulations allow for an employer who is undergoing a “substantial business hardship” to cease non-elective contributions if the employer satisfies certain specified requirements.
Although suspending matching or nonelective contributions may help the employer with its bottom line, this may adversely impact the employees’ rate of savings because many employees will not likely contribute to their company’s 401(k) if the employer is no longer providing a match.
Many companies do not provide pension plans and an employee’s 401(k) may be the only way for the employee to save for retirement.
Finally, employers may ease their employees' economic burden by amending their plans to provide for participant loans and hardship distributions to the extent that their plans do not already permit such access to assets. This may allow some relief to employees.
In sum, although employers are facing increased difficulties in funding their qualified retirement plans, there are several options available to them. In addition, employees have some comfort in knowing a certain level of benefits in pension plans is guaranteed by the PBGC.
--By Stephen L. Ferszt and Farah N. Ansari, Wolff & Samson PC
Stephen Ferszt is a partner with Wolff & Samson in the firm's West Orange, N.J., office. Farah Ansari is an associate with the firm in the West Orange office. The opinions expressed are those of the authors and do not necessarily reflect the views of Portfolio Media, publisher of Law360.
[1] Although there are different types of defined contribution plans, this article will focus on 401(k) plans.
[2] Pension Protection Act of 2006, Pub. L. No. 109-280, § 101, 120 Stat. 780.
[3] Suspension or Reduction of Safe Harbor Nonelective Contributions, 74 Fed. Reg. 23134-01 (May 18, 2009).
[4] These rules apply generally to single employer defined benefit plans.
[5] A fully funded pension plan may be terminated in a standard termination.
[6] ERISA §§ 4041(a)(2); 4041(c)(1)(A); 4041(c)(2).
[7] ERISA § 4041(c)(2)(B).
[8] PBGC Reg. § 4041.42(b).
[9] ERISA § 4041(c)(3)(D); PBGC Reg. § 4041.42(c).
[10] ERISA § 4042(a)(1)-(4).
[11] PBGC Reg. § 4022.22; See www.pbgc.gov.
[12] Suspension or Reduction of Safe Harbor Nonelective Contributions, 74 Fed. Reg. 23134-01 (May 18, 2009).
[13] Sponsors of terminated 401(k)s must wait 12 months to implement a new plan. See Treas. Reg. § 1.401(k)-1(d)(4).