As an expert in the field, I have delved into the world of defined benefit plans to gain a better understanding of the current landscape. One term that kept cropping up during my research was “funding relief.” This concept, when combined with improved funded status and derisking strategies, has greatly reduced the likelihood of companies being compelled to contribute to their plans.
To my surprise, I discovered that recent legislation has made a significant impact on the relationship between interest rate fluctuations and required contributions for private sector defined benefit plans.
The Impact of the Pension Protection Act
In 2006, the Pension Protection Act was implemented in response to the dot-com bubble fallout and the subsequent plunge in interest rates. This legislation aimed to address these issues by introducing two key changes.
Firstly, it reduced the time frame for eliminating unfunded liabilities to just seven years. Secondly, it established specific interest rates that should be used to discount promised benefits. These rates were based on the average corporate bond yield over the preceding 24 months. Although there were three separate rates depending on the expected payment dates of the benefits, we will focus on the main concept here.
The Effects of Funding Relief
Funding relief represents a departure from the stringent requirements introduced by the Pension Protection Act. This relief has had a direct impact on how corporations navigate their defined benefit plans. However, it is essential to note that these changes coincide with alterations made by the Financial Accounting Standards Board (FASB) regarding reporting requirements.
Under the new FASB rules, net pension liabilities must now be treated as debt on a company’s balance sheet. This change had already upheaved corporate accounts when, soon after, the world faced another crisis – the global financial meltdown. In this time of economic turmoil, both the stock market and the economy experienced significant collapses.
Consequently, companies had to bear the brunt of lower funded statuses. Their balance sheets were impacted, and they faced a sudden surge in obligatory pension contributions.
As we analyze the current state of defined benefit plans, it becomes evident that funding relief, combined with various regulations and economic shifts, has reshaped this landscape. It is crucial for professionals in the field to stay up to date with these changes to guide their clients effectively.
Congress Takes Action for Funding Relief
Congress has taken measures to address funding relief in response to ongoing challenges. One significant piece of legislation is the 2012 Moving Ahead for Progress in the 21st Century Act. This act requires the averaging of interest rates established by the 2006 Pension Protection Act over a 25-year period. It aims to consider higher rates from the past, ultimately setting the minimum and maximum rates at 90% and 110% of the average, respectively.
Initially, the legislation predicted that the corridor would widen over time. With market rates significantly lower than the corridor, this would have resulted in a decrease in the funding discount rate. Consequently, it would increase liabilities and minimum required contributions. However, subsequent iterations of funding relief prevented this widening from happening. As a result, the rate used to calculate liabilities for funding purposes has remained approximately 200 basis points higher than the “market rate” specified in the Pension Protection Act (see Figure 1).
The American Rescue Plan Act of 2021 (ARPA) introduced the second and most significant pieces of funding relief. Firstly, it established a floor of 5% on the 25-year average and narrowed the corridor around the average from 10% to 5%.
Interestingly, this change occurred just as the 25-year average was moving away from historically high rates. This movement would have eliminated the gap between the minimum permissible rate and the “market rate.” The ARPA also increased the amortization period from seven years to 15 years on a permanent basis. This modification extends the time for underfunded plans to achieve full funding.
Undoubtedly, sponsors must have lobbied for these ARPA provisions. The higher assumed rates and longer amortization period offer them the ability to continue their contribution holiday. However, it is important to note that plans’ liabilities will eventually need to be paid, and plans contributing only the minimum amount will have inadequate resources.
While it is essential to protect sponsors against excessive volatility in interest rates, there is a concern that funding relief has been taken too far. This may lead to future issues that we need to be mindful of.