September 23, 2011 – 8:14 am
The Federal Reserve’s “Operation Twist” is intended to boost consumer spending, but it could cause lots of problems for defined benefit pension plans who haven’t adopted a liability-driven investment (LDI) strategy. Here’s what plan sponsors need to consider:
1. If long-term interest rates drop due to “Operation Twist”, then pension liabilities will likely increase and have a negative effect on many plans’ funded status. This issue will be compounded by market turmoil that is lowering the value of equities in pension trust assets.
2. The effect of lower pension discount rates should be muted to the extent that a plan has adopted an LDI strategy. The fixed income investments that are part of the LDI portfolio will increase in value due to the interest rate drop and offset the increase in liabilities.
3. As we’ve mentioned in previous posts, frozen pension plans aiming for termination should monitor the situation carefully. Any increase in liability could be a big setback to their lump sum and annuity purchase strategy.
There often isn’t an ideal time to switch to LDI, but a gradual shift in policy is always possible and will help offset future interest rate volatility. Plan sponsors should work with their advisers now to see how their year-end accounting and 2012 funding contributions might be affected by the “Twist”.
September 16, 2011 – 9:43 am
In this post we highlight three new PBGC premium relief items:
1. Seven Day Rule – for waiver of late premium penalties in 2011 and later.
2. “Alternative” premium method election relief – for 2010 and later years.
3. Waiver of certain “alternative” method penalties – for 2008 and 2009.
Below is a detailed summary of each relief item along with background information.
1. Seven Day Rule
Background: If a plan sponsor does not make their annual PBGC pension insurance payments on time, then there are late payment penalties and late payment interest.
Relief: For plan years beginning in 2011 and later, the PBGC will automatically waive penalties due solely to late payment as long as the payments are not more than 7 days late. Note that late payment interest is set by ERISA and cannot be waived by the PBGC. Read More »
August 15, 2011 – 4:16 pm
Over the past several years, GASB 45 has required public employers to recognize the cost of Other Postemployment Benefits (OPEB: e.g., retiree health insurance, life insurance) while employees are accruing the benefits, not after they retire. For many public entities, the true cost of their healthcare promises has been an eye opener.
However, public employers (especially local entities) should remember that GASB-type calculations are valuable in the “off-season” too. This post discusses one of the biggest missed opportunities for cost-saving: Measuring the cost impact of changes to retiree OPEB before contracts are signed.
In the corporate world, it is almost unheard of for employers to adjust their retiree benefit promises without first measuring the cost impact. This is especially true of collectively-bargained pension and retiree health plans. Both sides hire an actuary to estimate the cost of these benefits and bring their numbers to the table.
However, many local public entities may not be used to this process yet. During the biennial GASB 45 valuation process, we still encounter contractual changes to retiree benefits that occurred after the prior actuarial study but were not reported to us in the interim. There are two main problems with this approach:
- It’s not prudent to make or change benefit promises without estimating the cost impact. Suppose an employer is renegotiating a contract and there is a proposal to change the retiree health benefit from “fully-paid single premiums until age 65” to “fully-paid family premiums for up to 5 years”. Is this a cost increase or decrease? There’s no way to know unless you measure the cost beforehand.
- GASB 45 requires a full actuarial valuation if there is a significant change in benefit promises. As we discussed in a previous post, public employers shouldn’t wait until the next scheduled actuarial study (2 or 3 years, depending on plan size) to reflect significant plan changes in their financial statements.
As public employers get acquainted with valuing the actuarial cost of their OPEB benefits for GASB 45 financials, they should embrace the philosophy of “measure it before you promise it” for any changes to these benefits. Public sector OPEB are becoming front page news and administrators must proceed cautiously when adjusting benefits or making new promises.
There’s been a lot of discussion recently about whether the automatic enrollment feature in many 401(k) plans actually leads to lower overall retirement savings rates. This blog post gives a brief overview of the issue and proposes a couple of solutions to combat automatic enrollment inertia and enhance employee engagement in the retirement plan.
Background: Automatic enrollment is an optional 401(k) plan feature which allows employers to defer employee compensation into their 401(k) accounts, even if they haven’t elected to do so (they can always opt out). A recent article explained how 401(k) automatic enrollment may have unintended consequences.
Automatic enrollment can overcome employees’ initial inertia to saving more than 0% in the 401(k) plan (Participation Inertia), but it could unintentionally cause some employees to get stuck at the default rate (Default Inertia) instead of saving more.
If we can agree that automatic enrollment is a good idea because it helps overcome Participation Inertia, then we just need to devise a solution to the Default Inertia problem.
Solution #1: Add auto-escalation to the automatic enrollment option. As mentioned in the WSJ article, this feature automatically increases the default deferral rate each year that an employee participates in the plan. For example, the automatic deferral rate might be 3% for new employees with 1% annual increases up to an ultimate deferral rate of 6% of pay after 3 years. Read More »
GASB 45 requires a complete actuarial valuation of public retiree health plans to be completed every 2 to 3 years (depending on number of plan members), and sponsors usually don’t look forward to the administrative hassles of their next study. However, there are several situations where a new valuation could be advantageous and, likely, mandatory.
In addition to the standard 2 or 3-year cycle, GASB 45 rules also state that:
“A new valuation should be performed if, since the previous valuation, significant changes have occurred that affect the results of the valuation, including significant changes in benefit provisions, the size or composition of the population, … or other factors that impact long-term assumptions.”
Below are some factors which can compel a new valuation sooner than the standard 2 or 3- year cycle:
- Establishing an OPEB trust.
- If a revocable trust is established, then this won’t change the unfunded liability for accounting purposes, but it can affect the liability discount rate. See our previous post on the effect of OPEB trusts on GASB 45 discount rates.
- If an irrevocable trust is established, the discount rate may be impacted and the assets will decrease the plan’s unfunded liability. This will likely reduce the GASB 45 annual accounting expense (Annual OPEB Cost).
- Large change in retiree health benefits. This includes changes to plan coverage levels (e.g., deductibles and co-pays), premiums, or eligibility for benefits.
If employment contracts are amended to scale back (or increase) the amount of retiree health benefits paid by the employer, then this can have a big impact on plan liabilities as costs are shifted to retirees. See our previous post on the leveraging effect of OPEB liabilities.
Plan changes will affect the per-member costs and will likely affect future assumptions about retiree participation in the plan. A new valuation should be performed to capture this liability increase (or decrease) as soon as possible for the year of change.
- Large change in number of employees or retirees. If there are significant employee layoffs/retirements or if many retirees drop coverage due to increasing costs, then a new valuation may be needed to accurately capture the effect on the plan’s GASB 45 liabilities.
There are likely many other scenarios which would require a new GASB 45 study. This is especially true in the case of a plan on the 3-year cycle where there is an increased likelihood of a significant change in the “off-cycle” periods.
Most large retirement plans don’t worry about the maximum pension deduction limit because the plan benefits (and related contributions) are often well below the IRS limits. However, small- and medium-sized retirement plans can unknowingly run into the limits. This post summarizes important deduction pitfalls to be aware of.
- Self-employment “earned income” limit [§404(a)(8)]. For self-employed individuals, a year of low earnings can hinder pension plan deductions. This is because annual retirement plan deductions cannot exceed your “earned income” for the year (net self-employment income with a Social Security tax adjustment).
- Combined DC and DB plan deduction limit of 25% of payroll [§404(a)(7)]. This annual contribution limit has a couple of important adjustments.
- Contributions to a defined benefit plan insured by the PBGC are excluded from the 25% calculations. So, most PBGC-covered pension plans won’t have to worry about the combined limit.
- For defined benefit plans that are not covered by the PBGC, the limit applies only to the extent that employer DC contributions (other than 401(k) deferrals) exceed 6% of payroll. This means that:
1. The total DB/DC deduction can exceed 25% of payroll if employer DC contributions are 6% or less; and
2. When DC employer contributions exceed 6%, the combined deduction limit is essentially 31% of payroll.
- 401(k) deferral refunds reclassified as catch-up contributions. If your 401(k) plan fails the ADP test, the most common remedy is to refund deferrals to HCEs. Don’t forget, though, that if an eligible HCE has not yet reached the catch-up contribution limit then their refund should be reclassified as a catch-up contribution to the extent possible.
There can be a lot of confusion among sponsors of small- and medium-sized pension plans regarding the different deduction limits. This post aims to clarify some of these issues, but you should consult with a tax professional regarding the details and your specific situation.
Th
e IRS finally released the 2009 Form 8955-SSA used for reporting participants with deferred vested pension benefits. They also extended the deadline for the 2009 and 2010 filings from August 1, 2011 to January 17, 2012. Here are links to:
2009 Form 8955-SSA (fill-in the box version)
Instructions for Form 8955-SSA
Employee Plans News with Deadline Extension
The form seems fairly straightforward to prepare, but here are a couple of items to keep in mind:
- For calendar year plans, both the 2009 and 2010 Forms 8955-SSA are now due by January 17, 2012. This deadline can NOT be extended using a Form 5558 filing.
- Information for both the 2009 and 2010 8955-SSA may be combined into a single 2009 8955-SSA filing.
- You can file the 8955-SSA either on paper or electronically. Electronic filings will need to use third-party software to prepare forms in the appropriate format for the IRS FIRE system.
- Line 8 of the Form 8955-SSA requires plan sponsors to certify that they have notified participants listed on the 8955-SSA that they have a deferred vested benefit. This requirement can be found in section 6057(e) of the Code.
Plan sponsors should get started with collecting the information to be disclosed on the 2009 and 2010 Forms 8955-SSA, and also make sure they have complied with the participant notification requirement. The IRS has a nice list of FAQ regarding the Form 8955-SSA filing requirements and deadlines.
The 2010 Form 5500-EZ (with instructions) is now available for “one-participant” retirement plans. Sponsors and practitioners have waited months for the release of these forms. The filing deadline is July 31, 2011 (without extensions) for calendar year plans, or 2 1/2 months later with extensions. The documents are available here:
2010 Form 5500-EZ
2010 Form 5500-EZ instructions
The form and instructions are very similar to the ones from prior years. One subtle difference is that there is an explicit instruction that information for both the DB and DC components of an “eligible combined plan” [i.e., a DB(k) plan under IRC 414(x)] should be reported on the same filing.
During the plan termination process, one issue often overlooked is the consequences of investment risk prior to paying out benefits. This can lead to disastrous results. Benefits may be fully-funded when the termination decision is made, but significant contributions will be required if assets are not invested conservatively and a market downturn occurs prior to paying benefits.
Here are a few investment issues to consider when working through the plan termination process.
- Plan terminations change the focus of pension plan investments to short-term risks. An investment strategy based on 30-year expectations is not compatible with a one- to two-year plan termination horizon.
- The plan termination process can take a while (over a year) and financial conditions may change dramatically between the termination decision and the date when benefits are actually paid out. Funded status volatility during this waiting period should be minimized.
- A change in investment policy doesn’t have to be abrupt, but it should adjust quickly to minimize investment risk as terminating plans get closer to being fully-funded.
- Minimizing investment risk helps lock-in the funding gains made over the past couple of years. It may also limit the chance of large investment returns, but for many plan sponsors this will be a satisfactory risk/return trade-off.
- A liability-driven investment (LDI) strategy works well for terminating pension plans because it focuses on keeping plan assets aligned with plan liabilities. Keep in mind, though, that the plan termination liability target will be different than the traditional funding or accounting liabilities.
Many sponsors of frozen DB plans are becoming more interested in terminating their plans, especially as their funding level improves. We’ll continue to add posts that address important issues related to plan terminations and how to make them go as smoothly as possible.
Many small pension plans are exempt from PBGC pension insurance coverage. These include “substantial owner” plans, where all participants in the plan own (directly or indirectly) more than 10% of the corporation’s stock. This post highlights what happens when the classification of a “substantial owner” plan changes, and what happens next.
We often see “substantial owner” plans when a pension plan covers only a business owner and their spouse. These plans are not covered by the PBGC and don’t have to pay PBGC pension insurance premiums. However, once there are any non-substantial owners in the plan (e.g., hiring one non-owner employee), things change.
Here’s the key points:
- A pension plan ceases to be a “substantial owner” plan (and is then covered by the PBGC) on the date when a non-substantial owner becomes a participant in the plan (PBGC Blue Book Q&A #2005-11).
- A plan returns to “substantial owner” classification when there are no longer any non-substantial owners participating in the plan. This interpretation is documented in PBGC Opinion Letter 90-6.
Example:
Suppose that Jones is the sole owner and participant in the Jones Pension Plan. After several years, Jones hires Smith (a non-owner) to work at the company. If Smith is hired in June 2010 and becomes a participant in the plan on July 1, 2011, then the plan is subject to PBGC coverage on that date as well. From that point on, PBGC premiums and filings must be completed annually.
Now, suppose that Smith terminates employment after a couple of years. Jones should notify the PBGC that the only remaining participant in the plan is a substantial owner. The PBGC will then confirm that the plan is no longer subject to PBGC coverage.
