Steering Clear of Pension Benefit Restrictions

Negative asset performance and declining valuation interest rates during 2011 will cause some pension plans to face benefit restriction issues for the first time in 2012.   Potential repercussions include limits on accelerated distributions (lump sums), restrictions on plan amendments increasing the value of benefits, mandatory benefit accrual freezes and restrictions on unpredictable contingent event benefits (UCEBs).

Many sponsors want to do all that they can to avoid these benefit restrictions.   Regulations allow four options to do so:

  1. Waiving credit balance – If there is any credit balance (carryover balance or prefunding balance) on the valuation date, the easiest way to improve the funding status is to waive the balance.  In fact, this action is required in certain cases.  The trouble is, for most underfunded plans, the credit balance is not big enough to be of much help.  It can also reduce future funding flexibility.
  2. Posting security – Sponsors can also post funds in escrow outside of the plan and count it as an asset for purposes of determining if benefit restrictions apply.  This option comes with plenty of strings attached, and would not truly improve the funding status of the plan.
  3. Additional current year contribution – A third option is to make an additional contribution for the current year (a “436 contribution”).  A 436 contribution needs to be made before the date the restriction would otherwise start.  This option can avoid restrictions on UCEBs, amendments and accruals, but not limits on lump sums.
  4. Additional prior year contribution – The fourth and perhaps most attractive option is to make an additional contribution for the prior year.  Here are a few things plan sponsors considering this solution should know:
    • The contribution does not need to be made before the valuation date.  For example, a plan sponsor that is concerned their January 1, 2012 funded status may trigger benefit restrictions would not need to make an additional contribution by December 31, 2011.  This is important because it allows time for the plan’s actuary to measure the preliminary funded status, determine if a contribution is needed to avoid restrictions, and to calculate the amount of such a contribution.
    • The January 1, 2012 funded status generally needs to be certified by March 31, 2012.  Ideally, additional contributions would be made by this date because the actuary can not certify the status based on contributions that haven’t already been made.  However, an actuary can issue a “range certification”.  For example, the actuary can certify that once the contribution is made, the funded status will be between 80% and 100%.  This prevents restrictions and allows the sponsor to have until the normal contribution due date (the earlier of September 15, 2012 and the date the 2011 tax return is filed) to fund any additional contribution for 2011.
    • The contribution increase may be more affordable than it first appears.  That’s because any additional contribution for the prior plan year is included in the assets for determining the minimum contribution on the next valuation date.   Making an additional 2011 contribution of $1,000,000 may reduce the 2012 minimum contribution by about $160,000.
    • WARNING:  If, for any reason, the additional contribution isn’t made so the final funded status is outside of the previously certified range, there are serious consequences.  Potential consequences include retroactive benefit restrictions and plan disqualification.  Therefore, the sponsor needs to be absolutely sure that they will be able to make the contribution prior to requesting a range certification.

Since benefit restrictions can be complicated and costly to implement, it makes sense to avoid them – especially if they can be avoided by paying down unfunded liability that needs to be funded sooner or later.