Provisions in the American Rescue Plan Act (ARPA) have the potential to help many single employer pension plan sponsors weather the economic impacts of the COVID-19 pandemic while providing time to consider how to integrate their business and pension funding strategies, suggests Jonathan Price, corporate retirement practice leader and senior vice president in Segal’s New York office. In a recent interview, Price said the law is likely the one of the most significant legislative developments for single employer pension plans in the last decade.
Here’s a look at some of the issues Price discussed during our interview.
New Opportunity for Single Employer Pension Plans
Price said that for single employers the biggest impact of the new law is control. Under the prior funding regulations, sponsors of underfunded plans would have been required to make plan contributions potentially at inopportune times, such as when they are still recovering from the business impact of the pandemic. “This is critical because it allows them an opportunity to align pension funding and other pension strategies with broader cash usage and business strategies,” he said.
How does it work?
A pension plan’s funding obligation is determined primarily by the relationship between the assets and liabilities. The higher the interest rate a plan can use to value plan liabilities, the lower the value of the liabilities, and therefore the lower the contributions required to make to make up any funding shortfalls. Conversely, lower interest rates mean higher liabilities and thus higher contributions.
Price provided some history for context: Under the Pension Protection Act of 2006, pension plans had to use current interest rates to determine the liability of a plan, which determines the funded status and the sponsor’s funding obligation. That became more problematic during the historic low-interest-rate environment that followed the Great Recession, so Congress stepped in and instead said plans could use a corridor around the 25-year average of interest rates. That corridor was intended to widen over time, and it was expected it would eventually become broad enough to sweep in the current interest rates.
Few expected a global pandemic and the impact it would have on the economy over the last year. To provide relief for single employer pension plans during the challenging environment, ARPA narrows the 25-year average interest rate corridor used to value plan liabilities from 10% to 5% for the 2020 through 2025 plan years. This means that the rate used can’t vary from the current average rate by more than 5%, which has the effect of allowing plans to use a higher interest rate to determine liabilities.
To help illustrate this, Price explained that if the 25-year average interest rate were 6%, under the new narrower corridor, the interest rate used to value liabilities couldn’t be lower than 5.7% or higher than 6.3%. Previously that range would have been 5.4% to 6.6%.
When the current rate is below the 25-year historical rate, which is how interest rates sit currently, plans would use the lowest rate in the range. So, in the example above, the plan would use a 5.7% rate to value its liabilities instead of the 5.4% rate, and contributions would be lower.
ARPA also establishes a 5% floor, so if the new historical average rate is less than 5%, the rate will be considered to be 5% for that year.
This narrower corridor continues until 2026, when it will be widened by 5% each year to eventually reach 30%. The expectation is that the current rates will eventually be within that corridor, so plans would begin using current rates as the basis for determining liability. This also means that the value of the liability will grow as the corridor expands over time.
Another piece of the ARPA also provides funding relief for single employer pension plan sponsors. Price said ARPA extends the underfunding amortization period from seven to 15 years. As a result, employers and plan sponsors with underfunded plans can defer the timing of the contributions they make to reduce a plan’s unfunded liability. Instead of having seven years to make the plan whole—They now have 15 years. The ability to make those contributions over a longer time period lowers the minimum required contribution per plan year.
When will the changes take place?
An additional advantage is that plan sponsors can elect to have the new rules start with the 2019 or 2020 plan years, in addition to 2021. Price said that additional guidance is needed on this topic, including how this may affect prior certifications, benefit restrictions or credit balance elections. But this ability to retroactively apply the rules provides additional flexibility for plan sponsors that may be helpful in some circumstances.
Why might plan sponsors want to consider making use of the new provisions to invest in their businesses?
Price explained that there are pros and cons to diverting near-term required pension contributions to investments in businesses and operations.
“The clearest advantage relates to the ability to invest in the core operations of the business right now rather than tying up cash in the pension plan, especially for businesses and industries that are struggling through the pandemic,” he said. Plan sponsors can be strategic when looking at their plans and manage the cash flow and risks in light of their broader business objectives.
“The con is the inverse of that, which is that those contributions will be due at some point in the future. Deferring them today means that in all likelihood they will be due tomorrow.”
Because of that, Price cautions that plan sponsors should not use the new law “to kick the can down the road. They should use this opportunity to create a clear strategy for cash flow and risk management.”
[Learn more about how the American Rescue Plan Act (ARPA) is impacting employee benefits.]
Kathy Bergstrom, CEBS
Senior Editor, Publications at the International Foundation of Employee Benefit Plans
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