American Rescue Plan Act: What is the Impact on Plan Sponsors of Corporate Defined Benefit Plans
By Patrick Ring
Retirement Section News, September 2021
Editor’s Note: Zorast Wadia is a principal and consulting actuary with Milliman. He has expertise with pension valuations and risk management for corporate pension plans. He is the principal author of the Milliman Pension Funding Study and Milliman 100 Pension Funding Index.
Congress passed the American Rescue Plan Act (ARPA) on March 11, 2021. The driver behind ARPA was to mitigate financial hardships created by the COVID-19 pandemic faced by a wide range of Americans, businesses, communities, and local governments. The part of ARPA applicable to businesses included provisions lessening the financial burden on corporations who sponsor defined benefit (DB) plans, and are a complete overhaul of the IRS funding rules that have been in effect for over a decade.
I interviewed Zorast Wadia to recap these landmark rule changes and discuss the impact on plan sponsors. Zorast was very optimistic on the future DB Plans given the passage of ARPA and several of his comments are based upon an article he published earlier this year in May titled “Defined Benefit Pension Funding Resurrection.”[1]
Patrick Ring (PR): What was the driver behind making changes to corporate defined benefit plans?
Zorast Wadia (ZW): Interest rate relief under the previous law (the Moving Ahead for Progress in the 21st Century Act or MAP-21) was scheduled to begin wearing away starting in 2021 and continuing through to 2024. This would have had a significant cash impact on plans that were underfunded. Minimum contribution requirements for many plan sponsors would have greatly increased over the next four years.
PR: Please give us a helicopter view of the impact of the ARPA on corporate DB plans.
ZW: The two main funding relief components of ARPA were: (1) an extension of interest rate smoothing, and (2) a restart and extension of shortfall amortization bases.
With respect to interest rate smoothing, ARPA provides for the use of higher interest rates used to calculate pension liabilities for minimum funding purposes and benefit restrictions. The interest rate relief is actually set at a higher level than seen before under previous funding relief legislation (like the Moving Ahead for Progress Act (MAP-21) and the Highway and Transportation Funding Act (HATFA)) and relief is scheduled to last longer, namely until the end of this decade. In addition, you may be aware that under the current infrastructure proposal, this pension law change would even be extended another five years to 2035.
With respect to a restart and extension of funding shortfall amortization bases, ARPA allows for current shortfall amortization bases for prior plan years to be eliminated (“fresh start”) and all new shortfalls to be amortized over 15 years, rather than seven years under the prior law.
The combined effect of interest rate and amortization shortfall relief is expected to be profound for many plan sponsors, especially those with plans facing current funding shortfalls. Moreover, ARPA allows for plan sponsors to elect to apply its provisions retroactively, going back to the 2019 plan year. This retroactive application may further help many plan sponsors to get immediate cash contribution relief with respect to their IRS mandated minimum contributions.
PR: What are the implications for a fully funded corporate plan?
ZW: For a plan that is fully funded under IRS rules (assets greater than or equal to plan liabilities), there is generally no amortization component (ignoring the presence of credit balances) to their minimum required contribution. This would leave only the normal cost component[2] that would make up a plan’s minimum cash contribution requirement. For a plan with ongoing accruals, the normal cost would be less under ARPA due to its extension of interest rate smoothing. For a frozen plan (no ongoing accruals for participants) that is fully funded, their contribution requirement would not immediately change under ARPA. But the likelihood of a frozen overfunded plan remaining that way (i.e., still overfunded after several years) would be increased under ARPA due to its extension of interest rate smoothing.
PR: What are implications for a fairly well funded corporate plan?
ZW: Under ARPA, a fairly well funded (funded percentage between 85 percent to 99 percent) corporate plan will see reductions in the minimum cash requirements relative to prior law. This reduction will likely be sustained over a longer period given the ability to amortize funding shortfalls over 15 years rather than the seven years under prior law. Fairly well funded plans may also be able to establish higher credit balances (prefunding balances) due to the ability to elect to retroactively apply the funding relief provisions of ARPA as early as in 2019. Credit balances can be used by plan sponsors to satisfy minimum funding requirements in lieu of making cash contributions. Credit balance election is possible as long as a plan is at least 80 percent funded on an “adjusted assets” basis.[3]
PR: What are implications for a significantly underfunded corporate plan?
ZW: Significantly underfunded plans (below 70 percent funded, for example) would benefit from both the interest rate and amortization relief provisions under ARPA. Their minimum required contributions for the next several years would most certainly be lower under ARPA than under prior law. Plan sponsors of these plans can also establish higher credit balances by retroactively applying the provisions of ARPA. Although the credit balances may not be available right away—i.e., while the plan’s funded status is below 80 percent (as noted above)—they could be used to offset funding requirements in the future, once the plan’s funded status improves.
PR: What is the impact of ARPA on the Pension Benefit Guaranty Corporation (PBGC) Insurance premiums?
ZW: Under ARPA, plan sponsors have roughly double the time to make up for underfunding relative to prior law, but this could also result in paying higher PBGC premiums for longer. PBGC insurance premiums consist of a flat dollar premium and a variable rate premium (subject to a cap). The variable rate premium is based on a plan’s funded status, without the reflection of smoothed interest rates as allowed under ARPA. This means that if a plan sponsor chooses to make lower contributions (as allowed under ARPA) then they will often be required to pay a PBGC premium that could be significantly higher than prior to ARPA. For significantly underfunded plans, this relationship could be mitigated by the PBGC variable rate premium cap which is a function of the total number of plan participants ($582 per plan participant in 2021). As long as the variable rate premium cap applies, plan sponsors are protected from the larger variable rate premiums that would otherwise apply.
In summation, sponsors who are considering reducing their pension contributions as a result of ARPA will need to weigh this with increased PBGC insurance premiums.
PR: What sorts of impact do you think ARPA will have on investment strategies?
ZW: The relaxed minimum contribution requirements under ARPA allow plan sponsors to take longer-term views toward pension de-risking. As such, plan sponsors may want to take on less risky investments and consider the adoption of liability-driven investment strategies, if they have not done so already. Prior to ARPA, many plan sponsors had significant funded status deficits, and with interest rates steadily declining in 2019 and 2020, the possibility of shifting assets from equities to fixed income may have not been palatable. Plan sponsors would not want to lock in underfunding by taking on greater fixed income positions, given the cascade of upcoming required contributions that they would have faced prior to ARPA.
With funded ratios immediately improving under ARPA and minimum required contributions significantly muted over the next several years, shifting asset allocations from equities into fixed income seems like a viable alternative again. Many plan sponsors had already been doing this via glide path strategies adopted well before the passage of ARPA. For those plan sponsors, further progression down the glide path toward full funding is very likely to continue.
PR: Do you think ARPA will slow the overall market movement from DB to defined contribution (DC) plans?
ZW: Generally, when a DB plan sponsor freezes ongoing accruals, they may also accompany this action by enhancing defined contribution plan benefits through either higher profit sharing or enhanced matching contributions. ARPA is beneficial to frozen plan sponsors since it allows for lower cash contributions. It also paves the way for plan sponsors to adopt less risky investment strategies going forward in their pursuit of full funding.
For plans that are not frozen, ARPA will similarly help plan sponsors by lowering contribution requirements over the next decade. This cash savings would not be possible or applicable for sponsors providing benefits through only DC designs. The cash savings and flexibility for plan sponsors along with the renewed interest in lifetime income options from plan participants will certainly be strong incentives to keep DB plans intact.
PR: Do you believe the ARPA will moderate the de-risking efforts via pension risk transfer of corporate plan sponsors?
ZW: While the passage of ARPA will not affect the costs of annuity purchases and plan terminations, the general improvement in ERISA funded status may cause some plan sponsors to re-evaluate their pension risk transfer strategies.
With the costs of maintaining a frozen plan significantly decreasing over the next several years due to lower minimum required contributions, some plan sponsors may decide to choose a plan hibernation strategy over annuity purchases and plan termination. Continuing along the pension glide path to full funding and letting the plan run its natural course by paying out benefits to retired pensioners over time can offer cost savings to plan sponsors relative to third-party risk transfer strategies. After the ERISA full funding threshold is crossed, immunization investment strategies can lock in surplus sufficient for the elimination of contributions and the minimization of PBGC premiums. Upon this juncture, a plan sponsor can decide to further ride out its pension plan naturally once the ongoing costs are essentially covered, or terminate the plan depending on its risk and financing preferences. Terminating a pension that is already in a position of funding surplus will certainly be less costly than doing so for a plan with a funding shortfall.
PR: Do you believe that ARPA provides any incentive to start up a DB plan?
ZW: ARPA combined with carefully selected plan design formulas that have higher degrees of risk sharing between the plan sponsor and plan participant can serve as a strong incentive to start up a new DB plan or unfreeze the accrual formula for an existing defined benefit plan. Examples of plan design formulas that include better risk sharing options are cash balance plans and variable annuity plans. Plan participants will benefit from the lifetime income options under a defined benefit plan. Plan sponsors will be able to manage their plans with less risk under the ARPA relief provisions and achieve a cash savings over a similar offering via a DC plan.
PR: In closing, how do you think ARPA funding relief will impact benefit security for pension plan participants?
ZW: Ultimately, if ARPA makes it easier for plan sponsors to meet minimum funding requirements and achieve full funding, this will serve as a strong incentive to preserve providing benefits for participants through a DB design. Defined benefit plans can provide lifetime income for plan participants and their prevalence will improve benefit security for plan participants. Plan sponsors may consider strategies to shift their funding budgets from DC plans into DB plans should funding options for these defined benefit plans become more manageable and predictable under ARPA.
Statements of fact and opinions expressed herein are those of the individual authors and are not necessarily those of the Society of Actuaries, the newsletter editors, or the respective authors’ employers.
Patrick Ring, ASA, volunteers as the acting chair of the Retirement Section Council’s Communication Team, which is responsible for publishing Retirement Section News and the Retirement Forum, hosting podcasts, and maintaining the Retirement Section Council’s webpage. He can be contacted at pringactuary@gmail.com.
Endnotes
[1] Full article can be found on https://www.milliman.com/en/insight/Defined-benefit-pension-funding-resurrection
[2] Including administrative expenses
[3] Adjusted assets = actuarial value of assets, offset by any prefunding balance