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Guest Article

Deloitte logo

(From the November 17, 2008 issue of Deloitte's Washington Bulletin, a periodic update of legal and regulatory developments relating to Employee Benefits.)

Declining Asset Values in Defined Benefit Plans Could Invoke Benefit Restrictions and Deferred Compensation Concerns


Beyond the obvious effects on funding, there are other potential consequences to declining asset values for defined benefit pension plans and their sponsors. Single-employer defined benefit plans that fail to reach specified funding attainment levels will trip increasingly severe benefit restrictions (e.g., prohibitions against plan amendments, against payment of amounts in excess of single life annuity payments, and eventually against benefit accruals). At-risk defined benefit plans will also restrict the ability of publicly-traded corporations to set aside amounts for the purpose of paying deferred compensation to the executive officers.

IRC §436 -- Funding-Based Benefit Restrictions

In the case of a single employer defined benefit plan (and a multiple employer defined benefit plan, applying the rules separately to each employer under the plan), if the adjusted funding target attainment percentage (AFTAP) is below 80 percent for the plan year, various restrictions will apply. If the AFTAP is less than 100 percent and the plan sponsor becomes a debtor in bankruptcy under Chapter 11, restrictions will apply. These restrictions are identified and summarized briefly below.

AFTAP Applicable Limitation Restriction
< 100%
& Chapter 11 Bankruptcy of Plan Sponsor
Accelerated Benefit Distributions No Prohibited Payments: No "prohibited payments" with an annuity starting date that is during the period in which the plan sponsor is a debtor in bankruptcy under Chapter 11 may be paid, except for payments with an annuity starting date within a plan year that is on or after the date on which the enrolled actuary certifies that the AFTAP is not less than 100 percent. A "prohibited payment" is any payment for the month that is in excess of the monthly payment amount paid under a single life annuity (plus any social security supplements) to a participant or beneficiary whose annuity starting date occurs during any period a limitation is in effect, or any payment for the purchase of an irrevocable commitment from an insurer to pay benefits.
< 80%
(or , < 80% taking into account the proposed plan amendment)
Plan Amendments Plan Amendments Prohibited: No amendment may take effect during the plan year if it has the effect of increasing liabilities by reason of increases in benefits, establishment of new benefits, changing the rate of benefit accrual, or changing the rate at which benefits become nonforfeitable. (An exception exists for an amendment that provides for an increase in benefits under a formula that is not based on compensation, provided that the increase does exceed the rate of increase in average wages of the participants covered by the amendment.) This restriction will not apply for the plan year if the employer makes the contribution specified under IRC §436(c)(2).
< 80%
but > 60%
Accelerated Benefit Distributions Limited Payment of "Prohibited Payment" Amounts: Only a portion of a "prohibited payment" amount may be paid. (See Accelerated Benefit Distributions, above.) On or after the IRC §436 measurement date (e.g., the date of the enrolled actuary's certification of the AFTAP if it occurs within the first nine months of the plan year), the plan may pay a "prohibited payment" only if the present value does not exceed 50 percent of the present value of the benefit -- or, if lesser, does not exceed the present value of the maximum PBGC single-employer plan benefit guarantee amount under ERISA §4022.
< 60%
(or, < 60% taking into account the payment of the benefits)
Shutdown and Other Unpredictable Contingent Event Benefits No Payment of Benefits: No shutdown or other unpredictable contingent event benefit may be paid during the plan year. An unpredictable contingent event is any event other than the attainment of any age, performance of any service, receipt or derivation of any compensation, or occurrence of death or disability. This restriction will no longer apply for the plan year if the employer makes the contribution specified under IRC §436(b)(2).
< 60% Accelerated Benefit Distributions No Prohibited Payments: No prohibited payments may be made with an annuity starting date on or after the IRC §436 measurement date. (See Accelerated Benefit Distributions, above.)
< 60% Benefit Accruals Cessation of Benefit Accruals: Benefit accruals under the plan must cease as of the IRC §436 measurement date. This restriction will no longer apply for the plan year if the employer makes the contribution specified under IRC §436(e)(2).

See IRC §436, Proposed Treasury Regulations §1.436-1 (at 72 FR 50544 (August 31, 2007), as corrected), and Notice 2008-21.

IRC Section 409A -- Deferred Compensation Income Tax and Penalties

If the employer is a publicly-traded corporation and its defined benefit plan -- or any single-employer defined benefit plan within the controlled group -- is insufficiently funded, IRC §409A restricts the ability of the controlled group members to set aside funds for payment of deferred compensation to the executive officers and directors (i.e., the chief executive officer and other four highest compensated officers required to be reported to shareholders under the Securities and Exchange Act of 1934, and any individual subject to the requirements of §16(a) of the Securities Exchange Act of 1934).

Specifically, IRC §409A(b)(3) imposes punitive tax treatment on assets that are "set aside" for the payment of deferred compensation to the identified individuals during a "restricted period." It targets:

assets [which] are set aside or reserved (directly or indirectly) in a trust (or other arrangement as determined by the Secretary) or transferred to a trust or other arrangement for the purpose of paying deferred compensation of an applicable covered employee under a nonqualified deferred compensation plan.

The restriction applies to transfers to a trust, and to less direct "set asides," the scope of which remains unclear.

A "restricted period" is any period in which a single-employer defined benefit plan of the plan sponsor (or member of a controlled group which includes the plan sponsor) is "at risk" as defined under IRC §430(i). It also includes the 12-month period that begins 6 months before such a defined benefit plan's termination date if the plan is not sufficiently funded for a standard termination under ERISA §4022. Lastly, a "restricted period" includes any period the plan sponsor is a debtor in bankruptcy under Chapter 11.

If funds are "set aside" during a "restricted period," the funds are treated as property transferred in connection with the performance of services under IRC §83, and are taxable to the employee when they are no longer subject to a substantial risk of forfeiture. In addition to income tax, the amounts are also subject to a 20 percent penalty tax, and to interest at the underpayment rate plus 1 percent on the underpayments that would have occurred had the amounts been includible in the gross income of the employee in the year first deferred or, if later, in the year the amounts are no longer subject to a substantial risk of forfeiture.

In the event the employer "grosses up" the employee for such taxes, the gross up is considered part of the deferred compensation and is itself subject to the 20 percent tax and to the interest assessment. The employer is denied a deduction for the gross up amount.

A defined benefit plan is "at risk" for a plan year if:

  • The funding target attainment percentage for the preceding plan year is less than 80 percent, and
  • The funding target attainment percentage for the preceding plan year -- determined by using the "at-risk" actuarial assumptions under IRC §430(i)(1)(B) in computing the funding target -- is less than 70 percent.

In the case of plan years beginning in 2008, 2009 and 2010, the "80 percent" standard is replaced with 65 percent for 2008, 70 percent for 2009, and 75 percent for 2010. The actuarial assumptions under IRC §430(i)(1)(B) require that:

  1. All employees who are not otherwise assumed to retire as of the valuation date but who will be eligible to elect benefits during the plan year and the 10 succeeding plan years are assumed to retire at the earliest retirement date but not before the end of the plan year for which the at-risk funding target and at-risk target normal cost are being determined.
  2. All employees are assumed to elect the retirement benefit available under the plan at the assumed retirement age (determined after application of the preceding paragraph (1)) which results in the highest present value of benefits.

See IRC §§409A(b) and 430(i), and Proposed Treasury Regulations §1.430(i)-1 (at 72 Federal Register 74215 (12/31/07)).


Deloitte logoThe information in this Washington Bulletin is general in nature only and not intended to provide advice or guidance for specific situations.

If you have any questions or need additional information about articles appearing in this or previous versions of Washington Bulletin, please contact: Robert Davis 202.879.3094, Elizabeth Drigotas 202.879.4985, Mary Jones 202.378.5067, Stephen LaGarde 202.879-5608, Erinn Madden 202.572.7677, Bart Massey 202.220.2104, Mark Neilio 202.378.5046, Tom Pevarnik 202.879.5314, Sandra Rolitsky 202.220.2025, Tom Veal 312.946.2595, Deborah Walker 202.879.4955.

Copyright 2008, Deloitte.


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