benefit restrictions - significantly underfunded plan

[Effen]

I have a small plan (<20 participants) with a funding ratio of less than 5%. Due to their size AFC's never applied and they had a large credit balance so they never had to make a contribution. Benefit accruals were frozen years ago (pre 1980). Don't ask me why they still have the plan 'cause I don't know - they just don't want to terminate it.

The plan also pay's lump sums, so basically, they make a contribution whenever they need to pay someone. I was thinking PPA would put an end to that since lump sums would be restricted if funding ratio was less than 60%, BUT, it seems they are exempt from that rule since the plan was frozen on 9/1/2005 (ERISA 206(g)(5)©(ii). So, I think they can keep doing the "same old same old" and continue to pay lump sums.

Their required contributions will go up post PPA, and they can't use their credit balance anymore (it is gone anyway), but they can continue to pay lump sums even though their funding ratio is basically 0%.

Agree?

[Andy the Actuary]

Not that this is your question, but you may want to check IRS Reg. 1.401(a)(26)-3© because the Plan will have to pass 401(a)(26) in respect to its prior benefit structure (which your plan may or may not do). I.e., the IRS doesn't want a plan to stay frozen forever. This is in the regs. only and not in the code. Surprise!

[Effen]

Thanks Andy, the plan satisifies one of the exemptions of 1.401(a)(26)-1.

[Guest Carol the Writer]

Why wouldn't this be considered "terminal funding", which was expressly forbidden by ERISA at the outset? I know I'm showing my age here, but I did not think you could do this. Carol Caruthers

[Effen]

Maybe I'm showing my age, but I'm not sure what you mean by "terminal funding"? I may also not have been clear about the plan. The employer did make contributions during the early years of the plan. Assets (and credit balances) were accumulated. At some point contributions were no longer required. Once the assets fell below the liabilities, they used their credit balance to satisfy minimum funding standards. They have now reached a point where the credit balance is virtually gone.

As participants retire or terminate, they are paid - mostly in the form of a lump sum. Last year they reached a point where, although due to the credit balance their minimum was still $0, they didn't have enough money to pay out the next person who retired. So now, they make a contribution to the plan whenever someone needs to be paid.

I don't think any rules have been violated. There are only a few people left in the plan and they are all close to NRA. I anticipate the employer will keep the plan around until the last person retires and is paid. Then, I guess, they will terminate a plan with no assets and no liabilities.

[AndyH]

Effen, I am unable to follow your cite to your conclusion. Where is a freeze referenced? Would you mind explaining the logic you are proposing? I don't see it and would like to.

[Guest Carol the Writer]

Oh my!!! I did reveal my age!

The original version of ERISA (containing IRC 412), which was signed into law by President Ford on September 2, 1974, expressly outlawed two actuarial cost methods: pay-as-you-go and terminal funding. Terminal funding was a funding approach whereby the plan was not funded at all until a worker retired, and then the plan sponsor contributed enough - and only enough - to purchase the annuity to pay the retiring worker's benefits.

And pay-as-you-go was weaker still. It could be viewed as an uninsured version of terminal funding, whereby the plan sponsor's contributions were only sufficient to pay the monthly benefits coming due on a current basis - a sort of unfunded emerging liability approach.

These "actuarial cost methods" were mentioned by name in the original ERISA statute, as well as the original corresponding IRC 412, as being not reasonable funding methods under the then-new pension reform law (i.e., ERISA). It would seem to me that the instance that was described above - a frozen plan with a <5% funded ratio - would fall into one or the other of these categories.

Carol Caruthers

[Andy the Actuary]

Carol, thank you for taking me down memory lane when life was not plagued with a morass of predominantly irrational laws and a brick of Velveeta cost $1.19.

As I understand, each year Effen computed the funding standard account entries in accordance with the Plan, participant data, actuarial assumptions, and actuarial cost method -- just like with any other plan. The credits to the Plan included a credit balance which offset the charges. Since the deficit reduction contribution did not appy, minimum funding standards appear to have been satisfied. Certainly, there would be no concern if the Plan had lots of assets but credits exceeded the charges and no contribution was made. Under pre-PPA2006 law there is no requirement that small Plans maintain a certain funding level.

This is one of those situations that at first doesn't feel good and yet there appear to be no violations.

[AndyH]

This is one of those situations that at first doesn't feel good and yet there appear to be no violations.

Why is there no violation under PPA?

[Effen]

Andy, you summary regarding the funding is correct.

Regarding you question of the site, did you mean the 401(a)(26) site or the PPA site?

The plan is exempt from 401(a)(26) because it satisifies 1.401(a)(26)-1(b)(3). It is covered by the PBGC, frozen & underfunded.

The PPA site is from the PPA summary:

Additional restrictions on lump-sum payments under plans with funding percentage of 60 percent or more. The restrictions on accelerated distributions are not limited to benefits paid under a plan that has an adjusted funding target attainment percentage of less than 60 percent. Lump-sum payments under plans with an adjusted funding target attainment percentage of 60 percent or more, but not greater than 80 percent, are also subject to restriction. Payments under such plans are limited to the lesser of: (1) 50 percent of the lump-sum payment the participant would otherwise receive under the plan, or (2) the present value of the participant's maximum PBGC guaranteed benefit (using the interest rate and mortality table that apply in the determination of minimum lump-sum benefits (under ERISA Sec. 205(g) and Code Sec. 417(e), as amended by the Pension Act (see ¶740)) (ERISA Sec. 206(g)(3)© and Code Sec. 436(d)(3)(A), as added by the Pension Act).

...

Exemption for plans that did not provide for benefit accruals during select window period. The prohibited payment restriction will not apply for any plan year if the terms of the plan (as in effect during the period September 1, 2005 to December 31, 2005) did not authorize benefit accruals for any participant (ERISA Sec. 206(g)(3)(D) and Code Sec. 436(d)(4), as added by the Pension Act).

Based on this, it seems that as long as the plan was frozen prior to September 1, 2005, it is exempt from this restriction and can continue to pay lump sums regardless of the funded status.

[AndyH]

Andy, you summary regarding the funding is correct.

Regarding you question of the site, did you mean the 401(a)(26) site or the PPA site?

The plan is exempt from 401(a)(26) because it satisifies 1.401(a)(26)-1(b)(3). It is covered by the PBGC, frozen & underfunded.

The PPA site is from the PPA summary:

Additional restrictions on lump-sum payments under plans with funding percentage of 60 percent or more. The restrictions on accelerated distributions are not limited to benefits paid under a plan that has an adjusted funding target attainment percentage of less than 60 percent. Lump-sum payments under plans with an adjusted funding target attainment percentage of 60 percent or more, but not greater than 80 percent, are also subject to restriction. Payments under such plans are limited to the lesser of: (1) 50 percent of the lump-sum payment the participant would otherwise receive under the plan, or (2) the present value of the participant's maximum PBGC guaranteed benefit (using the interest rate and mortality table that apply in the determination of minimum lump-sum benefits (under ERISA Sec. 205(g) and Code Sec. 417(e), as amended by the Pension Act (see ¶740)) (ERISA Sec. 206(g)(3)© and Code Sec. 436(d)(3)(A), as added by the Pension Act).

...

Exemption for plans that did not provide for benefit accruals during select window period. The prohibited payment restriction will not apply for any plan year if the terms of the plan (as in effect during the period September 1, 2005 to December 31, 2005) did not authorize benefit accruals for any participant (ERISA Sec. 206(g)(3)(D) and Code Sec. 436(d)(4), as added by the Pension Act).

Based on this, it seems that as long as the plan was frozen prior to September 1, 2005, it is exempt from this restriction and can continue to pay lump sums regardless of the funded status.

Thanks, Effen. Got it from the Code 436 reference. Looks like you are right; I didn't know that was in there. Thanks.

[Mike Preston]

Boy, I wouldn't want to be the actuary for this plan if it were referred to the ASB. What part of the funding calculations fall under the definition of reasonable? I suppose it is possible that the client was kept abreast of not only the statutory minimums, but also the calculations of something that might satisfy the definition of reasonable.