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Free money for pension plans! The American Rescue Plan Act of 2021

Free money for pension plans! The American Rescue Plan Act of 2021

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On March 11, 2021 the American Rescue Plan Act (ARPA) became law. The new rules allow single employer pension plans to go back to 2019 and 2020 and recoup or recharacterize some of the contributions made in those years. Even if a plan did not make a cash contribution in those years, some of the “credits” used to satisfy contribution requirements can be clawed back.

Free money? Not exactly, but many pension plans can gain more flexibility in the timing of future contribution requirements. While the amount of flexibility to be gained by a plan sponsor can vary, most sponsors should take advantage of these new rules. Let me explain.

The ARPA legislation provides two key areas of relief for single employer pension plans:

Extension of time allowed to make-up funding deficits

Under current law, any unfunded liability (or “shortfall”) is amortized over seven years. ARPA extends this amortization period to 15 years. The impact of this change can vary widely for plans depending on the pattern of gains and losses in the past, but a 50% reduction in this component is a reasonable ballpark estimate (it could be 25% to 75%).

So, the more underfunded a plan is, the greater this benefit will be, right? Not exactly.

While it is true that more underfunded plans get a higher cash boost, a plan can be overfunded, or even very overfunded, and gain future contribution flexibility. This is because it matters how underfunded the plan is after subtracting the “funding balance”. A funding balance is just the accumulation of contributions made by the plan sponsor that is over and above the minimum required. The funding balance is subtracted from the asset value to determine if a plan has a shortfall.

Asset value $110,000,000
Funding balance 20,000,000
Net assets (asset value-funding balance) 90,000,000
Liability 100,000,000
Shortfall (liability-net assets) 10,000,000
Current law amortization of shortfall 2,000,000
New law amortization of shortfall 1,000,000

 

For example, a plan could be 110% funded, but only 90% funded after subtracting the funding balance and have a 10% shortfall. Here is an example (simplified) of the impact of ARPA for a plan like this.

If this plan went back to 2019 (which is allowed) and recalculated the minimum contribution under the new rules, it would be $1 million lower. Since it is in the past and the contribution (in cash or using the funding balance) has already been made, the $1 million increases, or goes back to, the funding balance and can be used at any time to satisfy future contribution requirements.

Interest rate increase

The second major change is an increase the interest rate used to calculate the funding liability. The amount will vary depending on the year, but it typically would be enough to decrease pension liability by 5% to 7%, starting in 2020 if a plan sponsor elects.

This will increase some important funded status ratios, but it will also decrease the required minimum contribution because it decreases a plan’s shortfall, as follows:

Liability before ARPA $100,000,000
Liability after ARPA 95,000,000
Reduction in shortfall 5,000,000
Amortization of reduction in shortfall (and decrease in minimum contribution requirement) $500,000

What should plan sponsors do?

Plan sponsors need to understand the impact ARPA could have on their plan, both retroactively and going forward as there are positive impacts for both underfunded and overfunded plans.

At first blush, many overfunded plans may believe there is no benefit, or too little benefit, to adopting the rules retroactively. But there are some items to keep in mind:

  1. The interest rate for funding purposes is going down. This new legislation provides relief, but it is only temporary. Interest rates will decline from about 5.5% currently to 3.5% by 2030 if market rates don’t rebound. The decline is gradual in the next few years and turns steeper starting in 2026. That decrease will cause 20% to 30% increases in liability. So an overfunded plan today can turn underfunded as these lower interest rates kick in. Note that hedging interest rate movements with fixed income securities does not help with this liability, because legislation is keeping the interest rate above market rates.
  1. If your plan holds risky investments, the funded ratio can change quickly. The last decade has been very good for equity investments, very different from the 2000’s. Let’s hope we get another good one in the 20’s, but investing in equity means accepting the risk that comes with it.
  1. When markets are down, business is also down. Unfortunately, that tends to be the time contributions to pension plans are required. When businesses are doing well the appetite for pension contributions tends to be overestimated.

Going back to capture contribution flexibility is an opportunity that does not come around often.  Plan sponsors should take advantage of the new rules. Even if you don’t think it will matter today, it may matter tomorrow, and you will be unlikely to regret the decision.