Pension relief has arrived! But what does that mean, exactly?
The American Rescue Plan Act (ARPA) became law back in March. No need to rehash the details of the law (and anticipated IRS guidance still outstanding) for we’ve got that by now. The relevant pension provisions within ARPA generally lower defined benefit (DB) plan minimum required contributions and may provide plan sponsors with cash contribution flexibility now and in the future.
So naturally our mind shifts to how will this affect your pension plan’s funding policy.
All companies should have a funding policy plan to determine how they will manage the financials of their pension program. But in a quick poll conducted during a recent Buck webinar on pension plan funding almost 40 percent of respondents stated that was not the case.
What is a funding policy?
A funding policy is a plan for managing the financials of a pension program. It helps with the decisions a sponsor needs to make, cements understanding of the implications of those decisions, and helps manage the volatility inherent in the plan.
Some may consider adopting the IRS minimum finding as their funding plan, but that foregoes flexibility, is not based on the principles that guide the plan, and opens sponsors to constantly changing targets. With a funding plan of its own that management has agreed to, it can be changed as circumstances change – the important point is that the policy is considered and based on consensus.
What are the plan sponsor’s priorities?
Dealing with the problems that pension plans seem to have can be irritating at best – but that’s why it’s important to have a strategy. Foregoing a different discussion on how valuable pension plans are, the focus is often how expensive the plan is, or how volatile that expense can be. A good funding policy can solve these problems, if not help avoid them in the first place.
And plan sponsors will naturally have different approaches to their funding policies.
Some sponsors care a lot about what the plan’s funded position looks like on the balance sheet or what the P&L implications are now and in the future. A cash contribution strategy can mitigate these concerns.
Others will be asking why do we have to allocate cash (or take on debt) for these plans when our business needs it instead? Yet contributing more than the minimum provides flexibility in the timing of future contributions, avoids the implications of underfunding, and can accelerate tax deductions.
De-risking efforts also go hand-in-hand with funding policy. As sponsors decide that they’d rather not even have these plans on their balance sheet, funding policy will help prepare for annuity buyouts or glide path investment strategies so that plans become smaller and/or better funded. Yes, this will require cash, which is why you need a funding policy to guide the plan toward its goals.
The time for funding policy consideration is now.
The new funding order under ARPA makes for more options and flexibility. Plan sponsors need to make sure the ARPA elections align with their plan’s funding policy. It’s not about avoiding cash contributions – more about aligning your cash allocation with plan priorities:
- Don’t like contribution volatility? Design a level funding plan where funded status improves, but also builds a prefunding balance to maintain funding flexibility.
- Want to avoid benefit restrictions? Set a policy that achieves and maintains appropriate funded status goals.
- Dislike paying PBGC premiums? Set the level and timing of contributions to minimize or eliminate the variable rate premium.
- Are participants accruing benefits or is the plan frozen? Cash contributions are often suggested to at least cover accruals and expenses paid out of the trust even if a credit balance is available.
Minimal funding is not always the answer.
While choosing to fund the minimum is one approach, not putting cash into the plan has its consequences. For example, ARPA does not provide relief when it comes to paying PBGC premiums. Insufficient cash contributions could result in higher PBGC premiums; funding policy decisions can lower those. Contributions not made now will likely serve to increase future contributions and related concerns about volatility of those amounts.
A habit of making the smallest cash contribution possible may also result in stagnating funded status, and ARPA doesn’t help with this. A poor funding policy is too risky all by itself.
Ask yourself: How healthy is your plan?
ARPA does provide needed relief for many plan sponsors who, in the short term, may have difficulty making cash contributions to their plans in light of other priorities. The lower minimum required contribution will help. In addition, plan sponsors can use ARPA to initiate or augment credit balances to increase flexibility – which could include contribution holidays when desired.
But the current state of the plan – its funded position, maturity, and risk profile – should be what drives longer-term funding policy decisions. If the plan is significantly underfunded, a funding policy should address how to improve funded status over time. Relying on investment returns to help in this regard is risky business.