The Pension Funding Equity Act of 2004; Internal Revenue Service Notice 2004–34 and Announcement 2004–38

On April 10, the President signed the Pension Funding Equity Act of 2004 (the "Act"). On April 12, as a direct response to the mandates of the Act, the Internal Revenue Service (the "IRS") published Notice 2004–34 and Announcement 2004–38. The Act and the IRS publications are intended to provide temporary funding relief for sponsors of defined benefit plans. The temporary relief, which is effective as of January 1, 2004, will expire in 2006. The expressed intent of the Act’s Congressional sponsors is that permanent funding reform will be in place by 2006. Given the intense lobbying generated by even this temporary legislation, the more likely scenario is continued "temporary" fixes for the foreseeable future.

The Act addresses a number of mostly funding related issues affecting defined benefit plans:

• the interest rate for certain pension plan funding and limitation requirements;

• elections by a select group of employers for alternative deficit reduction contributions;

• multiemployer defined benefit plan funding notices;

• elections by a very limited number of multiemployer plans to defer a charge for a portion of a net investment loss for 2002; and

• Various "Philadelphia nun" relief provisions.

The Act (and the IRS Notice and Announcement) will affect, among other things:

• minimum required contributions;

• restrictions on plan distributions to the top 25 highly compensated employees;

• determination of the maximum deduction limits; and

• calculation of non-annuity benefit limitations under Section 415(b)(2)(E) of the Internal Revenue Code (the "Code").

For plans and plan sponsors that do not qualify for specifically targeted relief, Section 101 of the Act is likely to have the broadest impact.

Temporary Funding Relief for All Defined Benefit Plans

Section 101 of the Act amends the minimum funding rules of Employee Retirement Income Security

Act of 1974 ("ERISA") and the Code to change the interest rate used in determining a plan’s required minimum contributions and current liabilities from the 30-year Treasury constant maturity bond rate to a rate based on long-term corporate bonds. The change is effective for plan years beginning in 2004

and 2005. Specifically, the Act redefines the term "permissible range" (which applies to the relevant interest rate) for plan years beginning in 2004 and 2005 as a rate of interest based on long-term corporate bonds rather than 30-year Treasuries (which are no longer being issued). This temporary permissible interest rate cannot be greater than, and cannot be more than 10% less than, the weighted average of the rates of interest on amounts invested conservatively in long-term corporate bonds during the four year period ending on the last day before the beginning of the plan year. The Act mandates that the IRS select two or more indices that are in the top three quality levels available and that these indices be used to determine the rate. The Act also mandates that the Secretary publish the permissible rate, the indices and the methodology used to determine the average rate. For actions taken by the IRS to comply with these mandates, see the discussion of Notice 2004–34 below.

As part of this temporary permissible interest rate redefinition, the Act provides a two pronged lookback rule. Under the first prong, in determining whether a single employer plan must make a deficit reduction contribution under ERISA section 302(d)(9)(B)(ii) and Code section 412(l)(9)(b)(2), the plan sponsor may recalculate the funded current liability percentage for applicable preceding plan years as if the amendments under the Act had been in effect for all prior plan years. Under the second prong, for purposes of determining whether a single employer plan must make a current year quarterly contribution under ERISA section 302(e)(1) and Code section 412(m)(1), the plan sponsor may recalculate the funded current liability percentage of the preceding plan year as if the amendments under the Act had been in effect for all prior plan years. The second prong of the lookback, however, does not apply to the calculation of the actual amount of a quarterly contribution if such a contribution is required.

The redefinition of permissible interest rates in combination with the lookback rules will have an immediate, if somewhat indeterminate, impact on minimum contributions to defined benefit plans.

Plan sponsors should consult with their enrolled actuaries for an evaluation of the precise impact these temporary changes will have on their funding obligations.

The Act’s temporary redefinition of permissible interest rates will also affect the calculation of a single employer plan’s unfunded vested benefit liability for purposes of determining whether the plan sponsor must pay variable rate premiums to the Pension Benefit Guaranty Corporation, and the amount of those premiums. ERISA section 4006(a)(3)(E)(iii)(V) specifies that the required interest rate for this calculation is a percentage (currently 85%) of the interest rate specified by the IRS for minimum funding requirements under ERISA section 302 and Code section 412. The new interest rate basis applies to PBGC premium payment years beginning in 2004 and 2005. For more information, see the discussion of Notice 2004–34 below.

The redefinition of permissible interest rates for plan funding purposes will also affect the operation of the rules restricting lump sum distributions to the top 25 most highly paid highly compensated employees.

These rules provide that payments to a top 25 highly compensated employee can not exceed the annual payments under a single life annuity unless, after payment to a participant or former participant whose benefits could be so restricted, the value of plan assets would still exceed 110% of the value of the plan’s current liabilities or if payments to that individual are less than one percent of the value of the plan’s current liabilities. Since the change in interest rate assumptions under the Act generally should result in a reduction of a plan’s current liabilities, plans which prior to the Act faced the possibility that a proposed distribution would result in plan assets totaling less than 110% of current liabilities may now well find that assets exceed 110% and, thus, that the restrictions no longer apply.

Section 101 of the Act also contains a provision which allows an employer to disregard the Act’s amendments to the minimum funding interest rate definition when calculating the maximum deductible contribution under Code section 404(a)(1). Since deductibility is pegged to assets not exceeding current liabilities, this provision will allow employers who wish to fund their plans at a higher level to ignore the amended interest rate (which will lower current liabilities) and still remain eligible to receive the deduction.

Temporary Section 415 Benefit Limitation Rule

Section 101 of the Act also amends, for plan years beginning in 2004 and 2005, Code section 415(b)(2)(E)(ii) which deals with the calculation of the maximum benefit payable from a defined benefit plan as a lump sum or in other "non-annuity" benefit forms. Specifically, the Act changes the interest rate assumption used in this calculation from "the greater of the applicable interest rate (as defined in Code section 417(e)(3)) and the interest rate specified in the plan" to "the greater of 5.5% and the rate specified in the plan." There is, however, a transition rule for this change in determining the Section 415 limitation: for any participant or beneficiary receiving a distribution after December 31, 2003 and before January 1, 2005, the amount payable under any form of benefit subject to Section 417(e)(3) of the Code shall not be less solely because of the amendment to Code section 415(b)(2)(E)(ii) than it would have been before the amendment.

The intended effect of the amendment to Code section 415(b)(2)(E)(ii) is to reduce fluctuations in calculation of maximum lump sum and other nonannuity distribution options. Such fluctuations have become somewhat more frequent lately because a number of plans simply use the Code section 417(e)(3) rate as the plan rate for determining nonannuity forms of benefit; accordingly, when that rate is very low it can produce a larger than expected maximum lump sum amount.

The change in the interest rate assumption with respect to Code section 415(b)(2)(E)(ii) will, in the case of most plans, require a plan amendment. (In contrast, the change in interest rate with respect to plan funding requirements generally will not require a plan amendment, since most plans either are silent on the subject of minimum funding or merely incorporate the relevant statutory provisions by reference.)

Any such amendment can be made on or before the last day of the first plan year beginning on or after January 1, 2006. However, the amendment must be retroactive to the first day of the first plan year beginning on or after January 1, 2004, and during the period in question the plan must be operated as if the amendment were in effect. The Act specifies that a retroactive plan amendment which satisfies these requirements will not violate the anti-cutback provisions of Code section 411(d)(6).

Note that this change in interest rates under Code section 415 does not apply to the determination of lump sums and other non-annuity payment forms under Section 417(e)(3) of the Code. The 30-year Treasury constant maturity bond rate (or the plan rate if lower) must still be used in those calculations.

The temporary change in the rate only applies to the calculation of the maximum allowable distribution under Section 415 that can be made in that payment form.

Multiemployer Pension Plan Funding Notices

Section 103 of the Act provides that for plan years beginning after December 31, 2004, the administrator of a multiemployer defined benefit plan must provide an annual funding notice to:

• each participant and beneficiary;

• each labor organization representing such participants or beneficiaries;

• each employer that has an obligation to contribute under the plan; and

• the Pension Benefit Guaranty Corporation.

The notice must contain the following information:

• identifying information about the plan (i.e., plan name, the address and phone number of the plan administrator and the plan’s principal administrative officer, each plan sponsor’s employer identification number and the plan number);

• a statement as to whether the plan’s funded current liability percentage for the plan year to which the notice relates is at least 100 percent (and, if not, the actual percentage);

• a statement of the value of the plan’s assets, the amount of benefit payments, and the ratio of the assets to the payments for the plan year to which the notice relates;

• a summary of the rules governing insolvent multiemployer plans, including the limitation on benefit payments and any potential benefit reductions and suspensions (and the potential effects of such limitations, reductions, and suspensions on the plan); and

• a general description of the benefits under the plan which are eligible to be guaranteed by the Pension Benefit Guaranty Corporation, along with an explanation of the limitations on the guarantee and the circumstances under which such limitations apply.

The notice must be provided no later than 2 months after the deadline (including extensions) for filing the Form 5500 for the plan year to which the notice relates. Since this is the same deadline for distributing the summary annual report, it is likely that the funding notice can be included as part of that report. The Secretary of Labor may assess a civil penalty against the plan administrator of up to $100 per day for each failure to provide a notice to a beneficiary or participant. The Department of Labor is required to prepare a model notice and issue regulations by April 10, 2005.

Miscellaneous Provisions

The remaining Sections of the Act are targeted mainly to specific types of plans and specific employers and, because of very limited scope and impact, are only briefly summarized below. Section 102 of the Act amends ERISA and the Code to allow certain so-called "applicable employers" to elect to make alternative (i.e., smaller) deficit reduction contributions for up to two years. Applicable employers include commercial passenger airlines, manufacturers of steel mill products or iron ore pellets and the staff pension plan for a particular labor union. Under Section 104 of the Act, a very limited group of multiemployer pension plans that face IRS funding deficiencies because of severe investment losses during 2002 may elect to temporarily defer the amortization charge for a portion of those losses. The Act imposes significant restrictions on the ability of plans to improve benefits if they avail themselves of the temporary relief provided by Section 102 or 104.

Title II of the Act contains various miscellaneous provisions, most of which benefit only specific employers (and presumably they know who they are) or are not benefit related. Of more general interest is Section 204 which extends, through the 2013 calendar year, various provisions of the Code and ERISA that allow the transfer of excess pension assets to retiree health accounts. These provisions originally were scheduled to sunset at the end of 2005.

Notice 2004–34

On April 12, shortly after the Act was signed into law by the President, the IRS issued interim guidance in the form of Notice 2004–34, on the determination of the new weighted average interest rate under Code section 412(b)(5)(B)(ii)(III) and ERISA section 302(b)(5)(B)(ii)(III), as mandated by Section 101 of the Act. Notice 2004–34 also provides interim guidance on the interest rate for determining unfunded vested benefits for purposes of determining variable rate premiums payable to the PBGC.

The determination of the weighted average involves:

• a specification of the corporate indices used; • the composite corporate bond rate (that is, the rate of interest on amounts invested conservatively in investment-grade corporate bonds); and

• the corporate weighted average interest rate (that is, the four-year weighted moving average of the composite corporate bond rate).

For the period January 1997 through August 2000, the Notice specifies the indices as:

• the Citigroup High Grade Corporate Index (AAA/AA 10+ years);

• Merrill Lynch US Corporates AA–AAA Rated 10+ Years; and

• the Merrill Lynch US Corporates A Rated 15+ Years.

For the period September 2000 to the present, the Notice specifies the indices as:

• the Citigroup High Grade Credit Index (AAA/AA 10+ Years);

• the Merrill Lynch US Corporates AA–AAA Rated 10+ Years; and

• the Lehman Brothers US A Long Credit.

The composite corporate bond rate for a month is determined by calculating the average of the monthly rates for each of the indices. The monthly rate for an index is determined based on the daily values for the yield to maturity for the bonds that are included in the index (as determined by the entity maintaining the index).

The corporate weighted average interest rate for a month under Code section 412(b)(5)(B)(ii)(III) is determined by applying weighting principles set forth in IRS Notice 88–73. The weighting principles are applied to the composite corporate bond rate for the 48 months preceding the month in question.

The permissible range under Code section 412(b)(5)(b)(ii)(III) is 90 to 100% of the corporate weighted average interest rate. The lookback rules mandated by the Act (and discussed above) apply.

The composite corporate bond rates and the corporate bond weighted average interest rates are set forth in tables appended to the Notice (which will be updated monthly) and can be found at:

http://www.treasury.gov/press/releases/reports/notice.pdf

The PBGC has also updated its guidance on the interest rates used to calculate variable rate premiums to reflect the mandates of the Act. This guidance, which also will be updated monthly, can be found at:

http://www.pbgc.gov/services/interest/vrprate.htm#reqrate

Announcement 2004–38

Announcement 2004–38 sets forth the procedures for electing an alternative deficit reduction contribution under Code section 412(l)(12) as permitted under Section 102 of the Act. As discussed above, the election is available only to certain applicable employers. An applicable employer may make the election for any plan year beginning after December 27, 2003 and before December 28, 2005. The applicable employer must make the election annually and cannot make the election for more than two years for each plan.

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