Human Resources: Weathering the Turbulent Storms of Pension Funding

Companies are facing dramatic--and often traumatic--minimum pension contributions. This article explains why companies that have not been required to make contributions to their pension plans for over a decade are now facing stiff contributions, if not this year, then next year. Most companies will see a spike in the near future unless Congress acts quickly. We''ll explore what you can do now to help your company weather these turbulent times.

Understanding Pension Funding

Defined benefit plans are funded on a group basis, using actuarial assumptions about long-term interest rates, mortality, turnover, retirement age, and other factors that influence how much money will be needed to pay the promised benefits. The assumptions that determine the required contributions for underfunded plans are more stringent and remarkably more short-term in nature than the assumptions used for well-funded plans. In addition, there is yet a third set of assumptions that determine the employer''s liabilities for accounting purposes.

ERISA funding assumptions reflect long-term projections of economic factors and do not necessarily represent current conditions. The plan''s actuary sets the assumptions, taking into account the experience of the plan and reasonable expectations. The funding rules have a number of smoothing techniques, including amortization of gains and losses, to give greater stability and predictability to annual required contributions.

Underfunded plans are required to make an additional "deficit reduction contribution" that is based on current liabilities determined using an interest rate based on a 4-year average of 30-year Treasury rates and a specified mortality table. Because Treasury has stopped issuing the 30-year bond, the interest rate on the outstanding bonds has fallen below the rate used by PBGC to calculate termination liability. Recognizing this problem, while most Washington observers expect that a permanent fix will be enacted this year, funding projections based on current law show a dramatic spike in 2004. Even without this anomaly, interest rates are the lowest in 40 years. Rather than smoothing out gains and losses, the deficit reduction contribution actually accelerates funding, attempting to eliminate underfunding over four to six years as the funded percentage drops.

Financial accounting requires that the interest rate be adjusted to reflect current rates at which the liabilities could be "settled." Since this rate changes annually at the plan sponsor''s reporting date with then current high-grade corporate bond yields, there can be substantial swings in the size of the liabilities from year to year.

Last November, Merrill Lynch estimated that underfunding for all of the Fortune 500 companies would be $323 billion at the end of 2002, in contrast to their net overfunded position of $215 billion at the end of 2000.

Weathering the Storm

Some companies have been able to weather the storms over the past couple of years because their pension funding has stayed above the level at which the deficit reduction contribution kicks in. No deficit reduction contribution is required if actuarial value of the plan''s assets is at least 90% of the plan''s current liabilities. A plan that has been above the 90% level but drops below that level gets an additional two years to get back up to the 90% level before the deficit reduction contribution kicks in, so long as the plan stays at or above 80% funded.

The drop in interest rates, combined with the third year of declining stock prices, has made it likely that many companies with no required 2001 contributions will not stay at even the 80% level without making a contribution for the 2002 plan year. Such contributions may be made up until 8 1/2 months after the end of the plan year (e.g., September 15, 2003, for 2002 calendar year plans). Companies that are lucky enough to have no contribution due for 2002 will want to determine how close they are to the 80% or 90% funded level and make additional contributions to keep at or above those levels for 2002 and 2003. Even if current projections indicate that they will drop below 80% in 2004, a number of factors could change that outlook:

Congress could pass the permanent fix to the 30-year Treasury problem (or an extension of the current temporary fix);

interest rates could go up; and/or

the financial markets may rebound.

Anyone responsible for pension funding or pension accounting should understand the impact of both declining rates and declining stock prices. Also, to get a more realistic idea of what funding requirements will be, they should be looking at numbers with and without a permanent fix to the 30-year Treasury rate problem in projections for 2004 and beyond.