Ask FERF about ... the Pension Protection Act of 2006.

When President George W. Bush signed the Pension Protection Act of 2006 into law on August 17, he called it "the most sweeping reform of America's pension laws in over 30 years." Currently, the Pension Benefit Guaranty Corp. (PBGC), a federal corporation created by the Employee Retirement Income Security Act (ERISA) of 1974, protects the pensions of 44.1 million American workers and retirees in 30,330 private single-employer and multi-employer defined-benefit pension plans.

PBGC is not funded by general tax revenues, but by insurance premiums set by Congress and paid by sponsors of defined benefit plans, investment income, assets from pension plans trusteed by PBGC and recoveries from the companies formerly responsible for the plans.

The new law imposes the following rules:

Minimum Funding Standards for Single-Employer Defined-Benefit Plans 

Most pensions must become fully funded over a seven-year period, with a gradual transition from 90 percent to 100 percent. Plans with less than 80 percent funding that are considered "at risk" are subject to even stricter funding requirements, since liabilities are determined by assuming that employees eligible to retire in the next 10 years will retire as early as possible.

Changes to Measurement of Plan Obligations

For 2006 and 2007, the interest rate used to value pension liabilities can be based on investment-grade corporate bonds. However, starting in 2008, the rate will be based on a three-segmented yield curve, developed from a 24-month average of the yield on the top three grades of corporate bonds.

Assets can be averaged over 24 months, but the result is limited to 105 percent of the market value as of the plan's valuation date. The U.S. Department of the Treasury establishes the standard mortality table for plan participates. However, large companies are permitted to use plan-specific mortality tables for minimum contribution calculations.

Additional Premiums for Companies with Under-Funded Plans

Single-employer plans with unfunded vested benefits must pay the PBGC a variable-rate premium equal to $9 per $1,000. The unfunded vested benefits are to be valued using 85 percent of a rate based on investment-grade corporate bonds, a calculation that is extended from prior years through 2007. The premium is reduced for each participant to $5 times the number of participants in the plan for companies with 25 or fewer employees, starting in 2007.

Restrictions on Extra Benefits for Under-Funded Plans

Companies with under-funded pension plans are prevented from promising extra benefits to employees without paying for those promises up front. Also, those plans funded below 80 percent are prohibited from using credit balances for funding. Plans with less than 60 percent funding will be restricted from offering any lump-sum benefit payments or making new accruals.

Higher Caps on Employer Contributions

The upper limits on the amount that employers can put into their pension plans will increase, to encourage adding more money during good times and building a cushion that can keep pensions solvent in lean times. For plans beginning in 2006 and 2007, the law increases the maximum deductible amount from 100 percent to 150 percent of current plan liabilities. Allowable deductions are also increased for employers that maintain both a defined-contribution and defined-benefit plan.

Potential Consequences

Many expect the law to result in corporations moving toward hybrid cash-balance plans that act as part pension and part savings plans. Since this type of plan was believed to hurt older employees who have fewer years to build up savings, some employers were concerned about age-discrimination lawsuits. However, the Act establishes a standard for all defined-benefit plans that clarifies current law with respect to age discrimination under ERISA.

Additionally, on August 7, the U.S. Court of Appeals ruled that IBM Corp.'s cash-balance plan did not discriminate against older workers. Together, these changes may mean good news for companies that have these plans, particularly since The Wall Street Journal notes that about a quarter of the 22 million private-sector workers participate.

The U.S. Department of Labor estimates that plans are currently under-funded by about $450 billion. The reform, some critics say, could inadvertently encourage employers to terminate troubled plans or reduce benefits rather than pay more--potentially leaving taxpayers to pick up the bill. Only time will tell.

Cheryl de Mesa Graziano, CPA ([e-mail]), is Vice President, Research and Operations at Financial Executives Research Foundation (FERF).

contributed by FERF