Retirement plan strategies: finding the right balance; Expert advice on the implications, pitfalls and opportunities offered by the Pension Protection Act of 2006 is summarized by Financial Executives Research Foundation (FERF).

Picture retirement funding as a three-legged stool comprised of employer contributions, employee savings and Social Security. Now, imagine how that would change with primary reliance shifting on employee savings and Social Security, with the employer acting more as a facilitator ...

With the enactment of the Pension Protection Act of 2006, one thing is certain--companies are more focused on identifying the right retirement plan for their employees. But, the jury is still out on whether the right retirement options include defined-benefit (DB) plans, defined-contribution (DC) plans, cash balance plans--or a mix of more than one.

"On both the defined-contribution and defined-benefit side, the Act provides more rules, more disclosure and reporting," says Alan Glickstein, senior retirement consultant at Watson Wyatt. "And, although there are some things here to like and some not to like, at least now you know what the rules are."

Changes to Defined-Benefit Plan Funding

The new defined-benefit funding rules, effective for plan years beginning after Dec. 31, 2007, establishes a funding target of 100 percent. A special transition rule applies through 2011 if the plan is 92 percent, 94 percent or 96 percent funded in 2008, 2009 and 2010, respectively.

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For employer contributions to existing plans, the Act provides higher caps that are further increased for employers that maintain both a DC and DB plan. For plans beginning in 2006 and 2007, the law increases the maximum deductible amount from 100 percent to 150 percent of current plan liabilities. These factors are expected to result in both increased and more consistent funding.

Plans with less than 80 percent funding are considered "at risk" and are subject to even stricter funding requirements. At-risk plans must assume employees eligible to retire in the next 10 years will retire as early as possible, and that employees will leave an organization at the time when the present value of their benefits are at their highest.

Arthur L. Conat, executive director, Ernst & Young LLP Performance and Reward, warns that acquisitive companies need to be concerned about taking on at-risk plans. "When an organization has an at-risk plan in its controlled group, the organization may find more restrictions in funding nonqualified benefits. This could disrupt funding for other nonqualified programs. The law has no exception for newly acquired plans."

For 2006 and 2007, the interest rate used to value pension liabilities will remain based on investment-grade corporate bonds. 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. And, though plan assets are generally valued at the fair market value on the valuation date, asset value may also be averaged over 24 months, a decrease from the 60-month average allowed before the Act.

Since plan assets and liabilities will be reflected more on a mark-to-market basis, there will be more volatility when trying to identify required plan funding at a specific point in time. Clearly, companies are in for a bouncier ride, Glickstein says. "The law would rather have volatility in lieu of misstating a plan's current status. But sometimes, volatility is regular 'noise' that doesn't mean anything. To some extent, the 60-month averaging filtered this out. The turbulence that will result from its elimination," he says, "may be enough to have plan sponsors say it's not worth it."

However, as Glickstein points out, for those considering a freeze on their DB plans, the related legacy liability will not be dealt with under this law. "These plans will still be subject to volatility and increased funding. There is nothing you can do about that."

Conat adds that plans funded at the minimum level could quickly become under-funded and subject to restrictions. For example, if a plan is funded based on a 100 percent target, but the return on assets for that year is poor, a company could find itself below the 80 percent threshold. Then, the Act triggers restrictions on providing further benefits increases and on making lump-sum distributions. Plans with less than 60 percent funding are essentially frozen until plan assets top 60 percent.

This is further complicated, Conat adds, for plans within 10 percent of either the 80 percent or 60 percent threshold. In either case, a company would have to treat the plan as under-funded in the subsequent year until an actuary certifies the plan's funded status. If that certification doesn't happen in the first three months in the following year, the funded percentage is deemed to drop 10 percent. This is significant because in the past, this did not need to be reported until filing Form 5500, which usually occurs nine and one-half months after a plan year ends.

The Impact on Cash Balance Plans

The Act establishes a standard for all defined-benefit plans that clarifies current law with respect to age discrimination under the Employee Retirement Income Security Act (ERISA) and removes the last impediments to adopting cash balance plans. Coupled with the recent U.S. Court of Appeals ruling that IBM's cash balance plan did not discriminate against older workers, the law clears the way for adoption of these part-pension, part-savings plans.

Cash balance plans are defined-benefit plans with benefits based on annual credits to a hypothetical account. Birgit Anne Waidmann, manager, PricewaterhouseCoopers Human Resource Services practice, says that often, in converting a traditional DB plan to a cash balance plan, an age-weighted formula is used for the annual credits under the cash balance plan, in order to mimic the traditional plan's backloaded design. This design could offset the loss of early retirement subsidies tied to the traditional plan benefit, and might provide an incentive for employees to stay past early retirement age.

"Following a cash balance plan conversion, an employee's frozen traditional benefit must be 'grandfathered,' or preserved," Waidmann explains. "Some conversions provided that no new benefits would be earned under the cash balance plan formula until the value of the credits exceeded the value of the pre-conversion benefit. This is called a 'wearaway' of the grandfathered benefit, a provision which is prohibited by the Act."

Joan Gucciardi, Senior Consulting Actuary, Summit Benefit and Actuarial Services Inc., a firm that services smaller and medium-sized U.S. companies, offers this advice for those considering a move to cash balance: "If you have plan that's not well-funded, the defined-benefit plan would need to be up to snuff from a funding perspective. Only then, in the future, could a conversion to cash balance can be considered."

Though some say the general trend may move away from DB plans, both Glickstein and Gucciardi say that the technology and professional service industries may actually see more of them. Because of the increased choice and validation of cash balance plans, these industries are likely to consider DB plans when they had not done so in the past.

Considerations for DC Plans

William Arnone, practice leader of Ernst & Young LLP's Employer Financial Services practice, says that the "401(k) enhancement act" merely codifies the pre-existing move toward DC plans. Though he acknowledges the attempt to save the traditional DB plan, he predicts that the DC plan will become the official retirement vehicle for most American workers.

Indeed, the Act makes it much easier for DC plans by removing any perceived barriers to growth. The law promotes automatic enrollment in 401(k)s by preempting state laws, providing safe harbor and eliminating non-discrimination testing for employers.

Gucciardi thinks the automatic enrollment option provides more incentive for large companies, rather than for small companies with less than 50 employees that already have safe harbor. Their plans would likely have more eligible participants with smaller account balances. Since the Act provides the ability to withdraw from a plan quickly, she says this may equate to a higher per-person administrative cost for plans with fewer employees.

In addition to providing automatic enrollment, the Act reduces perceived risk elated to offering employees investment advice. "Under ERISA, many employers considered this too risky," Arnone explains. "But, under the new law, the responsibility for investment advice is shifted to the third-party advisor--if employers follow the regulations."

These regulations start with prudent selection of advisors. Computer models used by the advisor must be developed by another independent party that cannot favor the advisor's products or funds. Yet another independent third party has to certify the model. Finally, every year, an independent auditor has to report to the employer whether or not the plan advice is in compliance with the Act. The advisor must also disclose all real and potential conflicts of interest.

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Strategy, Strategy, Strategy

In the short term, Gucciardi says, companies should take advantage of the increased tax deductions allowed under the Act. Though the deductibility varies, for a cash balance profit-sharing plan, an amount that is 25 percent deductible could now be 31 percent deductible. "For an employer that has both defined-benefit and defined-contribution [plans], there may be even more benefit," she says. "In these instances, we work with the client to focus on plan changes that can be adopted this year."

Over the long haul, experts advise companies to run multiple what-if scenarios on what plan funding may look like in 2008, depending on actions taken over the next year. To Conat, this means closer monitoring of plans and greater interaction with plan actuaries to ensure more than adequate funding. A plan hovering between 90-100 percent funding levels, he says, might want to monitor status more closely versus a plan with 150 percent funding.

Waiting for Further Rules

Even though the law runs more than 900 pages and several provisions are not new, the rubber doesn't hit the road until further rules are issued. Regulation from the U.S. Department of the Treasury and the Internal Revenue Service would modify the internal revenue code and other previously issued guidance on pension funding. For example, the Act provides for 92 percent target funding for 2008, but this cannot be determined until Treasury defines the discount rate required for the calculation.

The U.S Department of Labor would do the heavy lifting on issues such as automatic enrollment, age discrimination and employee notification, resulting in modifications to ERISA. In addition, Glickstein notes that there are likely to be technical corrections that could address anything from disconnects with existing law to typographical errors. In the interim, employers are hoping the rules aren't too cumbersome and waiting to see what the early adopters will do.

So, bottom line, what does this new Act actually mean for the future of employee retirement plans? It's anyone's best guess right now. Most of the experts interviewed here agree that employers should identify their company's retirement plan statement. This, in turn, drives retirement plan strategies and the related policies that are communicated to employees.

Finally, all the experts agree that the Financial Accounting Standards Board's pension accounting rules may have a greater impact than the Act itself--so stay tuned.

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

RELATED ARTICLE: Tips for DB Sponsors

Stewart Lawrence, senior vice president and National Retirement practice leader at the Segal Co. and a member of FEI's Committee on Benefits Finance, has identified three major considerations for defined-benefit plan sponsors:

* Address plan design -- Results could range from a micro change in a formula, freezing a defined-benefit plan or conversion to a cash balance plan.

* Revise funding strategy -- Increase the contribution to reduce the volatility that would result from making only the minimum contribution. Lawrence likens this to an airplane ride: "Undulations will be felt when you're on the ground. But, as you fly higher and higher, you don't feel as much."

* Revise investment strategy -- Reduce investment risk by changing the allocation of plan assets. Although this equates to a higher contribution, Lawrence says that this may be acceptable to some companies if the increased cost can be built into their commercial contracts.

He provides the following illustration: "An employer funds the difference between the plan's assets and liabilities. On the liability side, the Act changes how to calculate a liability, which will be more volatile because of interest rate changes. However, if a plan has a hedging strategy against this interest rate risk, this can dampen volatility on debt.

"If rates and liabilities go up by $100 million, a hedge would offset the increased obligation. Two possible hedge approaches are to invest in interest futures or purchase a quasi-insurance policy--enough to hedge risk, but not large enough to result in a significant change in the allocation of plan assets."

RELATED ARTICLE: takeaways

* With the the signing of the Pension Protection Act of 2006, the jury is still out on whether the right retirement options include defined-benefit (DB) plans, defined-contribution (DC) plans, cash balance plans--or a mix of more than one.

* For employer contributions to existing plans, the Act provides higher caps that are further increased for employers that maintain both DC and DB plans. It aims to create increased and more consistent funding.

* Plan sponsors wanting to convert to a cash balance plan must either freeze the existing DB plan or include the value of the subsidies in their new plan.