by George G. Jones and Mark A. Luscombe

President George W. Bush signed the Pension Funding Equity Act of 2004 on April 10, just in time to allow companies to use the lower interest rate assumptions permitted by the act to reduce required pension contributions due on April 15, 2004.

The legislation, however, was just a temporary fix to a long-term problem of handling pension plan funding. Recent legislation has tried to increase the attractiveness of pension plans and stem their declining use by companies.

One of the key concerns of businesses in maintaining pension plans has been the unpredictable and erratic funding obligations. Practitioners evaluating the renewed attractiveness of pension plans for their clients will want to monitor changing pension funding requirements as they occur.

A short history of pension funding
The history of pension funding has some similarities to the childhood story about the monkeys building a house. When the weather was good and the house could be built, there was no need for a house. When the weather turned bad, the house was needed but could not be built until the weather improved.

With pension funding, when times are prosperous, market performance often did a lot of the work of pension funding, and significant contributions, although funds were generally available, were not needed or even allowed since the market performance itself was keeping the funding at required levels. When a recession hits, market performance deteriorates and plans often slip into an under- funded situation at just the point when companies are least likely to have the spare cash to make those contributions.

Unlike the monkeys, some of the companies may have been very happy to put extra funds into the pension plans in prosperous times because they would get a tax deduction for doing so, but pension regulations put a limit on such overfunding, at least if the business wanted a tax deduction and no risk of excise tax penalties.

This is not to say that pension funding has not been flexible. Indeed, it is a complicated actuarial process involving assumptions as to interest rates, life expectancy, salary and wage increases, terminations, disability, early retirement and plan expenses.

The regulations provide a range of acceptable interest rate assumptions that may be used by the company. The 30-year Treasury bond rate has been the standard for calculating this acceptable range of interest rates. From 1987 to 1993, plans were allowed to use an interest rate that fell anywhere between 90 percent and 110 percent of a weighted four-year average of the 30-year Treasury bond rate.

In 1994, the 110 percent limit was reduced to 105 percent to try to increase funding. In 2002, after the decision to terminate 30-year Treasury bonds led to a gradual decline in the 30-year Treasury bond rate, Congress raised the upper limit to 120 percent to try to counteract the decline in the underlying rate. The 120 percent limit expired on Dec. 31, 2003.

The Pension Funding Equity Act of 2004
Just in time, the Pension Funding Equity Act of 2004 was passed to replace the expiring formula based on the 30-year Treasury bond rate with a new formula based on average long-term corporate bonds.

Because corporate bonds are viewed as somewhat more risky than U.S. Treasury bonds, they tend to carry a somewhat higher interest rate. The higher interest rate assumption translates into lower current funding obligations.

The new law replaces the 30-year Treasury bond rate with a rate within a permissible range of the weighted average of the rates of interest on long-term corporate investment-grade bonds. Shortly after the enactment of the legislation, the Internal Revenue Service
issued Notice 2004-34, providing guidance for determining the weighted average interest rate and the resulting permissible range of interest rates used to calculate the current funding liability.

The new law also provides special funding relief to the airline industry, the steel industry, the Transportation Communications Union and certain multi-employer plans that can meet fairly restrictive qualification requirements.

The new rate calculation is effective only through 2005. This reflects Congress’ continued desire to try to address the pension-funding problem in a more comprehensive fashion.

Pension funding proposals
Although some proposals would simply replace the 30-year Treasury bond rate with an average long-term corporate bond rate, while retaining a similar flexibility range around the rate, the Treasury Department has proposed following this two-year use of the corporate bond rate with a three-year phase-in of interest rates based on a yield curve tied to the average age of a particular company’s workforce. The formula would specify an interest rate for that particular company.

While the Treasury proposal might produce a more accurate interest rate projection for a particular company, as proposed it would also reduce the funding flexibility that was previously available due to the range of acceptable rates around the specified rate. The proposal would also do nothing to address the problem of the uncertainty of year-to-year funding requirements due primarily to fluctuations in investment performance.

Congress over the next couple of years will be looking at these and other proposals to address pension funding for the long term. It is that legislation still to come that will be most influential in determining the future attractiveness and viability of pension plans.

Although the Pension Funding Equity Act of 2004 provides helpful relief in the short-term to pension plan funding requirements in general and targeted relief to particular industries, it does little to address the concerns that companies have had with the predictability of funding requirements for pension plans.

Until these long-term funding issues are more adequately addressed, the trend for existing companies to terminate pension plans and for new companies to look to defined-contribution plans instead when establishing employee benefit packages will most likely continue.

George G. Jones, JD, LL.M, is managing editor, Tax & Accounting, and Mark A. Luscombe, JD, LL.M, CPA, is principal analyst, Tax & Accounting, at CCH Inc.

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