Defined Benefit Plans Can Get Sick, Too

As has been well-publicized, the Coronavirus (along with other factors) has resulted in a steep financial market plunge this week. As of the day I’m writing this, the S&P 500 is down nearly 24% since the beginning of 2020, with about two-thirds of that decrease occurring in this week alone. Yeesh…

For our clients who sponsor defined benefit plans (including cash balance plans), a market drop like this, if followed by a lingering recession or depression, can have major implications for those plans. Here are some considerations:

Minimum funding requirements – Defined benefit (DB) plans are required to have a valuation each year, which determines the minimum amount that the IRS says must be contributed to the plan for the year. The valuation measures plan assets and plan liabilities, and (as might be expected) lower assets result in higher minimum contribution requirements.

At IAI, we perform our valuations on the first day of the year. For example, for calendar-year plans, our 2020 valuations will have a measurement date of January 1, 2020. That’s good news, since the market fluctuations will not impact those 2020 valuations. Also, remember that 2020 contributions just need to be deposited by the date that 2020 tax returns are filed for the business entity that sponsors the plan, so there’s some flexibility with the timing of contributions.

If the down market continues, of course, it will have an impact on minimum funding requirements for the 2021 plan year. For plan sponsors who are concerned about minimum funding requirements, it’s not too early to talk with your IAI consultant about potentially amending the plan to slow down or freeze benefit accruals, which will provide funding relief.

Benefit adequacy – In 2008 (our most recent recession), the grim joke among 401(k) participants was “My $401k just became $201k”. That’s a big problem for someone nearing retirement and counting on that nest egg. The IRS limits how much can be contributed to a 401(k) plan each year, so it can be difficult or impossible to recover from a loss like that, at least in a reasonable period of time.

One nice feature of DB plans, from the participants’ standpoint, is that the IRS allows (and eventually requires) any funding shortfall to be filled in. In other words, the business owner can contribute (and deduct) any amount necessary to make up for investment losses. For those business owners for whom cash flow is not a significant concern but income taxes are, this can be a real silver lining.

PBGC premiums and notice requirements – Plans that are covered by the Pension Benefit Guarantee Corporation (PBGC) must pay a premium for coverage each year, and a significant portion of the premium can be tied to the funded level of the plan. Again, these are based on annual measurements, so for calendar year plans the 2020 premium will not be impacted by this market drop, but 2021 premiums may very well increase substantially if that funding shortfall isn’t quickly filled in.

Underfunding can also trigger notice requirements to plan participants and/or the PBGC. That usually just means additional paperwork, but can cause confusion and/or concern among plan participants.

Accelerated distributions to HCEs – Unless a DB plan is well funded, the IRS will not allow for Highly Compensated Employees (HCEs) to receive lump sum distributions from the plan (unless the plan itself is terminated). In a recession, this restriction can come into play if the funding shortfall isn’t quickly filled in, which can cause consternation among impacted participants.

This isn’t a comprehensive list of the considerations for DB plan sponsors; the rules and dynamics surrounding these plans are broad and complex. Contact your IAI consultant if you’d like to schedule a meeting to go over the considerations specific to your plan and any steps you might consider taking now.

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