Bankruptcy-Related Provisions of the Pension Protection Act of 2006
Fiduciary Counselors Inc.; Washington, D.C.
Web posted and Copyright © November 1, 2006, American Bankruptcy
The Pension Protection Act of 20061 (PPA) began as an Administration pension reform proposal in January 2005 that included a number of proposed bankruptcy-related changes, including a proposal to allow the Pension Benefit Guaranty Corp. (PBGC) to perfect its lien for missed contributions while a plan sponsor was in bankruptcy. While the proposal to create a PBGC exception to the automatic stay never received serious consideration during the legislative drafting, PPA does contain a number of provisions that impact both employers in bankruptcy and their employees. Some of these are explicitly tied to bankruptcy, while others apply generally but will have significant impact on troubled companies that sponsor defined benefit plans. PPA also added new requirements for tax-exempt credit counseling organizations, which are outside the scope of this article (see PPA §1220).
Explicit Bankruptcy-Related Provisions
Accelerated Payments Prohibited. Once a company has filed for bankruptcy, its plan is prohibited from making lump-sum payments or other accelerated distribution options that are greater than a single life annuity (plus a Social Security supplement for those not yet eligible for Social Security).2 Annuities may not be purchased. These restrictions do not apply if the plan is 100 percent funded.
Freezing PBGC Guarantees at Bankruptcy. Section 404(a) of PPA added §4022(g) of the Employee Retirement Income Security Act of 1974 (ERISA), 729 U.S.C.A. §4022(g), which freezes PBGC guarantees as of the bankruptcy petition date. This provision is effective for bankruptcy filings on or after Sept. 16, 2006 (30 days after enactment).3
PBGC only guarantees the plan's nonforfeitable pension benefits, i.e., benefits as to which the participant has satisfied all the conditions except retirement or death. Prior to PPA, whether a participant had met all the requirements to make his or her benefit nonforfeitable was determined when the plan terminated. For bankruptcies filed on or after Sept. 16, nonforfeitable benefits will be determined as of the date the employer files for bankruptcy.
Benefits that are not guaranteed because they are not yet nonforfeitable include nonvested benefits and benefits for which a participant has not yet met the conditions in the plan, such as an early retirement benefit for which the participant has not yet met the age and service requirements.4 Similarly, benefits triggered by a shutdown ("shutdown benefits") are not guaranteed prior to the shutdown because the key condition—shutdown—has not yet occurred. Thus, if a shutdown occurs during the course of a bankruptcy, the additional shutdown benefits will not be guaranteed.
In addition, the maximum benefit guaranteed by PBGC (currently $3,971.59 at age 65) will be frozen at the petition date. Participants will continue to be paid their full benefits until the plan actually terminates, however. For benefit increases and new benefits, PBGC guarantees are phased in over five years. Benefits that have been in place for less than five years are guaranteed 20 percent (or $20 per year of service, if greater) for each full year in effect. The phase-in will now be measured by looking back from the bankruptcy filing date, rather than the plan termination date, for plans that terminate during the employer's bankruptcy.
Asset Allocations. For an underfunded plan that terminates, plan assets are allocated to benefits by category, in the following order:
• Category 1—voluntary employee contributions;
Category 2—mandatory employee contributions;
Category 3—benefits in pay status (or eligible to be in pay status) for at least three years prior to termination, under terms of the plan in effect for at least five years prior to termination;
Category 4—PBGC-guaranteed benefits;
• Category 5—other nonforfeitable benefits;
Category 6—all other benefits.
PPA provides that Category 3 priorities will be determined as of the bankruptcy filing date, rather than the termination date, which is also the date on which PBGC guarantees are fixed.5 As with the guarantee freeze, this provision is effective for bankruptcy filings on or after Sept. 16, 2006 (30 days after enactment).
Categories 1, 2, 5 and 6 will continue to be determined at the termination date. Since few plans have employee contributions (Categories 1 and 2), the real impact will be on those plans that are funded above the level of the PBGC guarantee (Category 5). Thus, a participant could have benefits that are nonforfeitable for purposes of the asset allocation (Category 5) but are not nonforfeitable for purposes of PBGC guarantee (Category 4). This could happen, for example, if a participant meets the age and service requirements for a subsidized early retirement benefit between the bankruptcy filing and the termination. In addition, if accruals continue, any additional benefits will generally fall into Category 5 if vested or Category 6 if not vested.
Funding Executive Compensation. If the employer is in bankruptcy or any of its defined benefit plans is "at risk" (see discussion of at-risk funding below) and funds nonqualified benefits of its top executives, PPA taxes those benefits and imposes the additional tax of 20 percent under §409A of the Internal Revenue Code. For this purpose, a rabbi trust, which is normally not considered funded for tax purposes because its assets are subject to the claims of the employer's creditors, are considered funded. This penalty applies only to officers and directors subject to §16(a) of the Securities Exchange Act of 1934.
Additional IRA Contributions for Employees Affected by an Employer's Bankruptcy. Certain employees whose employer went bankrupt are permitted to make up to $3,000 in additional IRA contributions in 2007 through 2009.6 Individuals are eligible to make additional contributions if their employer made a 401(k) match of at least 50 percent in company stock. In addition to bankruptcy, the employer must have been subject to an indictment or convictions resulting from transactions related to the bankruptcy. The individual must have been a participant in the 401(k) six months before the employer filed for bankruptcy.
Other Bankruptcy-Related Provisions
Shutdown and Similar Unpredictable Contingent Event Benefits. The Administration proposal would have eliminated shutdown benefits and similar unpredictable event benefits. PPA provides that the phase-in of PBGC guarantee begins at the time the event occurs, rather than when the benefit was added to the plan. Since most distress or involuntary terminations of underfunded plans occur in bankruptcy, this limit on PBGC's guarantees is likely to have its most significant effect in bankruptcy. For example, if the employer files for bankruptcy within a year after a shutdown, none of the benefits triggered by that shutdown will be guaranteed by PBGC because no portion of the benefit is guaranteed until the first anniversary, and the freeze-on guarantees at the time of bankruptcy (discussed above) will prevent any additional phase-in if the plan is terminated during the bankruptcy. If the employer files for bankruptcy on the fifth anniversary of the shutdown or later, the shutdown benefits will be fully guaranteed.
Treasury has the authority to issue regulations defining what benefits constitute "similar unpredictable event benefits." Generally, they will not include benefit payable as a result of age, service, compensation, death or disability.7
PBGC Exit Premium. The Deficit Reduction Act of 2005 added a new premium of $1,250 per participant to be paid by employers who have terminated their plans in a distress or involuntary termination for the first three years after termination.8 For employers in bankruptcy, the new termination premium is not due until the first month after the debtor is discharged from bankruptcy.9 Thus, the premium applies only if the debtor successfully reorganizes, which is likely to lead more companies to liquidate in bankruptcy.
The new termination premium was originally effective for terminations between Jan. 1, 2006,10 and Dec. 31, 2010.11 The PPA eliminated the sunset date so the exit premium is now permanent.12 However, it does not apply to plans terminated in bankruptcy if the debtor filed for bankruptcy before Oct. 18, 2005.13 Companies that elect the special airline funding schedule may face a higher exit premium (see Special Airline Funding Rules below).
Single-Employer Funding Reforms
New Funding Rules for Single-Employer Plans. The centerpiece of the pension reforms in PPA is a new set of funding rules for single-employer defined benefit plans effective for plan years beginning in 2008.14 These new funding rules require annual contributions equal to the sum of:
• Target normal cost plus
Seven-year amortization of the funding shortfall (the "shortfall amortization charge").
The funding shortfall is the amount by which the plan's assets fall short of the plan's liabilities (the "funding target"). The shortfall is measured annually and any increase in the plan's funding shortfall is amortized over seven years. If the plan's shortfall has gone down, there is no adjustment of the shortfall amortizations for prior years unless the plan is 100 percent funded.
Both target normal cost and the funding target are determined using a statutorily mandated discount rate and mortality table, similar to the methodology used under current law to calculate the current liability on which the deficit reduction contribution is based. However, instead of an interest rate based on long-term bonds, the new interest rate will be based on a modified yield curve tied to the timing of the plan's anticipated payments. Payments due within the first five years will be valued using a blend of corporate bonds maturing within five years, payments due between years five and 20 will be valued using a blend of corporate bonds maturing within those years, and payments beyond 20 years will be valued using a blend of corporate bonds maturing more than 20 years out. Corporate bond rates are averaged over 24 months. Employers can elect to use the full yield curve, rather than this averaged yield curve.
Increasingly, defined-benefit plan fiduciaries have been shifting from a strategy designed to achieve a particular rate of return to an investment strategy that takes into account asset-liability modeling to achieve an asset mix that is likely to minimize volatility in funded status. PPA (and the new Financial Accounting Standards Board (FASB) standard requiring recognition of pension liabilities on corporate balance sheets) will create additional pressure to shift assets away from equities to bonds. This is likely to reduce volatility in funding but at the expense of the long-term returns. After the United Kingdom adopted similar legislation, U.K. pension schemes shifted their asset allocations toward bonds and away from equities. This increased demand for long-duration bonds to defease liabilities drove bond yields down. If this occurs in the United States, it is likely to keep corporate bond rates low and the value of pension liabilities high, while lowering overall pension plan returns. The result is likely to be greater required contributions and/or more underfunded plans, at least in the short term. If employers want to immunize the liability, they will probably elect to use the full yield curve, without averaging, to get a better match between assets and liabilities at any given point.
The redefinition of target normal cost is likely to have the most direct impact in bankruptcy since this is the portion of the pension cost that bankruptcy courts have recognized as an administrative expense. Under current law, normal cost has been calculated using the actuary's long-term return assumption, which in the current interest environment is higher than the new mandated interest rate. The use of the statutory interest rate is likely to increase the target normal cost over the traditional normal cost determined using the actuary's assumption. In addition, the target normal cost has been defined to include not just the new benefits earned during the year but also any increases in benefits as a result of salary increases. Thus, for plans that continue to accrue benefits during bankruptcy, administrative costs are likely to go up if courts use the new target normal cost to determine what portion of the minimum funding requirement under ERISA and the Internal Revenue Code is to be given administrative priority under the Bankruptcy Code. Whether courts will look to ERISA and the Internal Revenue Code, however, remains an open question.
The seven-year amortization of the funding shortfall is likely to reduce the funding requirements for the most underfunded plans since the deficit reduction contribution is forcing those plans to amortize their liabilities over three to four years under current law. The new law will increase funding requirements for better-funded plans that are not subject to the deficit-reduction contribution under current law, particularly since the full funding limit has been eliminated. Recognizing this, Congress created a transition rule that phases in the requirements for plans that are not subject to the deficit-reduction contribution in the last year before the new rules become effective. For these plans, the 100 percent funding target is reduced to 92 percent for 2008, 94 percent for 2009 and 96 percent for 2010. A plan must be above-threshold in every year to retain the transition. Companies will have to evaluate their ability to make additional contributions to avoid the deficit-reduction contribution in the last year under the current rules and the likelihood that they will be able to stay above the transition level between then and 2010.
At-Risk Plans. If a plan is "at-risk," the funding target is determined assuming that all participants within 10 years of retirement elect to retire at the time that the benefit is most valuable. The at-risk rules apply only to plans with more than 500 participants. A plan is at risk if the plan's funding target attainment percentage for the prior year is less than 80 percent using the regular funding assumptions and is less than 70 percent funded using the at-risk assumptions.15 The "funding target attainment percentage" is determined by dividing the plan's assets (reduced by any credit balances) by the plan's funding target. Although the at-risk rules become effective in 2008, there is a transition rule that reduces the 80 percent threshold to 65 percent in 2008, 70 percent in 2009 and 75 percent in 2010. Years prior to 2008 are not included. There is also special rule for auto manufacturers and auto parts manufacturers.16
If a plan has been at-risk for two of the four preceding plan years, the funding target is increased by 4 percent plus $700 per participant. This increase is phased in 20 percent a year, beginning in 2008.17 The Administration originally proposed that "at-risk" status would be a function of the sponsor's credit ratings. However, at-risk status under PPA does not reflect the sponsors' credit rating. This was one of the most contentious issues during the legislative debates over PPA.
Funding-Related Benefits Restrictions. Once the new funding rules become effective (generally the 2008 plan year, with later dates for collectively bargained plans), new restrictions on benefits also come into play based on the plan's funded percentage (the "adjusted funding target attainment percentage"). The funded percentage is determined in the same fashion as the funded percentage for funding purposes except that the at-risk assumptions are ignored. All credit balances are subtracted from the assets in determining the adjusted funding target attainment percentage unless the employer opts to waive the credit balance.
If plans are less than 80 percent funded, no amendment increasing benefits is permitted, except amendments to a flat dollar plan to reflect the increase in average wages, and the plan can only pay lump sums up to 50 percent of a participant's benefit (or PBGC guarantee, if less).18 If the plan is less than 60 percent funded, benefit accruals cease and the plan is prohibited from paying (1) shutdown and other unpredictable contingent benefits or (2) lump sums or other accelerated distributions. These restrictions do not apply if the employer makes a contribution sufficient to keep the plan above the 60 or 80 percent threshold or if the employer proves security to the plan. Security may be a corporate surety bond, an escrow held by a bank or other financial institutions or another form of security approved by the Treasury Department. The security may be perfected and enforced only after the plan terminates, the employer fails to make a required minimum funding payment or if the plan has an adjusted funding target attainment percentage below 60 percent for seven consecutive years.19 Employees must be given notice of these benefit restrictions within 30 days.20
Special Airline Funding Rules. Commercial passenger airlines and companies that provide catering services to passenger airlines may elect one of two special airline funding rules. Companies that have frozen their benefits may elect an alternative funding schedule that amortizes the plan's liabilities over 17 years.21 For purposes of this alternative funding schedule, the interest assumption is 8.85 percent and the plan may use its own mortality and other assumptions, as long as they are reasonable. The underfunding is remeasured annually, and the underfunding for that year is amortized over the remaining years in the 17-year amortization.
Airlines that are not in bankruptcy will have difficulty freezing their collectively bargained plans, without the ability to renegotiate their collective bargaining agreements under §1113 of the Code. As a result, the 17-year amortization schedule is most likely to be elected by companies in bankruptcy. The two major carriers in bankruptcy, Delta and Northwest, both lobbied for this special amortization schedule.
If an employer elects the 17-year amortization schedule, previous funding deficiencies and funding waivers are eliminated.22 The election must be made by Dec. 31, 2007, and the employer may elect a new plan year in connection with the funding election with IRS consent.23 The IRS has issued guidance on how the election is to be made.24
If the plan terminates within the first 10 years, PBGC guarantees are frozen at the beginning of the 17-year amortization.25 If the termination occurs within the first five years, PBGC's exit premium is increased from $1,250 per participant to $2,500 per participant.26
Airlines that have not frozen their plans may elect a 10-year amortization period for their funding shortfall under the new funding rules. However, they must use the yield curve and statutory assumptions.
Participant Access to Termination Information. If a plan terminates after enactment of the PPA (Aug. 17, 2006) in a distress termination, participants and their union will have the right to see the information submitted by the plan administrator to PBGC in support of the distress termination filing, within 15 days after their request is received.27 New information must be provided within 15 days after it is submitted to PBGC. Similarly, if PBGC moves to terminate a plan involuntarily, participants and their union will have the right to see PBGC's administrative record, as well as any information submitted by the plan administrator or plan sponsor, within 15 days of receipt.28
Confidential participant information will not be disclosed.29 The court determining whether the plan should be terminated may limit disclosure of confidential business information and will only be available to the union that agrees to keep the information confidential.30
1 Pension Protection Act f 2005 (PPA), Pub. L. No. 109-280 120 Stat. 780 (2006).
2 ERISA §206(g)(3)(B) added by PPA §103(a) and Internal Revenue Code (IRC) §436(d)(2) added by PPA §113(a).
3 PPA §404(c).
4 See ERISA §4001(a)(8) (definition of "nonforfeitable benefit"); 29 CFR §§4022.3(a), 4022.4(a)(3).
5 ERISA §4044(e) added by PPA §404(b).
6 IRC §219(b)(5)(C) added by PPA §831(a).
7 ERISA §206(g)(1)(C).
8 ERISA §4006(a)(7) added by the Deficit Reduction Act of 2005 (DRA), P. L. 109-171, §8201, 120 Stat. 4 (2006).
9 ERISA §4006(a)(7)(B).
10 DRA §8201(d)(2)(A).
11 ERISA §4006(a)(E), repealed by PPA §401(b)(1)(B).
12 PPA §401(b)(1)(B).
13 DRA §8201(d)(2)(B).
14 ERISA §303 added by PPA §102(a), and IRC §430 added by PPA §112(a).
15 ERISA §303(i)(4)(A) added by PPA §102(a), and IRC §430(i)(4)(A) added by PPA §112(a).
16 ERISA §303(i)(4)(C) added by PPA §102(a), and IRC §430(i)(4)(C) added by PPA §112(a).
17 ERISA §303(i)(5) added by PPA §102(a), and IRC §430(i)(5) added by PPA §112(a).
18 The exception was designed to create parity between salaried plans in which benefits automatically go up with pay and flat-dollar plans that must be amended to keep pace with wage increases. It mirrors the way in which pension increases have traditionally been bargained for in the auto industry.
19 ERISA §206(g)(5)(A)(iii) added by PPA §103(a), and IRC §436(f)(1)(C) added by PPA §113(a).
20 ERISA §101(j) added by PPA §103(b).
21 PPA §402(a)(1).
22 PPA §402(f)(2).
23 PPA §402(d)(1)(B).
24 IRS Announcement 2006-70, 2006-40 I.R.B. (Oct. 2, 2006).
25 PPA §402(g)(2)(A).
26 PPA §402(g)(2)(A).
27 ERISA §4041(c)(2)(D) added by PPA §506(a)(1).
28 ERISA §4042(c)(3) added by PPA §506(b)(3).
29 ERISA §4041(c)(2)(D)(ii)(II) added by PPA §506(a)(1), and ERISA §4042(c)(3)(C)(i) added by PPA §506(b)(3).
30 ERISA §4041(c)(2)(D)(ii)(II) added by PPA §506(a)(1), and ERISA §4042(c)(3)(C)(i) added by PPA §506(b)(3).