General Session 1

1
General Session 1

• PPA Pension Funding Rules
• March 26, 2007

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PPA Pension Funding Rules2007 EA Meeting
General Session 1

• March 26, 2007

Ethan E. Kra, FSA, Ph.D. Worldwide Partner
Chief Actuary
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Nine Sessions

• General Session I PPA Pension Funding Rules
• General Session II PPA Overview Non-Funding
  Provisions and Implications
• PPA Funding I Measuring Assets and Liabilities
  Session 101 (repeated at Session 202)
• PPA Funding II (Min/Max) Session 201 (repeated
  at Sessions 401 502)
• PPA Multiemployer Session 404
• PPA Funding III How Low Can You Go?
  Ramifications of Underfunding in a Post-PPA World
  Session 501 (repeated at Session 601)
• PPA Issues (Small Plans) Session 506
• Top 10 Unresolved Issues in PPA Session 605
• PPA Funding IV Funding Strategies Session 701
  (repeated at Session 801)

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Funding and Benefit Restrictions

• Funding issues Ethan
• Modeling Jerry
• Benefit restrictions Tonya

5
Funding

• Yield curve
• Asset smoothing
• Managing credit balances 2007/2008
• Managing credit balances long term
• Burning credit balances
• 2008 At Risk 2007 lookback how is it done?
• Mortality tables

6
Yield Curve

• Choice of three approaches
• Approach I Three segments
• 24-month unweighted average
• Three-year phase-in
• Approach II Same as Approach I with no phase-in
• Approach III
• Full yield curve
• One month average
• No phase-in
• Default Approach I
• Election to use Approach II or III may be revoked
  only with IRS approval

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Yield Curve

• Optional look back up to four months
• Approach III appears only to be permitted for
  minimum funding
• Approach I or II would be required for other
  purposes
• Benefit restrictions
• PBGC benefit premiums
• Maximum deductible contributions
• Approach I vs. Approach II
• Choice depends on trends in interest rates
• No long-term effect a transition issue
• Approach III
• More precise measure
• Better attuned to immunization strategies
• Negligible difference between Approach 2 and
  unsmoothed, three-tier approach (typically less
  than 1)

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Yield Curve

• Yield curve issues which bonds to be included?
• Callables
• Putables
• Make whole bonds
• Weighting
• Equal weighting for three grades AAA, AAA, A, or
• Equal weighting for all bonds in these grades
• Averaging
• Is each months rate determined as an average of
  the rate of each day of the month, or based on
  last day of the month?
• Rates beyond 30 years?
• Developing yield curve Yields to maturity vs.
  spot rates
• Valuing lump sums Double weighting of short-term
  portion of yield curve

9
Asset Smoothing

• Two-year averaging two years or three years?
• Averaging vs. Smoothing
• PPA utilizes term averaging
• Averaging methods tend to have bias to
  below-market value
• IRS leaning toward applying restrictive
  definition and only permitting averaging
• Potential is for average asset value to have bias
  toward 95 to 98 of market value

10
Managing Credit Balances 2007/2008

• Complex decision process requires significant
  modeling
• Possible target Avoid DRC in 2007
• Necessary prerequisite for transition relief on
  new funding rules starting in 2008
• Reflecting 2007 quarterlies on 2006 Schedule B
• Accelerating more of 2007 contribution into 2006
• Possible target Avoid at-risk status for 2008
• Regulatory guidance needed from IRS
• Possibly based on funded status at beginning of
  PY 2007
• May require limitations on access to credit
  balance
• Retroactive burning of credit balance?

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Managing Credit Balances 2007/2008

• Possible objective Reduced PBGC variable
  premiums in 2008
• Any acceleration of 2008 contributions to 2007
  may reduce PBGC variable premiums by 9/10ths of
  1 of amounts so accelerated
• Credit balances from 2007 offer significantly
  more flexibility than credit balances developed
  in subsequent years

Passbook

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Managing Credit Balances Long Term

• Critical need for modeling
• Scenario modeling much more valuable than single
  deterministic model
• Old credit balances much more valuable than
  new credit balances (prefunding balance)
• Prefunding balance subtracted from assets for
  purpose of 80 threshold for use of credit
  balances
• Must utilize old credit balance before new credit
  balance
• Permitted to utilize credit balance to satisfy
  funding requirements while adding contributions
  to credit balance
• Alternative apply contributions to funding
  requirements and let credit balance grow with
  trust return
• Considerations actual trust for return of plan
  year old vs. new credit balance

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2008 At Risk 2007 Lookback ????

• Beginning of year 2007
• (Assets Credit Balance) by Target Liability gt
  65
• How you define Target Liability?
• PPA defines Target Liability at beginning of
  2008 no definition for 2007
• Possible solutions
• Option 1 Use 2007 Current Liability
• Option 2 Treasury promulgates 2007 yield curve
  for use in calculating 2007 liability for 2008 at
  risk status determination
• Problem Difficultly in planning process
  contributing enough by 9/15/07 to increase 1/1/07
  benchmark above 65

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2008 At Risk 2007 Lookback ????

• How do you elect to burn enough credit balance to
  get to 65?
• Possible solutions
• Option 1 Dont subtract the credit balance
• Option 2 Only subtract that portion of beginning
  of year credit balance utilized to meet 2007
  minimum funding requirements
• Option 3 Same as option 2 plus subtract that
  portion of beginning of year 2008 credit balance
  not waived (discounted back to beginning of 2007)
• Option 4 Whatever the IRS decides

15
Mortality Tables

• New mortality table for 2007
• Different mortality table for 2008?
• Split in table based on benefit commencement date
  not exit date from employment status
• Likely requirement to update table annually
• Option to utilize fully generational table?

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Mortality TablesPlan Specific

• Sponsor may utilize credible plan specific
  mortality, subject to IRS regulatory procedure
• How to demonstrate mortality credibility
• Controlled group all plans or no plans
• Avoidance of cherry picking by plan sponsors
• Small plans without credible experience
• Mergers Acquisitions

17
Mortality Experience Credibility
18
Pension Funding Reform Financial Implications
of PPA 2006

• Jerry Mingione
• Enrolled Actuaries Meeting
• March 26, 2007

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At a High Level, New PPA Funding Rules Imply

• Increased funding target
• set to 100 of a solvency liability vs. 90
  previously
• target further increased ? but only temporarily ?
  for plans deemed at-risk
• Faster recognition of capital market results
• smoothing period reduced to two years vs. four
  years previously
• seven-year amortization of unfunded amounts once
  recognized
• Reduced ability to delay contributions for poorly
  funded plans since the application of credit
  balances is restricted
• New constraints on plan operations for plans that
  fall below funding thresholds
• Greatly improved ability to advance fund pension
  plans
• Some expansion of plan sponsors access to
  accumulated surplus

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Different Plans Will See Different Impacts

• Poorly funded plans
• Unfunded amounts are amortized over seven years
  this represents a decrease in amortization
  amounts when compared to amortization rates as
  high as 30 under prior rules.
• Credit balances cant be used to delay
  contributions.
• At-risk designation essentially raises the
  amortization rate gradually over a period of
  years (until the funding level recovers) also
  raises PBGC premiums.
• Sponsors cant pay full lump sums or make plan
  improvements until the funded level recovers.

Bottom Line a mixed bag
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Different Plans Will See Different Impacts

• Moderately funded plans (near 90)
• Significant increase in funding requirements
  increased target hits these plans directly.
• If capital market conditions deteriorate, credit
  balance utilization may be restricted, at-risk
  designation and constraints on benefit operations
  may kick in.

increased
contributions greater downside risk
Bottom Line
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Different Plans Will See Different Impacts

• Well funded plans
• Contributions are not required unless the funded
  level drops below 100.
• Greatly increased advance funding opportunity
  up to 150. Resulting credit balances available
  to offset future contribution requirements
  (unless funded level drops below 80).
• Expanded opportunity to utilize surplus assets to
  pay retiree medical benefits ? albeit with
  significant restrictions attached.

more flexibility Bottom Line less downside
protection (against contribution increases)
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What Effect Will Segment Rates Have?

• For a typical plan, discounting based on a yield
  curve is not very different from discounting
  based on a composite index yield (as we have been
  doing since 2004).
• However, very young and very mature plans will
  seem some duration-related effects, for example
• The corporate bonds referred to under PPA are
  essentially the same bonds that were incorporated
  into the composite corporate rate under PFEA
  i.e., the top three quality levels.
• It is fairly simple to translate a full yield
  curve into segment rates little distortion is
  expected as a result of that conversion.

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Yield Curve/Segment Rates -- Implementation Issues

• Which bonds to reflect how to weight them
• whether optionable bonds should be included
• whether bonds in various grades should be
  weighted equally or market-weighted.
• What to assume for yields beyond 30 years.
• How monthly yields are developed average of all
  daily rates or single day (last day of month)
• end of month works better for those electing full
  yield curve.
• How segment rates are developed from full yield
  curve.
• Range of uses for full yield curve (snapshot
  market) results, if elected.
• How to (appropriately) value projected lump sums
• absolutely critical that the methodology not
  invoke the short end of the yield curve twice.
• What Treasury should document/publish each month.

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What Effect Will the Updated Mortality Table Have?

• For a typical plan, the update from 83 GAM to RP
  2000/Projected will bump liability values by only
  3-4
• groups with greater percentages of liabilities
  associated with male participants get much larger
  increases
• plans with younger demographics get slightly
  larger increases.

Percentage Increment
83 GAM to RP 2000/Projected Mortality
Active males
10.4
Inactive males
8.1
Active females
-2.0
Inactive females
-1.5
Blended 50-50 group
3.3
Blended 60-40 group
4.4
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Will Contributions Be More Volatile?

• Given the key parameters of PPA funding rules,
  youd expect the new rules to add volatility to
  pension plan funding, since
• smoothing is reduced to two years
• application of credit balance is curtailed
• at-risk designation increases contribution
  requirements during adverse periods.
• However, when looking more closely at the
  details, the picture gets complicated
• the amortization rate is likely to be reduced for
  the most poorly funded plans
• amortization amounts per of unfunded liability
  (essentially) stay constant, while under prior
  rules there were major cliffs in funding
  requirements.
• Also for plan sponsors who wish to manage
  contribution requirements proactively
• there is an enhanced ability to implement
  effective ALM strategies
• there is added flexibility to fund the plan in
  advance of funding requirements.

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How Alternative Funding Requirements Perform
-- Traditional Plan / Typical 60-40 Asset Mix
Change
Prior Rules
New Rules/PPA
Contributions
6.6
8.7
2
average over time
0 - 16
0 - 19
more variable
10-90 percentiles
5
7
percent gt 20 of payroll
more variable
Funded Levels
11
97
108
average, end of period
10-90 percentiles (end of period)
increased chance of large surplus
75 - 123
83 - 136
reduced chance of large unfunded
16
8
percent lt 80 funded
Methodology - 10-year forecast, including
transition period - plan starts
out about 90 funded - minimum contributions
paid each year -
no initial credit balance
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How Alternative Funding Requirements Perform
-- Traditional Plan / All Long Bonds
New Rules/PPA
Prior Rules
Change
Contributions
9.3
11.7
2
average over time
10-90 percentiles
3 - 16
5 - 17
same variability
percent gt 20 of payroll
3
2
same variability
Funded Levels
89
98
9
average, end of period
10-90 percentiles (end of period)
variability greatly reduced
82 - 98
95 - 101
no chance for large unfunded
1
--
percent lt 80 funded
Methodology - 10-year forecast, including
transition period - plan starts
out about 90 funded - minimum contributions
paid each year - no initial credit
balance
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How Alternative Funding Requirements Perform
Range of Contributions (10-year average)
20
90th percentile
16
12
average
8
10th percentile
4
Rules
Current
Current
PPA
PPA
Asset Allocation
60-40
All Bonds
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How Alternative Funding Requirements Perform
Funded Status (10th year)
125
115
105
90th percentile
average
10th percentile
95
85
75
Rules
Current
Current
PPA
PPA
Asset Allocation
60-40
All Bonds
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Putting Added Financial Commitments in Perspective
Average for 10
Average for 78
Fortune 100 Cos.
Fortune 100 Cos.
Annual Contributions
460 million
820 million
10
26
- as of Operating Cash Flow
11.5 billion
18.7 billion
ABO
0.3 billion
0.8 billion
Unfunded ABO
- of Operating Cash Flow
5
25
- of Book Value
1
7
Add 10 to ABO
- of Operating Cash Flow
24
60
- of Book Value
4
16
Notes
- Companies included are those with defined
benefit pension plans.
- Information is from 2005 annual reports.
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Concerns About Surplus

• The increased funding target implies that plans
  investing in equities are
• more likely to accumulate surplus assets over
  time.
• Costs related to ongoing benefit accruals can
  siphon off only some of this surplus.
• The expanded section 420 transfer opportunity
  will be an attractive option for some plans.
  However, its relevance is limited by
• the need to maintain a 120 funded level for the
  entire payout period
• the requirement to vest all accrued pension
  benefits
• the requirement to maintain retiree medical
  benefits (or costs) at existing levels for an
  extended period of time.
• Plan termination is typically not a viable option
  due to the cost of annuitization and the
  prohibitive excise tax applied on surplus.

The potential for creating surplus and the
limited avenues for effectively utilizing it
(once created) affects the perceived risk/ reward
tradeoff and makes lower-risk strategies more
appealing.
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How Will Plan Sponsors Adapt?

• Employer Survey Results
• Are pension financial risks expected to be
  manageable?
• 63 said yes
• 30 said acceptable
• 7 said significant risk.
• Will pension benefits be curtailed further?
• 17 intend to close the plan to future hires
• 5 intend to freeze benefits for existing
  employees
• 9 intend to reduce future benefit accruals
• 49 do not plan any changes.
• How will investment policies change?
• 32 said they would were likely to put greater
  emphasis on bonds
• 25 said they were likely to increase their use
  of derivatives
• 5 said they would consider annuities (pricing is
  viewed as problematic).

34
PPA 2006 Truth and Consequences

• Benefit Restrictions Based on Plan Funding
• for Single-employer plans, per Section 436

35
New Focus

• New measure of liability, assets, and resulting
  required funding
• Single liability measure focused on benefits
  currently accrued
• Assets have limited smoothing
• Discounted recognition of accrued contributions
• Restricted use of Credit Balance
• Lends to more focused discussion of plan
  liability
• More clear what to avoid / what to shoot for
• Still, somewhat muddled by FASB rules
• Also, added complexity if any pre-funding (i.e.,
  credit balance)
• Still a disconnect between funding and
  termination liability (but shrinking)

36
Pre-PPA

• Funded status affected plan provisions before PPA
• Could have restricted lump sum payments to Top 25
  if FCL lt 110
• Certain benefit improvements restricted if FCL lt
  60
• No credit balance adjustment to assets for
  above funded s
• Other restrictions applied (and still do) if
  terminating an underfunded plan
• Outside of the above, underfunded status
  generally did not affect the level or form of
  payment

37
PPA New Targets

• New rules now draw a stronger connection between
  the funded status and the accrual and payment of
  benefits

38
New Issues
39
New Impact
40
Plans That Miss The Target
41
Pre-PPA

• Plans funded status can affect
• Level of contributions
• Timing of contributions
• Forms of payment (Top 25)
• Level of benefit accruals
• PBGC premiums
• 4010 filings (larger plans)
• Participant Disclosure

42
PrePost-PPA

• Plans funded status can affect
• Level of required contributions
• Timing of contributions
• Use of Credit Balance
• Forms of payment (Top 25 all participants)
• Level of benefit accruals
• Shutdown benefits
• PBGC Premiums
• 4010 filings (large all plans)
• NQDC funding
• Participant Disclosure

• Participants confidence in the plan

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Key Percentages

• Less than 100
• Funding Shortfall Amortization
• Quarterly Contributions
• Less than 80, above plus
• May be At-risk
• No benefit increases
• Cannot apply Carryover Balance or Prefunding
  Balance
• Subject to Section 4010 filing (no longer based
  on 50 million UVB)
• Partial restriction on lump sum payments
• Less than 60, all of above plus
• No benefit accruals
• No shutdown benefits
• No lump sums payments

44
Determining Adjusted FTAP (AFTAP) Section
436(j)

• Ratio of assets to Funding Target
• Assets are
• Reduced by the Carryover Balance (COB) and
  Prefunding Balance (PFB)
• Increased by a form of security (optional)
• Increased by any purchased annuities for NHCEs in
  prior 2 plan years
• Funding Target is also increased by any purchased
  annuities
• Required to burn COB or PFB if doing so avoids
  restrictions
• If burning does not increase the AFTAP over the
  threshold, not required to do so

45
Determining AFTAP When Purchased NHCE Annuities
46
Exemption to Credit Balance Reduction Section
436(j)(3)

• IF FTAP (not AFTAP) would be at least 100
  without reducing assets for the credit balance,
  then
• AFTAPs assets are not reduced by the credit
  balance
• 100 threshold is phased-in for 2008-2010 if
  all prior targets are met
• Above means there is some recognition of the
  true funded position of the plan when
  determining whether restrictions apply
• But, what if you just miss the 100 threshold?

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(No Transcript)
48
Restriction on Benefit Improvements Section
436(c)

• Cannot improve benefits (i.e., change benefits so
  that the Funding Target increases) if
• AFTAP is less than 80, or
• AFTAP would be less than 80 after the adjustment
• Exceptions Can still improve benefits if
• Where AFTAP is already lt 80, contribute Minimum
  Required Contribution plus the change in Funding
  Target due to benefit improvement
• Where AFTAP drops below 80 due to benefit
  improvement, contribute the Minimum Required
  Contribution plus amount needed to get back to
  80
• Non-salary based benefit and increasing no more
  than the average increase in wages

49
Restricted Forms of Payment Section 436(d)

• Cannot pay Prohibited Payments (generally lump
  sums) if
• AFTAP is less than 60, or
• Plan sponsor is in bankruptcy
• Exception Can still pay lump sums if
• In bankruptcy, but AFTAP is at least 100, or
• Plan has been fully frozen since 9-1-2005
• If AFTAP is at least 60 but less than 80, can
  pay up to lesser of
• 50 of Prohibited Payment
• Present value of the PBGC Maximum Guaranteed
  Benefit, per Section 4022
• For both, limited to one prohibited payment
  per participant in consecutive PYs where
  limitations apply

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Restricted Forms of Payment (continued)

• Prohibited Payments include payments that exceed
  the single life monthly payment (plus any
  411(a)(9) SS Supp)
• Lump sums ? prohibited payment
• Purchase of annuities ? prohibited payment
• Social Security Level Income Options ? prohibited
  payment
• At-Risk plans
• AFTAP not adjusted for At-Risk assumptions (based
  on regular FT)
• But, is At-Risk FT adjusted for applicable
  benefit restrictions, such as restriction on the
  payment of lump sums?

51
Top-25 Rules for Restricted Lump Sums
1.401(a)(4)-5(b)

• Now based on FT vs. CL?
• Still relevant or appropriate restriction?
• We now have the new 60 Prohibited Payment rule
• By design, the Top 25 rule is more lenient for
  larger plans with large CL if criteria to pay is
  LS lt 1 of CL
• Not all HCEs have ability to influence funding or
  fate of pension plan, so why penalize them?
• But, intent is to protect NHCEs from top
  management draining money out of the plan
• Is 100 vs 120 enough?

52
Requirement to Freeze Accruals Section 436(e)

• Benefit accruals are frozen once AFTAP drops
  below 60
• Cease as of the valuation date for the plan
  year
• Accruals can begin again, effective first day of
  PY, once employer contributes
• Minimum Required Contribution, plus
• Amount needed to reach 60 AFTAP

53
Exemption for New Plans Section 436(g)

• Section 436 limitations on the following n/a for
  first 5 plan years
• Shutdown benefits,
• Benefit increases, or
• Benefit accruals
• Definition of plan includes predecessor plans

54
Actuarial Certification

• If restriction applied last year, assume applies
  current year until the enrolled actuary certifies
  otherwise Section 436(h)(1)
• Unclear how certification will work
• Can you use a reasonable estimation of the AFTAP?
• Without this, could be unnecessary limitation on
  benefits
• Can NHCE annuity purchases be ignored since they
  only increase AFTAP?
• If basing on prior years AFTAP, how are the
  following determined
• Receivable contributions
• Burned credit balances

55
Actuarial Certification (Continued)

• Many, many timing issues when basing on current
  years AFTAP
• Updated census data
• Asset value
• Asset method
• Assumptions
• Receivable contributions
• Credit balance
• Timing issues could result in new pressure on
  actuaries
• Will actuaries be another new target?

56
Timing for Plans Near Thresholds
January 1
Have you finished our valuation?
April 1
Have you finished our valuation?
October 1
What do you mean we didnt contribute enough?
57
Can Plan Sponsors Avoid Bad News?
Actuarial Certification
58
Other Potential Issues

• Will there be a run on the bank if it is known
  that a restriction on lump sums is forthcoming?

59
Potential Issues - Continued

• RASDs and Section 436(d)
• Can a participant elect a RASD to escape a
  restriction on form of payment?
• ? Based on ASD, not payment date
• Are RASD make-up payments Prohibited Payments?
• ? Probably not
• Cashouts
• Does 436(d) apply to lump sums if under the
  current cashout limit?
• Must a credit balance be burned under 436(f)(3)
  to avoid the distribution restrictions (436(d))
  if the plan only pays 5,000 cashouts?

60
Questions