This article is part of our continuing series on the coronavirus and its effects on qualified retirement plans. Recently, we wrote about ways employees affected by the coronavirus could access money from their retirement plans. Today, we are discussing defined benefit plan funding. Further developments that occur will be addressed in future articles.
Here, we refer to traditional defined benefit and cash balance plans collectively as “DB plans.”
The coronavirus has caused two problems for DB plan sponsors. Well, it’s probably caused a lot more than that, but two that relate directly to plan funding are
- Before the virus actually started significantly affecting the U.S., the stock market took a deep decline. This would mean larger required DB contributions down the road, maybe 2021 or 2022, although not right now.
- Once the virus came to the U.S., there were sports cancellations, quarantines, furloughs and layoffs, business closures, and COVID-19 cases in our communities. Any worry about those higher future DB contributions would have to take a back seat. Forget 2021 or 2022. Businesses just needed to survive 2020. The money set aside to pay 2019 plan year contributions in 2020? If they had it, it might be gone. If they didn’t have it, it might not come in as planned.
What’s a DB plan sponsor to do? Below are some considerations for employers whose plan assets have taken a hit in the recent bear market. We also touch on some immediate contribution relief recently granted by Congress and whether we can expect anything further.
BOY vs. EOY Valuation Dates
It will be helpful to introduce the idea of beginning-of-year vs. end-of-year valuations. DB contributions are based on an annual snapshot date called the valuation date. Consider a calendar year DB plan. The 2020 plan year contribution may be determined based on information as of 12/31/2020. This is, naturally, an end-of-year (EOY) valuation since December 31 is the last day of the plan year. Alternatively, the 2020 contribution may be based on 1/1/2020 information. This is a beginning-of-year (BOY) valuation.
Generally, a plan needs to choose between doing BOY or EOY valuations and not change from one year to the next. There are different reasons why an employer might choose one over the other. All defined contribution plans use EOY valuations. To those who work only with DC plans, the idea of a BOY valuation seems strange.
When the stock market began to fall in February, we started to get questions about what effect this would have on DB contributions. Let’s assume the market stays down for the rest of 2020. Assume the plan uses an EOY valuation:
- The 2019 required contribution is not affected. It is based on the 12/31/2019 asset value. The 2019 contribution is locked in as of 12/31/2019.
- The 2020 required contribution will be higher than it would be otherwise since it’s based on the lower 12/31/2020 market value. When plan assets suffer a loss, it must be made up over time with higher contributions.
- The 2020 plan year contribution does not have to be paid in full until 9/15/2021. This means that an employer has about a year-and-a-half before it needs to pay the higher contribution resulting from the market loss.
A plan using a BOY valuation date has even more time:
- The 2019 required contribution is not affected. It is based on the 1/1/2019 asset value. The 2019 contribution was locked in more than a year ago.
- The 2020 required contribution is not affected. As it is based on the 1/1/2020 asset value, the 2020 contribution was locked in before the market downturn.
- The 2021 required contribution will be higher than it would be otherwise since it will be based on the lower 1/1/2021 market value. However, the 2021 contribution does not need to be paid in full until 9/15/2022 – two-and-a-half years after the market decline that occurred in early 2020.
Dollar Impact on Required Contributions
When we say that a required DB contribution will increase because of the market drop, how many dollars are we actually talking about? That depends in large part on how many dollars the plan had to start with. Let’s take a look at a couple of examples:
Consider a relatively new plan with a $200,000 funding target, $200,000 target normal cost, and $200,000 in assets. Based on these facts, the required contribution would be $200,000. (This is a simplified example that ignores credit balances, interest discounting, and a lot of other things.)
Now assume the assets fall 20% overnight to $160,000. When there is an actuarial loss, a rule of thumb is that in the following year you need to contribute about one-sixth of that loss to start making the plan whole. So the contribution would be increased by one-sixth of $40,000, or approximately $7,000, for a total of $207,000. Not too horrible.
Let’s change the facts a bit. The funding target is $3,000,000, target normal cost is $200,000, and assets are $3,000,000. Again, in our simplified world, the required contribution is $200,000. Assume the assets drop overnight 20% to $2,400,000. The percentage loss is the same as in the first example, but the dollar loss is $600,000 instead of $40,000. The amount that needs to be contributed this year to start making up for the loss is one-sixth of $600,000, or $100,000. The required contribution is now $200,000 + $100,000 = $300,000.
Freezing Plan, Even Temporarily, Is an Option
An employer expecting a contribution of $200,000 may be willing to accept a contribution of $207,000, but not $300,000. If the projected dollar increase in DB contribution is too much for the employer to stomach, it may wish to freeze its plan.
Freezing a DB plan means that no further benefits will be earned by participants. It is not the same as a plan termination. A frozen plan remains active in every other sense – an annual valuation must be done, a Form 5500 must be filed, etc. While freezing the plan stops new benefits from accruing, benefits that accrued in past years must still be paid for.
Normally, the annual benefit for a DB plan participant is accrued when he crosses over 1,000 hours of service for the year. This usually occurs around the end of May. So freezing a plan by mid-May will prevent the accrual of another year’s benefit.
Freezing a plan might not reduce the contribution to $0, but it could help a lot. In the first example above, freezing the plan before the year’s benefit accrues would reduce the required contribution from $207,000 to $7,000. In the second example, the freeze would reduce the contribution from $300,000 to $100,000. This would certainly help a cash-strapped employer.
A freeze does not have to be permanent. If a plan is frozen in May 2020, but things improve later in the year, the plan can be unfrozen to restore the 2020 benefits. It’s almost as though the freeze never happened. Not quite, but close. Note that we do not recommend freezing and unfreezing regularly. In these unique circumstances, it might be okay.
In a way, we are fortunate that the big market downturn occurred early in the year. This gives employers time to think about freezing before 2020 benefits are earned. Had the market drop occurred later in the year, the 2020 benefits would have been locked in and would have to be funded. Even then, a freeze might still make sense to shut off future year benefits and allow the employer to get caught up on funding.
And, of course, the option to freeze the plan doesn’t help when the plan is already frozen. You can’t double freeze.
Relief for Contributions Due in 2020
Should you freeze your plan or not? That’s what we were going to consult with our clients on back when our biggest problem was a stock market drop. Then the pandemic came to all of our back yards, and our focus shifted to other concerns. Among them: what to do if you haven’t made your 2019 contribution yet and now might not have the money to do so.
Fortunately, the Coronavirus Aid, Relief, and Economic Security (CARES) Act came along in fairly short order. Under this Act, any DB plan contribution due in 2020 does not have to be deposited until 1/1/2021. For calendar year plans, this includes
- The final 2019 quarterly contribution due on 1/15/2020.
- The 2020 quarterly contributions due on 4/15/2020, 7/15/2020, and 10/15/2020.
- The final 2019 contribution due on 9/15/2020.
For a small employer, being able to delay that final 2019 contribution for three-and-a-half months will be of the most interest. Missing the September 15 deadline in a normal year means penalties. Missing the other deadlines usually isn’t as serious.
Interest will have to be added to any of these contributions that are made later than they originally would have been due.
It would be nice if we could snap our fingers and make the 2019 required contribution go away completely. That is not likely to happen. Benefits for 2019 have been earned already. It is illegal to cut them back. Not even the IRS can give you permission to cut an accrued benefit. It would take, literally, an act of Congress. We have the extension on contributions to 1/1/2021. Further relief, if any, would likely come in the form of additional extensions, more years to amortize actuarial losses, and/or higher interest rates for determining benefit obligations.
The penalty for missing the minimum funding deadline is a 10% excise tax. For employers with bleak prospects, the best option may be to just contribute what you can, pay the tax on the rest, terminate the plan entirely, and cut your losses. Talk to your actuary, TPA, or other advisors before making this decision.
Deductions Still Available for Those Who Want Them
For employers who established DB plans for the big tax deductions, those are still available. These are usually small employers or one-person shops. If plan asset values stay down, the maximum deductible contribution will be higher as of the next valuation date. The limits on what any employee may receive from the plan as a distribution remain the same, so these small employers will need to be mindful of not overfunding the plan. If nothing else, the market downturn could be an opportunity to buy investments at fire-sale prices.