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Paper on limits for deducting pension plan contributions (May 14, 2004)

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Averting the Next Pension Crisis

In this paper, the American Academy of Actuaries
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Pension Committee focuses primarily on the
maximum tax-deductible contribution rules for defined benefit plans. We are also studying the
minimum funding rules, with the goal of simplifying and fixing them without adversely affecting the
objectives behind those rules. We are presenting this draft on the maximum rules before our
minimum funding ideas are finalized, in response to requests from policymakers. Ultimately, some of
these suggestions may require change to mesh with our recommendations for minimum funding

The current pension funding rules tend to produce volatile contribution patterns and discourage adequate
funding margins. Almost by definition, the rules inhibit contributions when the economy is strong, and
require substantial contributions when the economy declines and plan sponsors can least afford them.
Thus, the funding rules create cyclical economic problems
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for the country; they exacerbate the
economic cycle by helping in the good times and hurting in the bad times. In addition, we have seen in
the news a number of companies in a wide variety of industries whose survival is threatened by the cash
contribution requirements of pension plans that were considered to be reasonably well-funded (or even
overfunded) just a few years ago.

In the 1990s, a number of companies might have contributed voluntarily to their well-funded pension
plans, but were discouraged because a contribution
(1) Would not have been deductible;
(2) Would have caused an excise tax assessment; and
(3) Would not have been returned to the employer even if the plans eventual surplus made the
contributions unnecessary.

Not only were employers discouraged from making contributions in past years, but unfortunately, many
became accustomed to the contribution holidays. Anecdotally, the budget line item for pension
contributions was eliminated at some companies for so long it was forgotten. The subsequent fall in the
stock market and very low interest rates made many plans underfunded and triggered the deficit
reduction contribution rule. (A chart at the end of this paper shows this graphically.) Now, employers
have to contribute unusually large amounts to their newly underfunded pension plans. Some employers
responded by freezing and/or terminating their defined benefit (DB) plans. Others find themselves in
bankruptcy, unable to support their pension plans and turning to the PBGC for benefit guarantees.


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The American Academy of Actuaries is the public policy organization for actuaries of all specialties within the United States. In addition
to setting qualification standards and standards of actuarial practice, a major purpose of the Academy is to act as the public information
organization for the profession. The Academy is nonpartisan and assists the public policy process through the presentation of clear
actuarial analysis. The Academy regularly prepares testimony for Congress, provides information to federal and state elected officials,
regulators and congressional staff, comments on proposed federal and state regulations and legislation, and works closely with state
officials on issues related to insurance. The Academy also develops and upholds actuarial standards of conduct, qualifications and practice,
and the Code of Professional Conduct for all actuaries practicing in the United States.

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Some of our members believe that this is also a function of ERISAs policy of diversification of assets across asset classes. If this ERISA
policy were changed to allow the use of bonds only (and if employers could be persuaded to make greater use of immunized bond
portfolios), then smaller margins might be acceptable, but that would be a major change in thinking for pension plans, and needs much
analysis before legislating such a change. However, other members believe that diversification remains a prudent and more cost-effective
way to invest pension assets so much debate is needed before any change in ERISAs diversification rules are implemented.
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In this paper we explore ways of reducing this volatility by raising current contribution limits.
Ironically, a number of plan sponsors who would have liked to shore up their pension funding (and
eliminate adverse accounting impacts)
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at the end of 2001 and 2002 were unable to do so in a tax
effective manner. Had employers been allowed to make deductible contributions, some would have
done so to avoid the difficulties they face today, and pension plans (as well as the PBGC) would be in
better shape financially. Going forward, employers are now more keenly aware of the risk of declining
funding levels, and many might be interested in taking advantage of any changes in the law that would
allow them to build larger funding cushions against this risk.

On the other hand, we should not overreact to the perfect storm, the rare convergence of poor asset
returns, unusually low discount rates, and other factors that have affected pension funding levels.
Therefore, we would like to see the rules changed so that employers who are financially able to better
fund may do so. At the same time, the funding rules should not unduly strain the existing pension system
by requiring large increases in pension contributions that may or may not be necessary in the future.

Below are a number of approaches that could accomplish this goal of allowing margins. We are not
suggesting that all of these approaches be adopted; but rather that legislators consider what combination
of these approaches would best balance the need for added security and stability in pension funding with
other legislative objectives.

The Problem

Contributions are not deductible (and are subject to a 10 percent excise tax) when plan assets exceed
maximum tax-deductible limits. In 1987, Congress addressed this problem to some extent by allowing a
deduction for the full amount of the unfunded current liability (UCL) in IRC Sec. 404(a)(1)(D). But
even that has not been enough to prevent the current shortfall in pension funding experienced by many
employers.

When interest rates were higher, the full funding limit provided a more generous margin above current
liability, at least for pay-related plans, which have the ability to project future compensation increases
when calculating the limit.
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However, when interest rates are low, the deductible limit provides little or
no margin
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for adverse fluctuations in assets or liabilities and in many cases (as discussed later in this
paper) does not even permit recognition of liabilities for benefits the plan is committed to provide. The
years 2000 through 2002 saw a significant decline in the funded status of most plans because the
market value of plan investments fell dramatically at the same time that liabilities increased due to lower
interest rates. Although conditions appear to be improving, we believe structural changes are necessary
if a recurrence of this problem is to be avoided.

Suggested Remedies

In a world where there is no concern about tax revenues, defined benefit plan sponsors could be allowed
to deduct up to the total present value of benefits, including benefits that can be earned through future

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Under FAS87, employers with plans that have any unfunded ABO frequently must record a reduction in net worth equal to
the amount of unfunded and unaccrued liability.
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For hourly plans (and plans with a large proportion of retirees), the full funding limit can be less than termination liability
(because current funding rules preclude anticipating benefit improvements), so these plans have no margin for adverse
fluctuations. These are the plans that are now most likely to be underfunded.
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Some actuaries suggest that using interest rates below 6 percent for regular ERISA funding today would be most
appropriate. However, at one time, the IRS sued certain plans that used a rate below 8 percent.
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employment with the company). At that point, the employer would not have to contribute any additional
funds (except for amounts that might be needed if experience is worse than expected or as new
employees are hired). Tax revenues are important, however, so current rules limit deductions to 100
percent of CL for accrued benefits (or the ongoing full-funding limit, if greater). Some groups have
proposed increasing this limit to 130 percent or 150 percent of CL. In order to assess how much margin
would be appropriate, we have estimated the margin that would have been needed to avoid underfunding
in past economic periods.

The Senate Finance Committee, in its 2003 markup of HR 3108, would have allowed sponsors to deduct
contributions until the plan is funded to 130 percent of current liability (CL).
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While a 30 percent
margin would have kept plans from falling below 90 percent funded using CL, not termination liability
(TL) in most economic periods, it would not have been adequate for the depression years (dramatic
decreases in stock prices) or the years 200