Minimum Funding Standards

When employers face financial difficulties, they may be tempted to cut costs by underfunding their defined-benefit pension plans. Those plans are insured by the federally owned Pension Benefit Guaranty Corporation (PBGC). Consequently, underfunding would not place benefits for retirees with monthly pensions of less than $3,971.59--the PBGC limit--at risk, but the practice could impose liabilities on the PBGC. To reduce the PBGC's potential burden and to protect any pensions not fully covered by the corporation, lawmakers have directed that employers sponsoring defined-benefit plans must meet minimum funding requirements. Failing to meet those requirements does not disqualify a plan in terms of the tax incentives it can provide, but it subjects the employer to special excise taxes. In addition, underfunded plans--even those that meet the minimum funding requirements for a given year--must pay higher PBGC premiums. (Defined-contribution plans are not subject to minimum funding standards except to the extent that a subcategory of them, money purchase plans, promises to follow a specific formula for contributions.)

The minimum funding standard for a given plan consists of two parts: the amount needed to fund benefits that are currently accruing and an additional amount to amortize unfunded liabilities that accrued in the past. The size of a required contribution for a given year can be reduced by investments that perform better than expected and by forfeitures that result when unvested participants leave the plan. The plan's actuaries periodically reexamine the benefit projections and adjust the contributions when experience diverges from the original assumptions. However, the Internal Revenue Service may allow firms with financial difficulties to postpone their annual contributions.

The tax code discourages firms from guarding against potential underfunding by overfunding their pensions in good financial times. Employer contributions in excess of a "full-funding limitation" are not deductible; in other words, there is no tax advantage to contributing more to the plan than is needed to fully fund the plan. Furthermore, if the plan nevertheless becomes overfunded (for example, as the result of a rapidly rising stock market), employers cannot withdraw excess funds unless they pay an excise tax of up to 50 percent on the withdrawal.

When estimating future liabilities, plan administrators generally have been required to assume an investment return linked to the interest rate on a 30-year Treasury bond. Between November 2001 and February 2006, the Treasury stopped issuing such bonds. As the price of the bonds increased, their interest decreased to exceptionally low levels. The Pension Funding Equity Act of 2004 temporarily replaced the 30-year Treasury bond rate with an average rate for investment-grade corporate bonds. That higher interest rate lowered the estimate of future liabilities and, in turn, sponsoring firms' funding obligations. Additional provisions reduced the funding obligations of the airline and steel industries. All of those funding-relief provisions expired at the end of 2005.