Pension Plan Amendments Required to Reflect Section 436 Contingent Limitations on Benefits

Time is running out for sponsors of defined benefit pension plans to adopt amendments that must be made by the end of the year to provide for limits on benefit payments and benefit accruals as required under section 436 of the Internal Revenue Code.

These limits apply in the event that the plan falls short of funding targets established under the Pension Protection Act of 2006 (PPA). Limits start to apply if the plan's adjusted funding target attainment percentage (AFTAP), as certified by the plan's actuary, falls below 80 percent, and additional and stricter limits apply if the plan's AFTAP falls below 60 percent.

Some pension plan sponsors may be unaware of the scope of these limitations and the amendments that may be necessary to reflect these limitations. However, the voluminous final IRS regulations under Code sections 430 and 436 published in the Federal Register on October 15, 2009, require that defined benefit plans be amended to reflect these limitations on a contingent basis.

Operational Compliance Not Enough

It is not sufficient just to operate the plan in compliance with the limits under Code section 436 if, due to insufficient funding, those limits become applicable to the plan. Furthermore, plan sponsors cannot simply wait until the plan has a low AFTAP certification to amend the plan and impose the limits. Rather, the plan document needs to reflect these limitations before the end of the 2009 plan year (subject to a later effective date for certain collectively bargained plans). If the plan is not amended within this time frame, the remedial amendment relief and Code section 411(d)(6) anti-cutback relief provided under PPA section 1107 will not be available to the plan.

Most Pension Plans Affected by Year-End Deadline

The 2009 plan year amendment deadline applies to most defined benefit pension plans, with a few exceptions. Certain collectively bargained plans have an extended deadline. For this purpose, a plan is "collectively bargained" if 25 percent of all the plan participants (or 50 percent of the employees currently accruing benefits under the plan) are members of collective bargaining units for which plan benefits are collectively bargained. Governmental plans and non-electing church plans are not subject to these funding rules and benefit limitations, and therefore do not have to be amended.

IRS Has Yet to Provide Sample Amendments

Despite the looming year-end deadline, the IRS has yet to issue sample amendments for the Code section 436 limitations. The preamble to the final section 436 regulations indicates that the IRS is considering whether to issue sample plan amendments, but the IRS has offered no assurance that it will issue sample plan amendments by year end. With time running short for calendar year plans, plan sponsors probably do not have the luxury of waiting to see whether the IRS provides sample amendments. For one thing, plan sponsors will want to have time to consider several alternative approaches that can be taken under the regulations, so that the amendments, once drafted, reflect whichever approaches the plan sponsor want to be available under the plan. Plan sponsors should start considering now which direction to take before the year-end crunch to finalize amendments.

Limitations Imposed by Section 436

The section 436 limitations that must be reflected in pension plans fall into four general categories:

Limitations on unpredictable contingent event benefits under section 436(b). Any plan that provides for any "unpredictable contingent event benefit" must be amended to provide that the benefit will not be paid during a plan year in which the AFTAP is less than 60 percent (or would be less than 60 percent if the AFTAP were redetermined assuming the occurrence of the unpredictable contingent event during the plan year). An unpredictable contingent event benefit is any benefit or increase in benefits to the extent the benefit would not be payable but for the occurrence of an event such as a plant shutdown or similar event (i.e., any event other than the attainment of any age, performance of any service, receipt or derivation of any compensation, or the occurrence of death or disability).

Limitations on plan amendments increasing plan liabilities under section 436(c). The plan cannot be amended to increase benefits, establish new benefits, increase the rate of benefit accrual, or accelerate the vesting schedule (other than as required by law) if the AFTAP for the plan year in which the amendment is to take effect is less than 80 percent. The regulations seem to impose this as a limitation that needs to be reflected in the standing amendment authorization provisions of the plan, not just as an operational limitation prohibiting adoption of such amendments.

Limitations on payments under section 436(d). The plan must limit the plan's ability to make certain lump sum or other accelerated distributions if the AFTAP falls below applicable targets as follows:

• If the AFTAP is less than 80 percent but not less than 60 percent, then the plan cannot pay a lump sum distribution (or any other accelerated payment that is subject to Code 417(e)(3), such as a Social Security level income option), with an annuity starting date on or after the "applicable section 436 measurement date" (as defined under the regulations), that is more than 50 percent of the present value of the accrued benefit (or more than the present value of the maximum PBGC guaranteed benefit amount, if less). (The current maximum PBGC guaranteed benefit amount for a single life annuity starting at age 65 is an annual payment of $54,000—the present value of that amount would obviously vary with the participant's age, but would currently be about $637,000 at age 65.)
• If the AFTAP is less than 60 percent or if the plan sponsor is in bankruptcy (unless the AFTAP is certified at no less than 100 percent), then the plan cannot pay any lump sum distribution or other accelerated payment with an annuity starting date after the applicable section 436 measurement date (or after the bankruptcy filing until the AFTAP is certified at no less than 100 percent).

There is no de minimis exception for small pensions. There is an exception to this limitation for plans that were frozen on or before September 1, 2005; however, if the plan is ever amended to provide for benefit accruals thereafter, the exception ceases to apply to the plan as of the date those accruals start. Accordingly, while it is not clear whether the IRS, in the determination letter review process, will require that these frozen plans also be amended to reflect the section 436(d) restrictions contingent on loss of the exception, a sponsor of a frozen plan will need to consider whether to amend the plan anyway because the plan would not have PPA section 1107 relief, in the event it loses the exception, unless it is amended currently.

This section 436(d) prohibited payment limitation will be of particular concern to plans such as cash balance pension plans that are designed with the intent of paying most benefits in the form of a lump sum distribution.

Limitations on Benefit Accruals under section 436(e). The plan must provide that if the AFTAP is less than 60 percent, then benefit accruals cease under the plan as of the applicable section 436 measurement date. The plan can provide for the automatic restoration of benefit accruals that were not permitted because of this limitation once the limitation no longer applies; however, the restoration of those accruals is generally treated as a plan amendment subject to the limitations under Code section 436(c) described above.

The definition of the "applicable section 436 measurement date" is based on a complicated set of rules depending on when the plan actuary certifies the AFTAP, the AFTAP from the prior year, and certain presumptions for the current year based on the prior year AFTAP. Plan amendments may end up incorporating this term by reference, rather than laying out all the detail in the plan amendment. However, because this is a fundamental concept for these benefit restrictions, it will be important for the plan administrator of any plan that is likely to be subject to these restrictions to have a good handle on these timing rules in order to administer the plan correctly.

Application of Limitations to New Pension Plans

The limitations under Code section 436(b), (c) and (e) described above do not apply to new pension plans (plans that have been in existence no more than five years, subject to certain predecessor plan rules). However, the limitations on payments under Code section 436(d) do apply to new plans. Furthermore, new plans will still need to be amended currently to reflect the limitations on benefit accruals under Code section 436(e) in order to have PPA section 1107 relief when the rules start to apply after the plan's fifth year.

Additional Contributions May Be Made to Avoid Section 436 Limitations

The regulations provide that the plan sponsor may make additional current year contributions, separate from any minimum required contributions under Code section 430, that are specifically designated at the time of the contribution as a contribution used to avoid the application of the section 436(b), (c) or (e) limitations (a "section 436 contribution). These section 436 contribution rules do not apply for purposes of avoiding the prohibited payment rules under section 436(d); however, a plan sponsor can avoid the section 436(d) prohibited payment limitations in any plan year by making an additional contribution for the prior year (sufficient to increase the AFTAP to the appropriate level) not later than 8½ months after the end of that prior year. Accordingly, the plan provision regarding the 436 limitations will likely refer to these techniques to avoid the 436 benefit limitations.

Alternative Approaches to Consider in Drafting Plan Amendments

The regulations provide that there are several alternative approaches the plan can take with respect to processing of participant benefit elections in the event the Code section 436(d) prohibited payment restrictions apply. It appears the approach selected for the plan needs to be reflected in the plan amendments.

One approach would be to go back to the participant and allow the participant to (1) choose another optional form of benefit that is not restricted, (2) defer commencement to a later annuity starting date, or (3) if the AFTAP is at least 60 percent but less than 80 percent, elect to bifurcate the benefit and receive the unrestricted amount and receive the remaining amount in a form that is not a lump sum distribution or other accelerated form that is subject to 417(e)(3). Another approach would be a one-step approach that avoids going back to the participant and instead makes every participant elect a backup form of distribution that would apply in the event the 436(d) restrictions apply as of the annuity starting date. A third approach similarly avoids going back to the participant by making all participants make separate elections with respect to the restricted and unrestricted portions.

For plans where the plan sponsor is likely to want to avoid the section 436(d) prohibited payment limitations by making an additional prior year contribution if and when ever necessary, the first approach is likely to be the most attractive, since the plan administrator would never bother the participant with all these complications until it ever becomes relevant (which, one hopes, is never).

Limitations Need to Be Communicated to Plan Participants

These contingent limitations also likely need to be reflected in the plan's summary plan description (SPD). However, there is also a separate notice required under ERISA section 101(j) if the limitations ever get triggered, so it is not clear how much detail about the particulars of the limitations should go into the SPD. (Proposed regulations under Code section 4980F also provide that the section 101(j) notice will also satisfy the ERISA section 204(h) advance-notice requirement for reduction of future benefit accruals.)

Start Amendment Preparations Now

The time available to prepare plan amendments for calendar year plans is short. Plan sponsors will likely want to consider some of these issues with legal counsel and discuss the AFTAP certification process with the plan's actuary before getting too close to the end of the year.