In the world of science and engineering, a black box is a device or system or object which can be viewed solely in terms of its input and output without the user knowing how it works.  In the world of ERISA, a black box can be an actuarial valuation, the report that your actuary provides you on an annual basis telling you how well – or not well – your defined benefit pension plan is “funded”.

So let’s take a peak inside the black box to help you better understand what it all means and why this understanding is crucial to managing the plan and your company’s objectives. Here is a very brief explanation of three important ways to view the “funded status” of your pension plan:

  1. Minimum Funding Requirements. The Internal Revenue Code (the “Code”) imposes certain minimum funding requirements on an employer to fund the plan on a annual, on-going basis. Generally, the contribution is based on plan’s “normal cost”, i.e., cost of benefits earned in the current year, plus an amount sufficient to amortize the plan’s shortfall (gap between assets and liabilities) over 7 years. Failure to meet minimum funding requirements can result in an excise tax of up to 100%.
  2. Benefit Restrictions. The Pension Protection Act of 2006 (“PPA”) added a funding measure called Adjusted Funding Target Attainment Percentage (“AFTAP”) which is the plan’s asset to liability funding ratio. Benefits must be restricted if certain percentage thresholds are not met, e.g., if less than 80%, there is a 50% restriction on lump sums and annuity purchases.
  3. Plan Termination. In order to terminate a pension plan, the plan must be fully funded, i.e., plan assets must be equal to or exceed plan liabilities. If the plan is subject to the Pension Benefit Guaranty Corporation (“PBGC”), it must demonstrate that assets are sufficient to meet liabilities. The Code and IRS regulations require the use of interest rates and mortality assumptions that are generally lower than those used for funding the plan on an on-going basis, i.e., more costly.

So why is all this important? Simply this: the “funded status” of your pension plan, however viewed, directly impacts both your contribution and investment strategy.

And more important still if your plan is part of the 40% of plans that have been frozen, the subject of the 2008 Government Accountability Office Report, DEFINED BENEFIT PENSIONS: Plan Freezes Affect Millions of Participants and May Pose Retirement Income Challenges. Are your objectives clearly defined and a strategy in place?