Funding Strategies for Employers with Defined Benefit and Cash Balance Pension Plans

By Steven Bull

Each year plan sponsors face the decision on how much to contribute to their pension plan.  There is a decision to make because the contribution must be at least equal to the minimum required contribution (MRC) but no greater than the maximum tax deductible contribution limit.  The MRC is the minimum amount, as defined by IRS regulations, that a plan sponsor must contribute for a given plan year.  The tax deductible contributions for a plan sponsor are limited by a maximum tax deductible amount for each plan year.  Since plan sponsors have an opportunity to develop a funding strategy within these boundaries, what  is the right contribution to make?

The Minimum Contribution

For each plan year, regulations define the MRC as the minimum amount a plan sponsor must contribute for the pension plan.  The MRC can fluctuate from year to year based on the plan’s funded status, which is the benefit liability compared to plan assets.  A company may choose to contribute the minimum required amount because cash is needed for alternative business activities or to meet an unplanned, significant increase in the MRC.  While contributing the minimum amount does satisfy the regulatory funding requirements, is  the minimum contribution sufficient to achieve the plan sponsor’s long-term funding goals?

The IRS Maximum

At the other extreme, plan sponsors can contribute up to the maximum tax deductible limitation.  Funding to the maximum level will help the plan sponsor reduce future contribution requirements and gain larger tax deductions compared to contributing only the MRC. However, a funding policy of always contributing the maximum amount could lead to an overfunded plan. If the plan sponsor intends to terminate the plan in the near future, an overfunded plan could have undesired tax implications at the time of termination.  Considering the above, is it better to fund the plan at the maximum level? Knowing the impact of the contributions and the future direction of the plan is of vital importance in the decision process.

Any point in between

The minimum required contribution and the maximum tax deductible limitation serve as boundaries on the amount of annual cash contributions.  The long-term impact of a contribution strategy that takes advantage of the available range of contributions can be evaluated to arrive at the best financial decision. Once the plan sponsor sets a specific long-term goal for the plan, the funding strategy can be tested to see whether it supports reaching this goal. A sponsor that contributes near the minimum amount takes a greater risk of potential exposure to contribution volatility from one year to the next.  Making a choice to contribute in excess of the minimum amount should help reduce this volatility and allow improved planning for future contribution requirements. Any additional contributions will generally reduce the contributions required in future years. 

A Cash Balance Plan Twist

Cash balance plans offer a unique twist to the annual contribution decision process that can be beneficial, especially for plans used by smaller business to build retirement security for business owners.  In lieu of the MRC, sponsors of cash balance plans could consider making contributions that are equal to the contribution credits for the upcoming year plus the interest credit amounts.  As the contribution credits are either a flat dollar amount or tied to pay, the plan sponsor can easily predict the amount for the coming year by knowing the number of employees and their salaries.  The interest credit rate is determinable in advance as well, because the rate is either a defined static rate or a published market index that is known prior to the start of the plan year.  Using this particular strategy will help dampen the annual contribution volatility more so than the basic MRC funding strategy, and it can help avoid a surprise like having an unfunded plan if it is later decided to terminate the plan and settle benefits.  In addition to dampening volatility and helping achieve a fully-funded plan, these additional contributions can help minimize or eliminate PBGC variable rate premiums. 

Making the right annual contribution

So what is the optimal strategy for a plan sponsor?  That  depends on the sponsor’s available cash and appetite for risk.  While funding strategies can range from the simple to the complex, here are a few broad frameworks for consideration when evaluating contributing an amount in excess of the current minimum required contribution:

• Contribute at the minimum plus some additional margin,
• Make an additional adjustment to maintain or pursue a plan’s funded percentage (ratio of assets to liability) at a predetermined level,
• Develop a contribution using more reasonable discount rates than those currently used for setting the MRC, or
• Contribute an amount equal to a targeted percent of payroll.  

Whatever the approach, formulating and implementing a well-tailored funding strategy will help minimize funding surprises and can help provide more predictable and tolerable contribution requirements from one year to the next.