Legislative corner
Coping with Deflation
The Phantom “Bonus”
Many benefit plans (including Social
Security) are indexed to inflation, as
measured from the third quarter of one
year to the next. But only increases, not
decreases, are automatic. So when the
Consumer Price Index (CPI) declined
roughly 2% from 2008 to 2009, Social
Security benefits and most every benefit
plan limit remained unchanged in 2010.
While there was a popular outcry about
this, it actually represented a 2% net increase in benefits over the previous year
on an inflation-adjusted basis. But what
one hand giveth, the other taketh away.
These Social Security and other benefits plan “bonuses” will be clawed back
because any net gains must be accounted
for—i.e., taken out of—future increases
due to higher rates of inflation. How this
works is relatively simple. Since 2009 the
CPI for Urban Wage Earners and Clerical Workers (CPI-W) went down, while
benefits remained unchanged for 2010.
Any change in benefits for 2011 will be
based on CPI-W for 2010 relative to 2008
(not 2009). Thus, it will take roughly a
2% inflation level over the course of the
next year to break even. For example, if
there is 3% growth in CPI-W from the
third quarter 2009 to the third quarter
2010, Social Security benefits for 2011
will increase only by the excess 1%. The
longer CPI remains negative (which is to
say, deflationary), the longer it will take
on the back end to make up for that inflation-adjusted “increase” in unchanged
benefits payments.
A similar automatic adjustment basis
is used for various IRS benefit plan limits, such as the maximum 401(k) contribution. (However, CPI for All Urban
Consumers (CPI-U) is used instead of
CPI-W.) In addition, it’s important to
remember that these limits have rounded thresholds that have to be crossed
before a change is realized. The chart
below shows some key limits and the
inflation needed over this year to generate a change.
A slightly trickier indexed amount is
the Social Security Taxable Wage Base
($106,800 for 2009), which limits wages
subject to the 6.2% Social Security portion of the Federal Insurance Contributions Act (FICA) tax and moves with
changes in national average wages. Because of reporting lags, the most recent
wage index is for 2008, but this is used
in determining the 2010 taxable wage
base. While 2008 shows an increase of
2.3% over 2007, the taxable wage base
for 2010 did not increase since there is
no cost-of-living adjustment in Social
Security benefits for 2010. Thus, the
2010 taxable wage base will continue
to be $106,800.
For 2011, the taxable wage base increase will be based on the increase
in 2009 average wages over 2007 (not
2008, since there was not an adjustment in this year’s wage base). As long
as there is any cost-of-living adjustment
in Social Security benefits (recall, that
means inflation will have to exceed
2%), then the full two years of wage
growth between 2007 and 2009 will increase the 2011 taxable wage base.
2009 & 2010
Rounded
threshold ($)
2009
Unrounded
threshold ($)
2010 Unrounded
estimated
threshold ($)
Next
threshold ($)
Inflation
needed to
increase (%)
195,000
197,360
194,156
200,000
3.0
Defined contribution dollar limit 415(c)
49,000
49,340
48,539
50,000
3.0
401(k) deferral limit 402(g)
16,500
16,707
16,436
17,000
3.4
5,500
5,569
5,479
6,000
9.5
Qualified plan compensation limit 401(a)(17)
245,000
246,700
242,695
250,000
3.0
Highly compensated employee threshold 414(q)
110,000
111,472
109,662
115,000
4.9
Key Benefit Plan Limitations
Defined benefit dollar limit 415(b)
Catch up contribution limit 414(v)
Source: J.P. Morgan Compensation and Benefit Strategies
8
JOURN EY Winter 2010
Legislative corner
Implicit Impact?
Considering longevity risk
According to recent J.P. Morgan analysis,
the 2008 market decline increased the
retirement age for a typical employee by
as much as four years. When potential
employer actions like a 401(k) match suspension and/or pension plan freeze were
added, the retirement age increased by as
much as seven years.
By considering
an analytic framework built around
a participant’s
determination of
retirement supply, demand and
optimal retirement,
it is possible to establish a preferred distribution strategy. From this framework,
we have determined that:
A lump sum distribution from a
pension plan can increase a participant’s
•
optimal retirement age by as much
as two years (longevity risk
significantly increases).
401(k) match suspensions have a
relatively small impact on optimal
retirement age (less than six months).
Failure to incorporate assumptions
on assets outside of corporate retirement
plans can have a large impact on assessing
retirement readiness (availability of outside assets can reduce retirement age by
three to four years for a typical employee).
Given the large boomer cohort and
retirement planning stress of the last 18
months, monitoring employee retirement readiness has become a critical
component in corporate talent and
succession planning. Bureau of Labor Statistics data shows that over 40
percent of the American workforce will
be eligible to retire in the next 10 to 15
years. Arguably, managing the orderly
progression of boomer retirements may
be the most important task facing HR
executives in the next decade.
•
•
IRS final regulations on funding and benefit restrictions
In August 2006, Congress passed the Pension
Protection Act. In October 2009, over three
years later, the IRS finalized regulations,
319 pages worth, on DB funding and benefit
restrictions. What’s new? In short, not much.
Since the proposed regulations were first
released, updated guidance has crept out
in various forms. For example, the Worker,
Retiree, and Employer Recovery Act of 2008
(WRERA) already settled the asset “averaging vs. smoothing” debate, and an IRS newsletter in late September allowed plans to
make a fresh interest rate election for 2010,
which meant they could take advantage of
the unusually high spot yield curve for 2009
funding. The final regulations formalize such
changes, and clarify some other items:
The use of a “standing election” to
apply credit balances against minimum funding requirements.
Allowing sponsors that apply a
credit balance to minimum funding
requirements and then “over-contribute”
for the year to use the excess to replenish
their credit balances.
Elimination of a requirement in the
proposed regulations that plans offer
participants the right to defer payment of
the restricted portion of a prohibited payment beyond normal retirement age where
the plan did not otherwise provide for such
a deferral.
Clarification of rules for calculating
the prohibited portion of an accelerated payment that will allow payment of
Social Security level income benefits in
many cases.
Pension Funding
Relief
House Rep. Earl Pomeroy
(D-ND) continued his efforts
to help DB plans weather
the financial storm. On
October 27, 2009, he and
Representative Patrick
Tiberi (R-OH) introduced the Preserve
Benefits and Jobs
Act of 2009 (H.R.
3936). The major
provisions of the
bill follow closely Rep. Pomeroy’s
earlier discussion draft that we
summarized in our last edition, including extended amortization of
2008 investment losses, expansion
of the “asset smoothing” corridor,
and “lookbacks” to 2008 pre-loss
funded ratios for benefit restrictions and credit balance purposes.
The primary goal of these provisions is to help sponsors save
cash by delaying contribution
requirements.
What’s changed? As before, if
a sponsor takes advantage of the
extended amortization option, a
“maintenance of effort” will be required—e.g., maintain the DB plan
or, if it is already frozen, provide
a 3% allocation in the DC plan, or
freeze all non-qualified benefits.
However, the maintenance periods
have been cut in half in the bill
as introduced. Further, the final
bill removed the ability to make
a fresh interest rate selection for
2010 since the recently released
final IRS regulations now provide
that ability. Finally, the new version tightens up the “PBGC 4010”
reporting required for underfunded DB plans.
J.P. Morgan
J O U R NEY
9