Pension Funding

Part Two of a Two-Part Article

Last month's installment presented an innovative approach to pension funding that provides employee life insurance benefits while creating income to fund an employer's pension plan. Using a third-party administrator owned by the Pension, death benefits for retired or withdrawn employees under this approach can inure to the Pension, thus creating income. The discussion detailed how the approach complies with UBTI rules, provides income that is not taxable, and meets PPA AFTAP certification requirements. This conclusion addresses: 1) whether the Program qualifies for AFTAP valuation as an asset; 2) whether the Program complies with COLI Best Practices of 2006 and IRC ' 101(j) and Notice 2009-48; and 3) whether the Program is a prohibited transaction.

Does the Program Qualify for AFTAP Valuation As an Asset?

The Statement of Financial Accounting Standards No. 157 (“SFAS 158″), Fair Value Measurements, explains how employers should measure fair value when they are required to use a fair value measure for recognition or disclosure purposes under GAAP. This new standard also provides a common definition of fair value, to be used where applicable in GAAP, and enumerates the existing standards that utilize fair value in various ways, which will be affected by the new standard. The FASB believes that the new standard will make the measurement of fair value more consistent and comparable, and improve disclosures about fair value measures. SFAS 157 is effective for financial Statements issued for fiscal years beginning after Nov. 15, 2007 (e.g., in 2008 for calendar-year-end companies).

SFAS 87, Employers' Accounting for Pensions (subsequently amended by SFAS 158, Employers' Accounting for Defined Benefit Pension and Other Postretirement Plans, an amendment of SFAS Statements No. 87, 88, 106, and 132(R)), was issued in 1985 and requires extensive use of present value techniques in estimating the current value of pension benefits earned each period, and the employer's liability for benefits accrued. It requires the disclosure of the fair value of plan assets.

The Government Accounting Standards Board (“GASB”) has finalized accounting standards GASB 25, 27, 43, and 45 for public sector entities. Because of these, governments must report costs that pertain to post-employment benefits other than pensions, known as OPEB (Other Post-Employment Benefits). These standards require that employers report liabilities that are accrued in Pension and OPEB plans over the service time of employees, rather than as the current year's cash outlay, as most employers (Public and Private Sector) previously reported.

In the past, employers would simply account for benefits on a “pay-as-you-go” basis when claims were actually paid. The new accrual accounting approach creates significantly higher annual accounting expenses than the previous cash basis. GASB 25 and 27, 43 and 45 serve the same purpose as FAS Statements 106 and 112, 87, and 158 for private and corporate employers, which have been in effect since the early 1990s. The accrual method is similar to GASB 25 and 27 for pension-related benefits.

• SFAS 87

In the absence of specific guidance from GASB 25 and 43, for governmental plans, SFAS 87 will apply to the insurance receivable to the Pension not only for private-sector but also for public-sector employers. The fair value of the post-retirement death benefits would be the present value, at a reasonable discount rate, of the death benefits to be received. Support for this comes from SFAS 87, paragraph 62:

Insurance contracts that are in substance equivalent to the purchase of annuities shall be accounted for as such. Other contracts with insurance entities shall be accounted for as investments and measured at fair value. For some contracts, the best available evidence of fair value may be contract value. If a contract has a determinable cash surrender value or conversion value, that is presumed to be its fair value.

The Pension cannot hold as an asset the cash value under the insurance contracts, because the Pension does not own the contracts outright. The interest the Pension has is a vested interest subject to divestment only upon the death of an employee previous to withdrawal from employment. The Pension does have a beneficial interest in the contracts, and so the question becomes how does one measure the value of that interest? To support the answer, note that the cash value of a life insurance contract is determined by the insurance company using a formula of the skeletal type: PV future benefits less PV future premiums.

The first term in this formula, “PV future benefits,” applies to the beneficial interest of the Pension in the life insurance. It is concluded that the Pension, using reasonable assumptions as to discount rate and mortality, can recognize an asset for its beneficial interest in the post-employment death benefits. Additionally, the Pension is not using its funds or assets to make premium payments for the Death Benefit, so there is no diminution of the PV future benefit by the future premiums. The pension cannot hold as an asset the cash value under the insurance contracts, because the pension does not currently own the contracts:

Cash value ' Not available to Employer, Employee or Plan;

Face amount ' Employee, if death is before withdrawal from employment;

Face amount ' Pension, if death is after employee's withdrawal from employment.

The Statement of Financial Accounting Standards No. 157, titled “Fair Value Measurements,” provides support for the pension trust to treat the present value of future claim payments as an asset.

Does the Program Comply with COLI Best Practices of 2006 and IRC ' 101(j) and Notice 2009-48?

The Program does comply with COLI Best Practices of 2006 and IRC ' 101(j) and Notice 2009-48. Because of the use of the actuarial stochastic method valuation and the co-ownership arrangement, the provisions of the COLI Best Practices are followed. The employer is not the owner of the policies or the named beneficiary, so the employer-owned life insurance provisions do not apply. The participant having the right to name a beneficiary during employment is a safe harbor for compliance purposes. This approach can also be wrapped around an existing COLI program to provide compliance on a tax-deductible basis.

Is the Program in Compliance With Notice 2009-48?