Pension Funding: A Program to Maximize Pension Growth and Limit Volatility

In light of the last two years of market volatility and declines, regulatory disclosures and transparency, and the required acceleration of funding for benefits-qualified employee plans (Pensions), sponsors are continually attempting to create growth that will maximize the return on their investments and limit the volatility of their investments in the financial marketplace. Pensions and their sponsors must present a simple, straightforward way to meet their goals in a meaningful and effective manner. Employers that can use this approach include Public and Private Sector, Profit and Nonprofit, and State and Local Government. There is an ongoing effort to improve their return on investment and create growth.

When a Pension is addressing its liabilities and assets, it is important that it present a simple, straightforward way to fund for the future for its participants in a meaningful and effective manner. The volatility of the markets since 2007 has increased demands on the Pensions, as an uneasy balance of influences and the Pension Protection Act of 2006 (“PPA '06″) have required increasing funding levels to meet mandated levels.

In order to reach the PPA '06 goals, the following example of a multidisciplinary, actuarially based, patented approach based upon actuarial statistics, stochastic methods, and modeling (“The Program”) was developed. It provides benefits for active employees and participants, while creating an asset for the Pension.

Due to the economic and market factors relating to life insurance, approximately 73% of employees will not die before retirement, and approximately 85% of the death proceeds will inure to the Pension through ownership of a third-party administrator (“TPALLC”). The TPALLC will be 100% owned by the Pension and will provide the present value of the death benefit for withdrawn and retired employees to the Pension over the lives of insured, active employees. The TPALLC will contract with the employer to provide insurance on active employees, and upon the departure of an employee, either through retirement or change of jobs, all economic rights to the death benefit will inure to the TPALLC. The arrangement is not intended to have a tax effect on the participants other than the economic benefit under ' 79 and Table I, and the funds within the TPALLC are actuarially determined to assist in reaching the Pension's goals.

As described in “TPALLC Roadmap” on page 6, TPALLC will provide the insurance coverage, administer receipt of the premium payments, take whatever reinsurance steps it deems necessary, and distribute the death benefits upon death of an insured. The TPALLC provides the insurance policies, as the value of the TPALLC will be reflected as an asset of the Pension. The Pension assets will increase based on the present interest of the premium stream of the Employer's payments to the TPALLC.

Discussion

Providing the insurance coverage for active employees of the employer is in compliance with the unrelated business taxable income rules (UBTI ” 511-514 IRC). The TPALLC will be taxed as a partnership for federal income tax purposes.

In viewing the Program, an Employer should consider whether its activities can be construed to violate any of the qualified plan rules and other compliance issues. A Pension is generally exempt from federal income tax. However, such an organization is nonetheless subject to tax, at corporate tax rates, on its “unrelated business taxable income” (“UBTI”) in excess of $1,000 per taxable year. Section 511(a) imposes a tax on the unrelated business taxable income (as defined in ' 512) of every organization otherwise exempt under ' 501(a), which includes organizations described in ' 401(a). Section 512 defines “unrelated business taxable income” to mean the gross income derived by any [exempt] organization from any unrelated trade or business (as defined in ' 513) regularly carried on by it, less the deductions allowed that are directly connected with the carrying on of such trade or business.

Section 513 states the general rule that the term “unrelated trade or business” means, in the case of any organization subject to tax under ' 511, any trade or business the conduct of which is not substantially related (aside from the need of such organization for income or funds or the use it makes of the profits derived) to the exercise or performance by such organization or its charitable, educational, or other purpose or function constituting the basis for its exemption under ' 501. TAM 97-39-001 provides additional protection and direction where the TPALLC income can be excluded as UBTI, had the Pension itself engaged in the activity.

However, for Public Sector employers ' 115(2) provides that gross income does not include income derived from the exercise of any essential governmental function that accrues to a state or political subdivision. Rev. Rul. 90-74, 1990-2 C.B. 34 held that income generated to provide insurance is excluded from gross income under ' 115.

If the Pension receives income that is not specifically excluded from UBTI (e.g., dividends, interest, and annuity payments), such gross income will be UBTI, except insurance company contracts. The Pension does not receive any such income.

Section 101(a)(1) provides a general rule that gross income does not include amounts received (whether in a single sum or otherwise) under a life insurance contract, if such amounts are paid by reason of the death of the insured. Section 101(a)(2) creates an exception from the general rule in the case of a transfer for a valuable consideration, by assignment or otherwise, of a life insurance contract or interest therein, in which case the amount excluded from gross income shall not exceed the sum of the value of the consideration and the premiums and other amounts subsequently paid by the transferee. Section 101(a)(2) provides further that the exception to the general rule of exclusion does not apply if (A) the life insurance contract or interest therein has a basis in the hands of the transferee determined, based on the basis in the hands of the transferor; or (B) if the transfer is to the insured, to a partner of the insured, to a partnership in which the insured is a partner, or to a corporation in which the insured is a shareholder or officer.

Under the Program, the TPALLC is providing life insurance coverage to employees with the Employer funds, the death benefit paid and distributed to active employees or reverting to the Pension. This program complies with all rules and regulations. In United States v. American Bar Endowment, 477 U.S. 105 (1986), and in Private Letter Ruling 9223002 (1992), a ' 501(a) organization participated in a casualty insurance promotion program. The organization provided a list of its members to an insurance company and advised its members of the availability of insurance coverage. Under a rebate program, the insurance company paid the Pension a share of the net profits from the program. The IRS ruled that the rebates were UBTI, because they stemmed from a regularly carried on trade or business that was not substantially related to the organization planning to replicate in the foreseeable future to non-employees of the employer.

Section 501(m) denies tax-exempt status solely to a ' 501(c)(3) and (c)(4) organization if a substantial part of its activities “consists of providing commercial-type insurance.” This does not affect a ' 401(a) qualifying entity. Thus, ' 501(m) is not applicable to The Program.

Section 512(b)(17) provides that dividends and other items of income generally excluded from UBTI under ' 512(b)(1) can nonetheless be treated as UBTI. In The Program, after the employee terminates employment, the benefit being received is the death benefit proceeds otherwise generally excluded from the definition of gross income under ' 101. Thus, the ' 512(b)(17) UBTI inclusion does not apply.

In Mose and Garrison Siskin Memorial Foundation v. U.S., 790 F.2d 480 (6th Cir. 1986), the court held that withdrawals against the accumulated cash value of life insurance policies were “indebtedness” for the purpose of finding “acquisition indebtedness.” Implicit in this holding is that the life insurance policies produced either no gross income or the passive type of income excludible from UBTI under ' 512(b), but for the fact that they created acquisition indebtedness. Under The Program the Pension will not receive any proceeds from a life insurance policy until the death of an insured; i.e., there will be no draw down of the cash surrender value by TPALLC or the Pension. The allocation and distribution by TPALLC of life insurance contracts to the Pension will not be an allocation of UBTI to the Pension either, because such proceeds are excluded from the definition of gross income under ” 101 and 115, or the Pension under ' 512(b)(1). In the absence of debt-financed property, policy dividends and life insurance income distributions will be excluded from UBTI for the Pension under ' 512(b)(1).

Under ' 514(b)(1), “debt-financed property” means any property that is held for the production of income with respect to which there is acquisition indebtedness. Where, as here, the Pension does not borrow money to acquire the benefits of the TPALLC or death benefits, there should not be any “acquisition indebtedness” within the meaning of ' 514(c)(1) with respect to the Pension and accordingly its benefits from the Program will not be considered to be income from “debt-financed property” under ' 514(b)(1). As a result, TPALLC distributions to the Pension should not be considered unrelated debt-financed income under ' 514.

Section 512(b)(13) will not cause the Pension to have UBTI from its interests in TPALLC. The Committee Reports on P.L. 105-206 (IRS Restructuring and Reform Act of 1998) clarify the purpose of ' 512(b)(13), viz., that rent, royalty, annuity,
and interest income that would otherwise be excluded from UBTI is included in UBTI under ' 512(b)(13) if such income is received or accrued from a taxable or tax-exempt subsidiary that is controlled by the parent of the Pension. The purpose of this provision is to prevent a taxable subsidiary that is controlled by the Pension from making a payment to the controlling entity so as to reduce the taxable subsidiary's income. Since the TPALLC and Pension will not be in control of the commercial life insurance company or companies issuing the insurance or reinsurance policies, ' 512(b)(13) will not apply to cause the allocations to the Pension of life insurance proceeds or premium to become UBTI to the Pension.

No Adverse Impact on Pension's Tax Exempt Status Under '401(a)

Section 401(a) provides for the exemption from federal income taxes of organizations that do not engage in proscribed legislative and political activities.

Section 501(m)(1) provides that only organizations described in
” 501(c)(3) and (4) shall be limited in providing “commercial-type insurance.” TPALLC does not provide the insurance ' it is provided by the Insurer.

No part of the Pension's activities, either with respect to the Program receiving revenues or death benefit will affect exempt status under ' 401(a), and a ' 501(a) organization will not be adversely affected by participation in the Program.

PPA '06 and AFTAP

PPA '06 created a new series of requirements and introduced a new acronym, AFTAP (Adjusted Funding Target Attainment Percentage), requiring certification requirements for a Defined Benefit Pension Plan. AFTAP plan certification is the result of IRS-proposed regulations that create benefit restrictions to underfunded plans. AFTAP certifications are required to ensure that all qualified Defined Benefit Pension Plans satisfy new funding requirements brought about by PPA. AFTAP is the ratio of a plan's asset values as compared to the plan's benefits that have accrued up to the valuation date. A plan's actuary is required under PPA to certify annually that the plan's AFTAP meets the new funding requirements. There are consequences to plans with low AFTAP ratios, and under some circumstances the AFTAP ratio must be calculated and certified more frequently.

In addition, if the certified specific AFTAP is not within the range, the plan faces difficulties if the difference causes a “material change.” There is a “material change” if plan operations with respect to benefits, taking into account any actual contributions and elections based on the range certification, would have been different based on the subsequent certified specific AFTAP. The Program does not create a material change and complies with the AFTAP rules.

Next month's installment will address: 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.

Lawrence L. Bell, a member of this newsletter's Board of Editors, is Counsel Special Projects for Lynchval Systems Worldwide. He teaches business and estate planning to actuaries, attorneys, accountants, financial planners, and insurance professionals. He is a qualified expert, and testifies on taxes and benefits. Bell works with entrepreneurial, profit, nonprofit, and government organizations in strategic planning on a regional, national, and international basis. He served as Tax Bar liaison to the IRS for 10 years. He has received patents in actuarial product fields dealing with COLI, BOLI, GASB, FASB, IASB, and OPEB solutions. He authors articles and speaks nationally about Decision Trees on COLI Best Practices, 409A, and Benefit Planning.

In light of the last two years of market volatility and declines, regulatory disclosures and transparency, and the required acceleration of funding for benefits-qualified employee plans (Pensions), sponsors are continually attempting to create growth that will maximize the return on their investments and limit the volatility of their investments in the financial marketplace. Pensions and their sponsors must present a simple, straightforward way to meet their goals in a meaningful and effective manner. Employers that can use this approach include Public and Private Sector, Profit and Nonprofit, and State and Local Government. There is an ongoing effort to improve their return on investment and create growth.

When a Pension is addressing its liabilities and assets, it is important that it present a simple, straightforward way to fund for the future for its participants in a meaningful and effective manner. The volatility of the markets since 2007 has increased demands on the Pensions, as an uneasy balance of influences and the Pension Protection Act of 2006 (“PPA '06″) have required increasing funding levels to meet mandated levels.

In order to reach the PPA '06 goals, the following example of a multidisciplinary, actuarially based, patented approach based upon actuarial statistics, stochastic methods, and modeling (“The Program”) was developed. It provides benefits for active employees and participants, while creating an asset for the Pension.

Due to the economic and market factors relating to life insurance, approximately 73% of employees will not die before retirement, and approximately 85% of the death proceeds will inure to the Pension through ownership of a third-party administrator (“TPALLC”). The TPALLC will be 100% owned by the Pension and will provide the present value of the death benefit for withdrawn and retired employees to the Pension over the lives of insured, active employees. The TPALLC will contract with the employer to provide insurance on active employees, and upon the departure of an employee, either through retirement or change of jobs, all economic rights to the death benefit will inure to the TPALLC. The arrangement is not intended to have a tax effect on the participants other than the economic benefit under ' 79 and Table I, and the funds within the TPALLC are actuarially determined to assist in reaching the Pension's goals.

As described in “TPALLC Roadmap” on page 6, TPALLC will provide the insurance coverage, administer receipt of the premium payments, take whatever reinsurance steps it deems necessary, and distribute the death benefits upon death of an insured. The TPALLC provides the insurance policies, as the value of the TPALLC will be reflected as an asset of the Pension. The Pension assets will increase based on the present interest of the premium stream of the Employer's payments to the TPALLC.

Discussion

Providing the insurance coverage for active employees of the employer is in compliance with the unrelated business taxable income rules (UBTI ” 511-514 IRC). The TPALLC will be taxed as a partnership for federal income tax purposes.

In viewing the Program, an Employer should consider whether its activities can be construed to violate any of the qualified plan rules and other compliance issues. A Pension is generally exempt from federal income tax. However, such an organization is nonetheless subject to tax, at corporate tax rates, on its “unrelated business taxable income” (“UBTI”) in excess of $1,000 per taxable year. Section 511(a) imposes a tax on the unrelated business taxable income (as defined in ' 512) of every organization otherwise exempt under ' 501(a), which includes organizations described in ' 401(a). Section 512 defines “unrelated business taxable income” to mean the gross income derived by any [exempt] organization from any unrelated trade or business (as defined in ' 513) regularly carried on by it, less the deductions allowed that are directly connected with the carrying on of such trade or business.

Section 513 states the general rule that the term “unrelated trade or business” means, in the case of any organization subject to tax under ' 511, any trade or business the conduct of which is not substantially related (aside from the need of such organization for income or funds or the use it makes of the profits derived) to the exercise or performance by such organization or its charitable, educational, or other purpose or function constituting the basis for its exemption under ' 501. TAM 97-39-001 provides additional protection and direction where the TPALLC income can be excluded as UBTI, had the Pension itself engaged in the activity.

However, for Public Sector employers ' 115(2) provides that gross income does not include income derived from the exercise of any essential governmental function that accrues to a state or political subdivision. Rev. Rul. 90-74, 1990-2 C.B. 34 held that income generated to provide insurance is excluded from gross income under ' 115.

If the Pension receives income that is not specifically excluded from UBTI (e.g., dividends, interest, and annuity payments), such gross income will be UBTI, except insurance company contracts. The Pension does not receive any such income.

Section 101(a)(1) provides a general rule that gross income does not include amounts received (whether in a single sum or otherwise) under a life insurance contract, if such amounts are paid by reason of the death of the insured. Section 101(a)(2) creates an exception from the general rule in the case of a transfer for a valuable consideration, by assignment or otherwise, of a life insurance contract or interest therein, in which case the amount excluded from gross income shall not exceed the sum of the value of the consideration and the premiums and other amounts subsequently paid by the transferee. Section 101(a)(2) provides further that the exception to the general rule of exclusion does not apply if (A) the life insurance contract or interest therein has a basis in the hands of the transferee determined, based on the basis in the hands of the transferor; or (B) if the transfer is to the insured, to a partner of the insured, to a partnership in which the insured is a partner, or to a corporation in which the insured is a shareholder or officer.

Under the Program, the TPALLC is providing life insurance coverage to employees with the Employer funds, the death benefit paid and distributed to active employees or reverting to the Pension. This program complies with all rules and regulations. In United States v. American Bar Endowment , 477 U.S. 105 (1986), and in Private Letter Ruling 9223002 (1992), a ' 501(a) organization participated in a casualty insurance promotion program. The organization provided a list of its members to an insurance company and advised its members of the availability of insurance coverage. Under a rebate program, the insurance company paid the Pension a share of the net profits from the program. The IRS ruled that the rebates were UBTI, because they stemmed from a regularly carried on trade or business that was not substantially related to the organization planning to replicate in the foreseeable future to non-employees of the employer.

Section 501(m) denies tax-exempt status solely to a ' 501(c)(3) and (c)(4) organization if a substantial part of its activities “consists of providing commercial-type insurance.” This does not affect a ' 401(a) qualifying entity. Thus, ' 501(m) is not applicable to The Program.

Section 512(b)(17) provides that dividends and other items of income generally excluded from UBTI under ' 512(b)(1) can nonetheless be treated as UBTI. In The Program, after the employee terminates employment, the benefit being received is the death benefit proceeds otherwise generally excluded from the definition of gross income under ' 101. Thus, the ' 512(b)(17) UBTI inclusion does not apply.

In Mose and Garrison Siskin Memorial Foundation v. U.S. , 790 F.2d 480 (6th Cir. 1986), the court held that withdrawals against the accumulated cash value of life insurance policies were “indebtedness” for the purpose of finding “acquisition indebtedness.” Implicit in this holding is that the life insurance policies produced either no gross income or the passive type of income excludible from UBTI under ' 512(b), but for the fact that they created acquisition indebtedness. Under The Program the Pension will not receive any proceeds from a life insurance policy until the death of an insured; i.e., there will be no draw down of the cash surrender value by TPALLC or the Pension. The allocation and distribution by TPALLC of life insurance contracts to the Pension will not be an allocation of UBTI to the Pension either, because such proceeds are excluded from the definition of gross income under ” 101 and 115, or the Pension under ' 512(b)(1). In the absence of debt-financed property, policy dividends and life insurance income distributions will be excluded from UBTI for the Pension under ' 512(b)(1).

Under ' 514(b)(1), “debt-financed property” means any property that is held for the production of income with respect to which there is acquisition indebtedness. Where, as here, the Pension does not borrow money to acquire the benefits of the TPALLC or death benefits, there should not be any “acquisition indebtedness” within the meaning of ' 514(c)(1) with respect to the Pension and accordingly its benefits from the Program will not be considered to be income from “debt-financed property” under ' 514(b)(1). As a result, TPALLC distributions to the Pension should not be considered unrelated debt-financed income under ' 514.

Section 512(b)(13) will not cause the Pension to have UBTI from its interests in TPALLC. The Committee Reports on P.L. 105-206 (IRS Restructuring and Reform Act of 1998) clarify the purpose of ' 512(b)(13), viz., that rent, royalty, annuity,
and interest income that would otherwise be excluded from UBTI is included in UBTI under ' 512(b)(13) if such income is received or accrued from a taxable or tax-exempt subsidiary that is controlled by the parent of the Pension. The purpose of this provision is to prevent a taxable subsidiary that is controlled by the Pension from making a payment to the controlling entity so as to reduce the taxable subsidiary's income. Since the TPALLC and Pension will not be in control of the commercial life insurance company or companies issuing the insurance or reinsurance policies, ' 512(b)(13) will not apply to cause the allocations to the Pension of life insurance proceeds or premium to become UBTI to the Pension.

No Adverse Impact on Pension's Tax Exempt Status Under '401(a)

Section 401(a) provides for the exemption from federal income taxes of organizations that do not engage in proscribed legislative and political activities.

Section 501(m)(1) provides that only organizations described in
” 501(c)(3) and (4) shall be limited in providing “commercial-type insurance.” TPALLC does not provide the insurance ' it is provided by the Insurer.

No part of the Pension's activities, either with respect to the Program receiving revenues or death benefit will affect exempt status under ' 401(a), and a ' 501(a) organization will not be adversely affected by participation in the Program.

PPA '06 and AFTAP

PPA '06 created a new series of requirements and introduced a new acronym, AFTAP (Adjusted Funding Target Attainment Percentage), requiring certification requirements for a Defined Benefit Pension Plan. AFTAP plan certification is the result of IRS-proposed regulations that create benefit restrictions to underfunded plans. AFTAP certifications are required to ensure that all qualified Defined Benefit Pension Plans satisfy new funding requirements brought about by PPA. AFTAP is the ratio of a plan's asset values as compared to the plan's benefits that have accrued up to the valuation date. A plan's actuary is required under PPA to certify annually that the plan's AFTAP meets the new funding requirements. There are consequences to plans with low AFTAP ratios, and under some circumstances the AFTAP ratio must be calculated and certified more frequently.

In addition, if the certified specific AFTAP is not within the range, the plan faces difficulties if the difference causes a “material change.” There is a “material change” if plan operations with respect to benefits, taking into account any actual contributions and elections based on the range certification, would have been different based on the subsequent certified specific AFTAP. The Program does not create a material change and complies with the AFTAP rules.

Next month's installment will address: 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.

Lawrence L. Bell, a member of this newsletter's Board of Editors, is Counsel Special Projects for Lynchval Systems Worldwide. He teaches business and estate planning to actuaries, attorneys, accountants, financial planners, and insurance professionals. He is a qualified expert, and testifies on taxes and benefits. Bell works with entrepreneurial, profit, nonprofit, and government organizations in strategic planning on a regional, national, and international basis. He served as Tax Bar liaison to the IRS for 10 years. He has received patents in actuarial product fields dealing with COLI, BOLI, GASB, FASB, IASB, and OPEB solutions. He authors articles and speaks nationally about Decision Trees on COLI Best Practices, 409A, and Benefit Planning.