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

The SDP will provide an asset comprised of debt (mortgages, student loans, credit card debt) secured by life insurance on the debtor. The debt and insurance are owned by the trustee, who is responsible to obtain the debt and the insurance coverage, administer receipt of the premium payments, take whatever reinsurance steps it deems necessary, and distribute proceeds from the payment of the collection of the debt and the death benefits upon death of an insured. The SDP will be growing over time, and the value of the SDP will be reflected as an asset of the Pension. The Pension assets will increase based on the present interest of the revenue stream of payments to the SDP over the life of the Pension.

Discussion

In viewing the Program, a plan sponsor and/or trustees should consider whether their 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 SDP 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 SDP were considered to be transparent (i.e., not a part of the transaction), the revenue stream for the recovery of the debt securitized by life insurance would not trigger any unrelated business income.

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 and SDP do 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 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 SDP is providing life insurance coverage on the debtors with the plan sponsor and/or Pension's 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 something the organization was 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, if the debt has not been paid off before the debtor's death, 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 Moose 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 SDP or the Pension. The allocation and distribution by SDP 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 SDP 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, SDP 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 SDP. 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 are 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 SDP 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.” The SDP 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 and MAP-21

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.

Does the Program Qualify for AFTAP Valuation As an Asset?

The Statement of Financial Accounting Standards No. 157 (“SFAS 157″), 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 Board 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 companies 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 payment of the indebtedness the Pension purchased previous to the death of the insured. The Pension does have a beneficial interest in the contracts through its ownership interest in the SDP, 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 amount ' During the period of contributions to the SDP the plan sponsor and trustees cannot access the funds, therefore the cash value cannot be booked as an asset;
• Face amount ' SDP, if death is before debtor satisfies claim;
• Face amount ' SDP, if death is after payment of indebtedness because insurable interest is determined at date of issuance.

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 revenue stream 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 on any employee of the employer or participants in the plan, 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.

Is the Program in Compliance With Notice 2009-48?

Notice 2009-48 provides new guidance in the form of 17 questions and answers, which are divided into five separate categories. The provisions that could adversely affect the Program are positively addressed:

Definition of Employer-Owned Life Insurance Contract: “Employer-owned life insurance contract” is defined in ' 101(1)(3) as a life insurance contract (i) which is owned by a person engaged in a trade or business and under which such person (or a related person) is directly or indirectly a beneficiary and (ii) which covers the life of an insured who is an employee of the applicable policyholder on the date the contract is issued. In addition, the term “applicable policyholder” generally means the person who owns the employer-owned life insurance contract and any person who bears a relationship specified in ” 267(b) or 707(b)(1) to the owner of the contract or who is engaged in trades or businesses with the owner of the contract which trades or businesses are under common control within the meaning of ' 52(a) or (b).

Section 101(j) does not apply if the contract owner is not engaged in a trade or business: A contract cannot be an employer-owned life insurance contract if it is owned by a person who is not engaged in a trade or business. The notice includes two specific examples. The first involves a contract that is owned by the owner of an entity engaged in a trade or business (such as for the purpose of financing the purchase of an equity interest of another owner). The second example involves a contract that is owned by a Qualified Retirement Plan or VEBA (“Voluntary Employees' Beneficiary Association”) that is sponsored by an entity engaged in a trade or business. The IRS concludes that in each example the contract is not an employer-owned life insurance contract because the actual owner of the contract is not itself engaged in a trade or business. The notice provides further, however, that a contract that is owned by a grantor trust (such as a rabbi trust), the assets of which are treated as assets of a grantor that is engaged in a trade or business, may be an employer-owned life insurance contract.

Does the Pension Have an Insurable Interest in the Debtor?

Yes, under applicable state insurance laws a creditor (Pension) has an insurable interest in an insured (debtor) that owes money to the creditor. Additionally the insured is not required to consent to the issuance of the policy where the creditor uses its own money to pay the premiums.

Is the Program a Prohibited Transaction?

The Program is not a prohibited transaction. A review of the operative documents and the regulations by the Office of Exempt Determinations of the Employee Benefits Security Administration at the Department of Labor determined that there is no prohibited transaction and there is no party in interest that is unduly benefiting. The employee or the pension are the only entities that receive a death benefit; the employer is merely providing the premium for the benefit.

How Does SDP Affect MAP-21 Calculations?

In basic terms, the Moving Ahead for Progress in the 21st Century Act provides underfunded Pension plans “breathing room” by adjusting the methodology for determining the discount rate. This essentially would allow a lesser Annual Retirement Contribution (“ARC”) right now, but does increase the overall liability. The Society of Actuaries 2012 report titled “Proposed Pension Funding Stabilization: How Does It Affect the Single-Employer Defined Benefit System?” supports this and warns that by using the MAP-21 election you are getting a short-term benefit while opening the fund up to additional unfunded liabilities with no assurances of being able to meet those goals.

Thus, MAP-21, if employed by the Pension, does not reduce the total liability for funding the Plan; it only delays it, which could create additional issues of underfunding down the road.

The use of the SDP with MAP-21 will allow for a net reduction of the liability because of the increased assets in the Plan, and the use of the reduced discount rate allows additional savings over the Plan's duration without increasing the cost and annual contributions. In basic terms, MAP-21 provides underfunded pension plans “breathing room” by adjusting the methodology for determining the discount rate. This essentially would allow a lesser ARC right now, but does increase the overall liability. The Society of Actuaries report supports this and warns that by using the MAP-21 election you are getting a short-term benefit while opening the fund up to additional unfunded liabilities with no assurances of being able to meet those goals.

This year, two GASB Statements create additional transparency for accounting and financial reporting of pensions by state and local governments and pension plans. Statement No. 67, Financial Reporting for Pension Plans, affects financial reporting for state and local government pension plans. And Statement No. 68, Accounting and Financial Reporting for Pensions, requires new accounting and financial reporting requirements for governments that provide their employees with pensions.

These Statements will change how governments calculate and report the costs and obligations associated with pensions. This reported pension information increases the transparency, consistency and comparability of pension information across governments. The use of the Program with this “just in time” accounting will provide less stress and volatility in the investment portfolio.

Statement 67 replaces the requirements of Statement No. 25, Financial Reporting for Defined Benefit Pension Plans and Note Disclosures for Defined Contribution Plans, and Statement 68 replaces the requirements of Statement No. 27, Accounting for Pensions by State and Local Governmental Employers. The new Statements also replace the requirements of Statement No. 50, Pension Disclosures, for those governments and pension plans.

Plan Sponsors provide pension benefits through various types of defined benefit pension plans, which specify the amount of benefits to be provided to the employees after the end of their employment. Single-employer pension plans provide pension benefits to the employees of one employer (a single employer). Multiple-employer pension plans provide pension benefits to the employees of more than one employer. Under an agent multiple-employer pension plan, the assets of a multiple-employer pension plan are pooled for investment purposes but separate “accounts” are maintained for each individual agent employer, so that each agent employer's share of the pooled assets is legally available to pay the pensions of only its employees. In a cost-sharing multiple-employer pension plan, cost-sharing employers share their assets and their obligations to provide pension benefits to their employees ' plan assets can be used to pay the pensions of the employees of any employer that provides pensions through the reporting by plan sponsors in defined benefit plans.

Plan sponsors have a present obligation to pay deferred benefits in the future ' a total pension liability ' once they have been earned. When the total pension liability exceeds the pension plan's net assets (now referred to as plan net position) available for paying benefits, there is a net pension liability. Plan sponsors will now be required to report that amount as a liability in their accrual-based financial statements (for example, the government-wide statement of net position). The Pension's net position available for paying benefits is to be measured using the same valuation methods that are used by the pension plan for purposes of preparing its financial statements, including measuring investments at fair value.

This is an important change that will more clearly depict the plan sponsor's financial position. The former position gives the appearance that a Plan Sponsor is financially weaker than it was previously; the financial reality of the government's situation will not have changed. Reporting the net pension liability (or asset, if plan net position exceeds the total pension liability) on the face of the financial statements will more clearly portray the government's financial status because the pension liability will be placed on an equal footing with other long-term
obligations. The use of the Program that will match the liabilities with the occurrence of the revenue stream will permit an asset valuation that will reduce liabilities in the most economically efficient fashion.

Conclusion

With proper planning, the Pension can meet regulations, be funded to the acceptable green zone levels (80%) and reduce the annual net periodic pension funding requirement.

Lawrence L. Bell, JD, LTM, CLU, ChFC, CFP', AEP, a member of this newsletter's Board of Editors, has served as Tax Bar liaison to the IRS for 10 years. He has received patents in actuarial product fields dealing with COLI, 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 five 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, those utilizing Taft-Hartley plans, and state and local governments. 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 fund for the future for its participants. The volatility of the markets since 2007 has increased demands on 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. Additional breathing room has occurred with the passing of the Moving Ahead for Progress in the 21st Century Act (“MAP-21″). In order to reach the PPA '06 MAP-21 goals, the following example of a multidisciplinary, actuarially based, patented approach based upon actuarial statistics, patented and stochastic methods, and modeling (“the Program”) was developed. Contributions funding a securitized debt portfolio (“SDP”) that is not volatile, provide guarantees, and are not chasing alpha, while creating an asset for the Pension.

The Pension purchases a portfolio of unsecured debt that is securitized by permanent life insurance on the lives of the debtors. Employing this patented product effectively creates a secured debt from one that was previously unsecured. The net present value (“NPV”) of this SDP is then determined by discounting the future revenue flows of these underlying assets. The GASB, IASB and FASB accounting rules require that the NPV of the plan portfolio be fully recognized immediately upon purchase. Additionally, the annual maintenance fee outlays in future years are not required to be recorded until the year in which they occur. This creates a multiplier effect for the Pension. The reality, from a purely economic perspective, is that even absent the multiplier effect, an SDP acts to reduce volatility and creates guarantees of revenue enhancement for the Pension. Due to the economic and market factors relating to alternate investments through ownership of the SDP, the Pension receives the added benefit of meeting Financial Accounting Standards (“FAS”), Government Accounting Standards (“GAS”) and International Accounting Standards (“IAS”) and recognizing an immediate multiplier effect. The SDP will be 100% owned by the Pension and will provide the present value of the asset purchased at a discount together with a death benefit securitizing the debt instrument for the Pension over the life of the Pension. The trustee of the SDP will contract with the Pension trustees to provide insurance on the debt holder, and upon the death of the debtor, if the debt had not been satisfied to the SDP, the insurance carrier will provide payment covering the indebtedness. The arrangement is not intended to have a tax effect on the debtor, and the assets within the SDP are actuarially determined to assist in reaching the Pension's goals.

The SDP will provide an asset comprised of debt (mortgages, student loans, credit card debt) secured by life insurance on the debtor. The debt and insurance are owned by the trustee, who is responsible to obtain the debt and the insurance coverage, administer receipt of the premium payments, take whatever reinsurance steps it deems necessary, and distribute proceeds from the payment of the collection of the debt and the death benefits upon death of an insured. The SDP will be growing over time, and the value of the SDP will be reflected as an asset of the Pension. The Pension assets will increase based on the present interest of the revenue stream of payments to the SDP over the life of the Pension.

Discussion

In viewing the Program, a plan sponsor and/or trustees should consider whether their 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 SDP 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 SDP were considered to be transparent (i.e., not a part of the transaction), the revenue stream for the recovery of the debt securitized by life insurance would not trigger any unrelated business income.

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 and SDP do 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 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 SDP is providing life insurance coverage on the debtors with the plan sponsor and/or Pension's 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 something the organization was 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, if the debt has not been paid off before the debtor's death, 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 Moose 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 SDP or the Pension. The allocation and distribution by SDP 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 SDP 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, SDP 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 SDP. 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 are 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 SDP 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.” The SDP 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 and MAP-21

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.

Does the Program Qualify for AFTAP Valuation As an Asset?

The Statement of Financial Accounting Standards No. 157 (“SFAS 157″), 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 Board 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 companies 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 payment of the indebtedness the Pension purchased previous to the death of the insured. The Pension does have a beneficial interest in the contracts through its ownership interest in the SDP, 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 amount ' During the period of contributions to the SDP the plan sponsor and trustees cannot access the funds, therefore the cash value cannot be booked as an asset;
• Face amount ' SDP, if death is before debtor satisfies claim;
• Face amount ' SDP, if death is after payment of indebtedness because insurable interest is determined at date of issuance.

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 revenue stream 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 on any employee of the employer or participants in the plan, 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.

Is the Program in Compliance With Notice 2009-48?

Notice 2009-48 provides new guidance in the form of 17 questions and answers, which are divided into five separate categories. The provisions that could adversely affect the Program are positively addressed:

Definition of Employer-Owned Life Insurance Contract: “Employer-owned life insurance contract” is defined in ' 101(1)(3) as a life insurance contract (i) which is owned by a person engaged in a trade or business and under which such person (or a related person) is directly or indirectly a beneficiary and (ii) which covers the life of an insured who is an employee of the applicable policyholder on the date the contract is issued. In addition, the term “applicable policyholder” generally means the person who owns the employer-owned life insurance contract and any person who bears a relationship specified in ” 267(b) or 707(b)(1) to the owner of the contract or who is engaged in trades or businesses with the owner of the contract which trades or businesses are under common control within the meaning of ' 52(a) or (b).

Section 101(j) does not apply if the contract owner is not engaged in a trade or business: A contract cannot be an employer-owned life insurance contract if it is owned by a person who is not engaged in a trade or business. The notice includes two specific examples. The first involves a contract that is owned by the owner of an entity engaged in a trade or business (such as for the purpose of financing the purchase of an equity interest of another owner). The second example involves a contract that is owned by a Qualified Retirement Plan or VEBA (“Voluntary Employees' Beneficiary Association”) that is sponsored by an entity engaged in a trade or business. The IRS concludes that in each example the contract is not an employer-owned life insurance contract because the actual owner of the contract is not itself engaged in a trade or business. The notice provides further, however, that a contract that is owned by a grantor trust (such as a rabbi trust), the assets of which are treated as assets of a grantor that is engaged in a trade or business, may be an employer-owned life insurance contract.

Does the Pension Have an Insurable Interest in the Debtor?

Yes, under applicable state insurance laws a creditor (Pension) has an insurable interest in an insured (debtor) that owes money to the creditor. Additionally the insured is not required to consent to the issuance of the policy where the creditor uses its own money to pay the premiums.

Is the Program a Prohibited Transaction?

The Program is not a prohibited transaction. A review of the operative documents and the regulations by the Office of Exempt Determinations of the Employee Benefits Security Administration at the Department of Labor determined that there is no prohibited transaction and there is no party in interest that is unduly benefiting. The employee or the pension are the only entities that receive a death benefit; the employer is merely providing the premium for the benefit.

How Does SDP Affect MAP-21 Calculations?

In basic terms, the Moving Ahead for Progress in the 21st Century Act provides underfunded Pension plans “breathing room” by adjusting the methodology for determining the discount rate. This essentially would allow a lesser Annual Retirement Contribution (“ARC”) right now, but does increase the overall liability. The Society of Actuaries 2012 report titled “Proposed Pension Funding Stabilization: How Does It Affect the Single-Employer Defined Benefit System?” supports this and warns that by using the MAP-21 election you are getting a short-term benefit while opening the fund up to additional unfunded liabilities with no assurances of being able to meet those goals.

Thus, MAP-21, if employed by the Pension, does not reduce the total liability for funding the Plan; it only delays it, which could create additional issues of underfunding down the road.

The use of the SDP with MAP-21 will allow for a net reduction of the liability because of the increased assets in the Plan, and the use of the reduced discount rate allows additional savings over the Plan's duration without increasing the cost and annual contributions. In basic terms, MAP-21 provides underfunded pension plans “breathing room” by adjusting the methodology for determining the discount rate. This essentially would allow a lesser ARC right now, but does increase the overall liability. The Society of Actuaries report supports this and warns that by using the MAP-21 election you are getting a short-term benefit while opening the fund up to additional unfunded liabilities with no assurances of being able to meet those goals.

This year, two GASB Statements create additional transparency for accounting and financial reporting of pensions by state and local governments and pension plans. Statement No. 67, Financial Reporting for Pension Plans, affects financial reporting for state and local government pension plans. And Statement No. 68, Accounting and Financial Reporting for Pensions, requires new accounting and financial reporting requirements for governments that provide their employees with pensions.

These Statements will change how governments calculate and report the costs and obligations associated with pensions. This reported pension information increases the transparency, consistency and comparability of pension information across governments. The use of the Program with this “just in time” accounting will provide less stress and volatility in the investment portfolio.

Statement 67 replaces the requirements of Statement No. 25, Financial Reporting for Defined Benefit Pension Plans and Note Disclosures for Defined Contribution Plans, and Statement 68 replaces the requirements of Statement No. 27, Accounting for Pensions by State and Local Governmental Employers. The new Statements also replace the requirements of Statement No. 50, Pension Disclosures, for those governments and pension plans.

Plan Sponsors provide pension benefits through various types of defined benefit pension plans, which specify the amount of benefits to be provided to the employees after the end of their employment. Single-employer pension plans provide pension benefits to the employees of one employer (a single employer). Multiple-employer pension plans provide pension benefits to the employees of more than one employer. Under an agent multiple-employer pension plan, the assets of a multiple-employer pension plan are pooled for investment purposes but separate “accounts” are maintained for each individual agent employer, so that each agent employer's share of the pooled assets is legally available to pay the pensions of only its employees. In a cost-sharing multiple-employer pension plan, cost-sharing employers share their assets and their obligations to provide pension benefits to their employees ' plan assets can be used to pay the pensions of the employees of any employer that provides pensions through the reporting by plan sponsors in defined benefit plans.

Plan sponsors have a present obligation to pay deferred benefits in the future ' a total pension liability ' once they have been earned. When the total pension liability exceeds the pension plan's net assets (now referred to as plan net position) available for paying benefits, there is a net pension liability. Plan sponsors will now be required to report that amount as a liability in their accrual-based financial statements (for example, the government-wide statement of net position). The Pension's net position available for paying benefits is to be measured using the same valuation methods that are used by the pension plan for purposes of preparing its financial statements, including measuring investments at fair value.

This is an important change that will more clearly depict the plan sponsor's financial position. The former position gives the appearance that a Plan Sponsor is financially weaker than it was previously; the financial reality of the government's situation will not have changed. Reporting the net pension liability (or asset, if plan net position exceeds the total pension liability) on the face of the financial statements will more clearly portray the government's financial status because the pension liability will be placed on an equal footing with other long-term
obligations. The use of the Program that will match the liabilities with the occurrence of the revenue stream will permit an asset valuation that will reduce liabilities in the most economically efficient fashion.

Conclusion

With proper planning, the Pension can meet regulations, be funded to the acceptable green zone levels (80%) and reduce the annual net periodic pension funding requirement.

Lawrence L. Bell, JD, LTM, CLU, ChFC, CFP', AEP, a member of this newsletter's Board of Editors, has served as Tax Bar liaison to the IRS for 10 years. He has received patents in actuarial product fields dealing with COLI, GASB, FASB, IASB and OPEB solutions. He authors articles and speaks nationally about Decision Trees on COLI Best Practices, 409A and Benefit Planning.