For the past decade, Section 420 of the Internal Revenue Code has permitted using surplus pension assets to pay retiree medical expenses. But the Department of Labor's Advisory Council on Employee Welfare and Pension Benefits recommends stronger measures to secure retiree health benefits.
The council recommends expanding Section 420 to allow for pre-funding of current retirees' entire future medical obligations. Freeing up excess assets to truly secure retiree health benefits creates a win for plan sponsors and a win for plan participants. Excess plan assets can be used effectively and pension plan participants are more assured of receiving post-retirement health benefits on a tax-effective basis.
When they withdraw assets from a pension plan, companies must pay prohibitive excise and income taxes and change the financial structure backing up accrued benefits from a trust fund to higher cost annuities. But plan sponsors do have an alternative -- they can apply extra pension plan assets to paying retiree health benefits. An employer has to meet several conditions, however, before it can use this option:
* An employer first must set up a separate account, called Section a 401(h) account, within the pension plan, and transfer into it any surplus assets to be used for paying post-retirement health benefits.
* The pension plan can transfer surplus assets only if the pension plan remains fully funded and the surplus assets exceed 125% of the plan's current liability after the transfer.
* The plan can pay only retiree health benefits for the year of transfer, and only one asset transfer is allowed per year.
* All plan participants must be fully vested in pension benefits accrued to the date of transfer.
* The employer must commit to a "maintenance of effort" in providing retiree health benefits for the year of transfer and the following four years.
This ability to transfer surplus pension assets under Section 420 was due to expire this year, but the Ticket to Work and Work Incentives Improvement Act of 1999 extended it through 2005. Still more can be done to improve Section 420.
A November report by the Department of Labor's ERISA Advisory Council recommended expanding Section 420 to allow prefunding of medical obligations up to the present value of post-retirement benefits for current retirees. Asset transfers of this magnitude would be allowed only if the pension plan remains fully funded and only to the extent that surplus assets exceed 135% of the plan's current liability after the transfer.
Ability to transfer assets to either a Section 401(h) account within the pension plan or to a voluntary employees' beneficiary association was established under Internal Revenue Code Section 419.
For many plan sponsors, adopting the DOL advisory council recommendations would be a significant positive step. At a time when pension plan funding is secure and investments are growing dramatically, there remains little funding of retiree health plans, due to the dearth of tax-effective funding vehicles. Unfunded retiree health benefits are significantly less secure than pension benefits. Yet retiree health benefit security is an integral element in overall retirement security.
It makes sense to apply overfunded pension plan assets to fund retiree health benefits. Section 420 currently allows application of surplus pension assets for paying retiree health benefits as they occur. Section 420 is a tested concept; expansion of that concept to fund a greater portion of retiree benefits should be pursued. The DOL Advisory Council's recommendation to allow for the pre-funding of retiree health benefits with surplus pension assets is attractive to plan sponsors, and enhanced benefit security is attractive to plan participants.
Franklin B. "Frank" Becker is a senior vice president of ASA Inc., Somerset, N.J., and chairman of the Financial Executives Institute's Committee on Benefits Finance.
