A small New England community organization with fewer than 100 employees wanted a predictable contribution pattern for its defined benefit plan. The funding policy was that contributions would increase 3% per year, on par with the expected long-term salary increases.

In reality, however, contribution requirements climbed for several years to much higher levels—a 79% increase in one year, for example. Changes in federal pension laws were a factor in creating this volatility. The skyrocketing contribution rates were also partly due to several years of low and even negative asset returns; well below the expected long-term rate of return of 8%. At the same time, interest rates on which current liabilities are calculated declined, requiring plan sponsors to make larger contributions because of lower projected investment yields.

These large, unpredictable contribution increases left the organization's management with a discouraged view of defined benefit plans. Management was encouraged by the prospect of pension reform, but kept a skeptical view of any positive effects, indeed, considering freezing the defined benefit plan and creating a defined contribution plan to use going forward.

PPA 2006—new requirements, different scenarios

When the Pension Protection Act of 2006 (PPA 2006) was signed into law, Milliman consultants to the organization suggested it take a look at various funding scenarios before making a decision to freeze the plan. Modeling would help determine if the organization could maintain a contribution pattern that would satisfy its desire for predictability as well as meet the PPA's new funding requirements.

We introduced group managers to FutureCost: a sophisticated, interactive modeling tool that produces a 10-year projection of contributions and funded status. A proprietary tool created by Milliman actuaries that is based in Microsoft® Excel, FutureCost incorporates the new funding requirements of PPA 2006. The results can be modeled under various scenarios.

Three options to meet full funding

Milliman mapped out three contribution patterns the plan sponsor could follow. All three met the minimum funding requirements and all three brought the plan to 100% funding no later than 2013. But the three proposals called for strikingly different contribution levels in the intervening years.

The first scenario was based on paying only the minimum required contribution in each year, including 2006. This created a significant spike in 2007, because of an additional funding requirement triggered by the low-funded percentage at the beginning of the year. This scenario does not qualify for the transition relief PPA 2006 offered for funding beginning in 2008.

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The second scenario involved making a very high contribution in 2006 in order to have the plan 90% funded for 2007, to take advantage of the transition relief PPA 2006 offered for achieving this target early. This option showed a gradually increasing contribution pattern—enough to maintain transition relief—until the plan was 100% funded, and then dipped to a lower level.

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Managers requested that one model offer a level contribution pattern with no spikes. This was achieved in scenario three by foregoing the relief offered by PPA 2006 for plans that achieve a higher funding level sooner. In all three scenarios, the contribution amount decreases when the plan reaches the 100% funded mark and levels out thereafter.

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The third scenario offered the stability managers sought. They elected to forego the relief offered by PPA 2006 and were able to move forward with their existing defined benefits plan, confident in the organization's ability to meet future contribution requirements.