October 1, 2006
By Dean B. Thomson
Many multiemployer defined-benefit pension plans in the construction industry are underfunded, which should be a cause for concern by signatory contractors, union officials and tradesmen alike. Banking and surety executives are also concerned about the unfunded liability issues involving their clients. Contractors who contribute to these funds will ultimately be liable if the plans are unable to meet their obligations. This Briefing Paper summarizes the causes for plan underfunding, union contractors’ liability for underfunded plans, strategies for dealing with these issues, and what improvements the Pension Protection Act of 2006 may provide.
Recent news articles have focused on shortfalls in single employer plans. For example, IBM discontinued its defined benefit plan, Northwest Airlines requested $3.7 billion from Congress to remedy the underfunding of its plan, and United Airlines saddled the taxpayer’s federal Pension Benefit Guaranty Corp (PBGC) with $6.6 billion in liability. Bradley D. Belt, Executive Director of the PBGC, testified before the U.S. Senate Committee on Budget in 2005, that “single employer pension plans [are] underfunded by more than $450 billion….”
Unlike these single employer plans that have the PBGC to rescue them, most construction trade plans are multiemployer plans. Single employer plans are distinctly different from multiemployer plans regarding liabilities. Multiemployer plans are funded by the contractors who are signatories to the collective bargaining agreements and managed by a board of trustees comprised of union officials and contractor representatives. The PBGC only guarantees the multiemployer plan after the obligations of the employers have been exhausted, and then only to a limited extent.
A PBGC report quoted in the May 26, 2006 Wall Street Journal reads, “big problems in many multiemployer plans have been largely overlooked…multiemployer retirement plans [were] underfunded by $150 billion in 2004, a 50% jump in the deficit from the year before.…” For example, the United Association of Plumbers and Pipe-fitter’s (UA) investments in projects such as the Diplomat Hotel recently suffered a $1.2 billion loss, which lead to prosecutions by the Department of Labor and plan amendments to significantly cut member benefits. While other trades’ plans have not been plagued by such well publicized misfortune, the June 28, 2005 Dow Jones International News reported that, “most workers covered by multiemployer pension plans, common in unionized construction firms, are in underfunded pensions….”
Generally, plan funding requirements are determined by actuaries who examine the plan’s assets and the beneficiaries’ demographics, estimate the rate at which the promised benefits will be paid out, estimate a rate of return on investment, and develop funding criteria to fulfill the plan’s obligations. Multiple factors, however, have been working against actuarial assumptions.
The first such factor is the decreasing percentage of unionized labor in construction. Unionized labor comprised 50% of construction craft-workers in 1965 and 30.9% in 1980. In 2005, unionized labor comprised only 14.7% of construction craft-workers, according to the Bureau of Labor Statistics. Some formulas include assumptions of growth in the unionized workforce base upon local organizing efforts. Thus far, local efforts have yet to produce sufficient numbers of new members to overcome the national trend. Thus, any assumed growth in funding based on increased market share of labor has not transpired.
The second factor involves the assumed rate of return on investment (ROI). An estimated ROI is plugged into the actuarial formulas to predict investment income. The higher the estimated ROI used, the lower the contributions required to meet the funding estimates. In retrospect, the ROI of several funds was over-estimated. Many funds have not met these aggressive goals in the post-9/11 stock market, which has contributed to the underfunding of the plans.
Assumptions related to demographics add to the difficulty. The baby-boom generation comprises two-thirds of the workforce while the following generations only comprise one-third. Therefore, as the baby-boomers retire and draw benefits, roughly two out of every three plan participants will be drawing on the funds while only one out of three will be contributing. Some argue that a new workforce will be present to take the place of the retiring baby-boomers. But, to attract a replacement workforce, unionized construction must compete with other industries for a greater percentage of either the X and Y generations or the immigrating labor pool. In addition to the declining number of working plan members, increasing life expectancy has extended the duration and amount of benefits that retirees withdraw.
The PBGC and AGC (Associated General Contractors of America ) have also testified that past flaws in the funding rules, such as the maximum limit on tax deductions for surplus funding, have deterred the development of fund savings in favorable market conditions.
Setting aside issues of management, even the slightest shortfall in these actuarial assumptions, some of which were made many years ago, can have significant impact on today’s funding. As PBGC Director Belt testified, “Future losses in the system will depend on numerous variables which are inherently uncertain, e.g., ups and downs in the business cycle, changes in the law, volatility of raw material prices, changes in equity prices, and changes in interest rates.”
The Employee Retirement Income Security Act of 1974 (ERISA) made the contractors who are signatories to collective bargaining agreements liable for the obligations of the defined benefit plans to which they contribute. 29 U.S.C. §§1001 to 1461. Trustees of the plans also have personal liability. It did so by establishing funding and reporting standards for defined benefit plans and imposed a penalty for non-compliance in the form of an excise tax. If a plan falls below the minimum funding standard, as many of the plans are currently in danger of doing, then the plan enters reorganization. If plan amendments are not made during the following year that bring the plan up to the minimum funding standards through additional contributions, then the contractors could be assessed a non-deductible excise tax by the IRS in the amount of 5% of the accumulated funding deficiency. An additional excise tax equal to 100% of the accumulated funding deficiency will be imposed if the funding deficiency is not corrected within the tax period. 26 U.S.C. §4971. Contrary to any conventional remedy, the excise tax is paid to the federal government and not applied to cure the shortfall in the plan! Thus, even if liable contractors were assessed an excise tax, the underfunded plan would remain underfunded until separate corrective action was taken. Moreover, the contractors cannot simply increase their contribution to avoid the excise tax. In most cases, plans that are seriously underfunded cannot be cured increased contributions alone.
For an underfunded plan to once again achieve statutory minimum funding standards, there must be an amendment made to the plan’s formula which is approved by the plan’s trustees and the PBGC. 29 USC §1400, 29 C.F.R. §4220. (2005). Several unions are currently working to ratify such amendments that would maintain or increase funding requirements but may compromise the accrual of benefits. These proposed amendments may restore the level of funding required to fulfill their current obligations, but may not achieve 100% funding for all future obligations.
After ERISA was enacted, some contractors, through the natural course of business, discontinued operation or switched to open-shop labor. This shifted liability for any then current underfunding to the other contractors still contributing to the plan. This escape route created a financial incentive for the currently contributing contractors to exit the plan to avoid liability for an underfunded plan. Congress responded to this with the Multi-Employer Pension Plan Amendments Act of 1980 (MPPAA). MPPAA created “withdrawal liability” which, in simplified form, imposes on the withdrawing contractor its pro rata share of a plan’s underfunding, based upon the amount previously contributed to the plan by the contractor, at the time of the contractor’s withdrawal. 29 U.S.C. §1381.
Contractors that discontinue operations, change to open-shop labor, or whose employees vote to withdraw from the union are all deemed to have “withdrawn” from the plan. This triggers withdrawal liability, whereby the union sends a bill for the contractor’s pro rata portion of the plan’s current level of underfunding. To place this liability in perspective, a recent withdrawal liability estimate for a well established, medium-size contractor was in excess of $1 million dollars. Likewise, if a contractor significantly reduces production and its corresponding contribution to the plan, the contractor may be deemed to have partially withdrawn and partial withdrawal liability may be triggered. A 70% decline in contribution has been the traditional threshold for triggering partial withdrawal liability. The partial withdrawal liability is calculated as a pro rata portion of complete withdrawal liability. 29 C.F.R. §4208.
The courts’ interpretation of MPPAA has extended the liability beyond the company that contributed to the fund to related corporations and partnerships that are under common control. 29 U.S.C. §1301(b)(1); see also Brown v. Astro Holdings, Inc., 385 F.Supp.2d 519, (E.D. Penn. 2005). “Companies are essentially held to be under common control when they are linked by either a parent corporation or group of five or fewer individuals who control 80% of a company’s voting shares or profits.” Id. If a company subject to withdrawal liability is linked through “common control” to a related company, the companies will be held jointly and severally liable. Id; see also 26 C.F.R. §§1.414(c)-1 to 1.414(c)-5. Fortunately, as a general rule, the courts have not pierced the corporate veil and found company owners personally liable, in the absence of fraud. Scarbrough v. Perez, 870 F.2d 1079, (6th Cir. 1989).
In the recent Brown case, however, the judge did pierce the corporate veil finding that the withdrawn company and the alleged alter ego company were “inextricably intertwined” and that the owners “failed to maintain corporate formalities” such that they “have effectively merged into a single enterprise akin to a partnership under which separate personalities of the corporation do not exist.” Id. The court also found “nothing in the legislative history of the MMPPA that would indicate Congress intended to foreclose the use of veil piercing and allow individuals who abuse the corporate form to escape liability.” Id.
If the threat of being assessed liability for something that you did not control and could not prevent is troubling to you, there are some things that can be done to manage and minimize this risk depending on your business model and goals.
In an effort to improve the financial health of defined benefit pension plans, Congress recently passed the Pension Protection Act of 2006 (the “Act”), which applies to plan years after January 31, 2007. Generally, the Act tightens requirements for the calculation of actuarial assumptions, funding formulas, and liability under the Act.
More specifically, the Act establishes criteria for determining when a plan “is in endangered or critical status;” requires annual actuarial certification of a plan’s financial condition; and imposes the duty to notify all the parties if a plan enters endangered or critical status. In the event that a plan does enter endangered or critical status, the Act requires the adoption of an improvement or rehabilitation plan that is reasonably expected to bring the pension plan within the funding requirements within 10-15 years. If the bargaining parties fail to adopt an improvement plan for an “endangered” pension plan, then the Act imposes a default improvement plan. If a plan enters “critical” status, contributing employers will be obligated to pay a surcharge in the amount of 5% of their annual contribution during the initial year, and 10% each year thereafter until the plan is no longer in critical status or is covered under a renegotiated collective bargaining agreement that is consistent with the terms of the funding rehabilitation plan schedule.
Other provisions of the Act applicable to contractors include the following: plan administrators are now required to provide detailed financial reports and an estimate of an employer’s withdrawal liability within 180 days, upon request; the maximum tax deduction is now increased to 140% of the plan’s current liability; pension plan participants and their families will receive periodic reports regarding their fund’s status; and an employers’ withdrawal liability of as a result of an asset sale is now also increased.
While the Act represents a significant change to the existing statutory structure, any impact will be noticed only in the long-term. In the short-term, these new requirements will probably not improve the financial health of pension plans or reduce a contractor’s withdrawal liability. However, the Act should improve communication between all stakeholders, increase awareness of the issues, and force the implementation of long-term improvement plans.
The first thing signatory contractors should do is establish a good working relationship with their collective bargaining agents. These people are in the best position to know about the fund’s condition, how the fund’s board of trustees works, and the goals of the bargaining parties.
Contractors who wish to significantly reduce union operations, change to open-shop labor, otherwise cease contributing to a plan, or simply assess their risk should contact their legal counsel and request a calculation of their withdrawal liability from the plan administrator. Knowing the extent of your company’s liability is essential and will allow a contractor to make informed, strategic business decisions.
Congress specifically created an avenue for the winding-down of operations in the building and construction industry in 29 U.S.C. §1383(b). It provides that a contractor may avoid withdrawal liability through the cessation of operation(s) or changeover to open-shop labor, if the contractor does not perform work in the building and construction industry within the jurisdictional boundaries of the previous collective bargaining agreement for at least 5 years. Id. Of course, this provision does not provide any relief to a contractor that wishes to continue operations in the same region. Id. Similarly, in the case of a collective bargaining agreement that covers the entire nation, the contractor may not perform work as an open shop contractor without triggering withdrawal. Id. This provision has also created some confusion for employers who thought they fell within this provision, only to discover that some of the company’s shop fabrication and off-site manufacturing activities did not meet the criteria for being part of the building and construction industry. For §1383(b) to be applicable, an employer’s activities must fall within the definition of building and construction industry as set forth in H.R. Rept 96-869 (Part I) (House Educ. & Labor Comm.), p. 76 (April 2, 1980). Contractors must utilize competent counsel versed in these issues.
If divesting is your goal, ERISA provides an exception to the withdrawal liability rule by allowing an arms-length asset sale to an unrelated entity without triggering withdrawal liability. 29 U.S.C. §1384, 29 C.F.R. §4204. As a condition of an asset sale, the purchasing party must agree to continue contributing to the plan and to post escrow funds or a 5-year bond to cover the withdrawal liability. Id. If the purchaser withdraws from the plan before the 5 years have elapsed and does not make the withdrawal liability payment, then the seller owes the payment. Id. A seller may reduce liability by informing the plan of the sale in writing and demonstrating that the sale is to be covered by a §4204 variance to the bond and escrow requirement. A seller qualifies for the variance if (1) the contributions “[do] not exceed the lesser of $250,000 or two percent of the average total annual contributions made by all employers to the plan” or (2) if the purchaser’s net income equals 150% of the amount of the bond or escrow or net assets equal to the liability. See §4204.11 to 4204.13 for the accounting details. A seller can limit the post-sale liability even further through the use of an indemnity agreement as a term of the contract. Nevertheless, the prospect of pension liability by prospective purchasers may unexpectedly reduce the value of the sale, if the seller has not already taken the pension liability into account. Furthermore, it may be difficult for the prospective purchaser to calculate the potential liability, based solely on the seller’s financial statements. These issues require significant due diligence during a merger or acquisition. Legal counsel should be sought to fairly assess and allocate the liability between the parties.
Growing entrepreneurial contractors who wish to reduce the percentage of their assets that are exposed to pension liability may want to diversify investment into other similar operations. Diversification of your investment may be accomplished by purchasing existing operations through asset sales and partnerships, but make sure to limit “common control” according the ERISA definition.
For union contractors who wish to maintain or grow their operation and have a continued interest in the success of the plans, the most practical course of risk management is active involvement. Contact your collective bargaining agent, meet with your union representative, learn about your plan’s condition, your liability, the current action plan, and help create a solution that will ensure a future for the employees and employers who have invested in these plans. Solutions to such problems can only be reached through competent counsel and the diligent attention and action of all stakeholders.
This discussion is generalized in nature and should not be considered a substitute for professional advice. © FWH&T