A new federal law intended to improve pension plan funding also makes it easier for employers to fund retiree health care liabilities using surplus pension assets.

Employers have had such an option for years, but with pension plan funding levels taking a nosedive due to lackluster investment returns and declining interest rates, few plans, until recently, had surplus assets that could be transferred.

But with pension plan funding levels rebounding due to improved investment returns and higher interest rates, more employers once again could be eligible to take advantage of this transfer mechanism.

And Congress, as part of the more than 900-page pension funding reform legislation, has lowered the barriers to use the transfer option through several changes. Those changes include:

c Eligibility. Under prior law, employers could transfer surplus pension plan assets to pay for retiree health care benefits if the pension plan remained at least 125% funded after the transfer.

Under the new law, surplus assets can be transferred if the plan is at least 120% funded after the transfer.

c Transfer period. Under the old rules, only current year retiree health costs could be paid with the transferred surplus pension plan assets. If the transferred amounts were not used to pay for retiree health costs, the money had to be returned to the pension plan and the employer was slapped with a 20% excise tax on the returned funds.

By contrast, the new pension law allows transferred assets to be used to pay for retiree health care expenses incurred for up to 10 years, decreasing the likelihood that the transferred amount would not be used up.

Additionally, another change in the pension law makes it easier for employers to overfund their pension plans and have surplus assets. Under the new law, employers are allowed to make annual tax-deductible contributions to their pension plans until their plans are 150% funded. By contrast, under prior law, employers generally could not take a tax deduction for pension plan contributions after their plans were 100% funded.

Benefit experts say all these factors increase the likelihood that more companies-as a financial strategy-will make the maximum contributions possible to their pension plans as a way of building up sufficient surplus assets, which they then can use to fund retiree health care expenses.

"When companies focus on this, they will see an opportunity," said Jerry Mingione, a principal in the Philadelphia office of benefit consultant Towers Perrin.

"Congress has given companies a great opportunity to prefund" retiree health care benefits, said Bill Sweetnam, a principal with the Groom Law Group in Washington and who lobbied for the changes on behalf of client Prudential Financial Inc., which has a significantly overfunded pension plan. Prudential is currently analyzing whether it will use the transfer approach, said a spokesman for the Newark, N.J.-based financial services giant.

By deliberately overfunding their pension plans, employers have a tax-effective way to prefund retiree health care expenses, experts note. In such an arrangement, the employer receives an immediate tax deduction for pension plan contributions, while the assets earn tax-free investment income, regardless of whether the assets are used to pay for pension or retiree health care expenses.

By contrast, employers now have few tax-effective vehicles to prefund retiree health care liabilities. For example, while employers that offer retiree health care benefits through collective bargaining agreements can prefund future obligations through contributions to tax-free trusts known as voluntary employee beneficiary associations, VEBAs are not a practical option to prefund retiree health care obligations for salaried employees. Under a 1984 federal law, investment income earned on VEBA assets held to pay for retired salaried employees' health care obligations would be considered unrelated income and subject to federal taxes.

Even before the changes in the pension law, employers had incentives to transfer surplus pension assets to prefund retiree health care expenses.

By so doing, companies could tap an unused asset-the surpluses in their pension plans-and conserve corporate cash.

"There are some good cash flow reasons to do this," said Scott Macey, a senior vp with Aon Consulting in Somerset, N.J.

On the other hand, there are several conditions, aside from keeping their pension plans at least 120% funded, that could chill employer interest in the surplus asset transfer approach.

For example, under both the old and the new law, employers transferring surplus assets to pay for retiree health care expenses are required to vest all pension plan participants' accrued benefits.

While the cost of vesting, especially at mature companies where most employees already are vested, may be relatively small, some companies may not want to incur the additional administrative burden-such as sending out benefit reports to participants-for what are very small benefits, Towers Perrin's Mr. Mingione said.

"The vesting requirement could hold up some companies," said Bill Miner, a senior consulting actuary with Watson Wyatt Worldwide in Chicago.

Additionally, the new law requires, in a so-called "maintenance of cost" provision, that employers not reduce retiree health care costs during the transfer period and four years after that period.

With health care costs continuing to rise, the likelihood of not meeting that requirement typically would be very low. Still, some employers that want to cut back on how much they want to pay for retiree health care expenses might not want to be locked into such a commitment, experts say.

At the same time, companies also might not want to be obligated to keep their pension plans 120% funded during the transfer period. "That could be troublesome for some companies," said Barbara Bald, a principal with the human resources unit of PricewaterhouseCoopers L.L.P. in New York.