Defined Benefit Pension Plan Termination FAQs
WE FROZE OUR DEFINED BENEFIT PLAN YEARS AGO TO CONTROL COSTS BUT IT IS STILL A BURDEN TO THE COMPANY, IS THERE ANYTHING WE CAN DO NOW?
Freezing a defined benefit plan is like owning a house that you don’t live in anymore but continue to pay the mortgage, taxes and upkeep on its behalf. When a company like yours decides to freeze their defined benefit plan it should be done simultaneously with discussing a strategy on how and when it will be terminated, or it will linger on for many years. Terminating a defined benefit plan is the only true way to eliminate the ongoing burdens of the plan. The best thing to do now is to begin developing a termination strategy that works with the company’s ongoing objectives, goals and vision. Engaging an independent advisor to help with this strategy is suggested to help manage conflicts of interest that your current consultants have.
WHAT DOES TERMINATING OUR FROZEN DEFINED BENEFIT PLAN ENTAIL? DOES OUR COMPANY STILL MAINTAIN ANY RISK OR ONGOING COSTS?
Terminating a defined benefit plan can take as long as 18 months to complete, or much longer if no strategy is in place yet. There are many steps to complete along the way and the timing of each step is primarily regulated by the Internal Revenue Service (IRS) and Pension Benefit Guarantee Corporation (PBGC). The process should be managed very carefully.
In the end, if executed correctly, the plan sponsor will no longer have any risk, administrative burden or financial burden, regarding the plan. All participants of the Plan will either elect to (1) take their benefit as a one-time lump sum payment, which can be rolled over into an IRA or 401(k) account, or (2) take their benefit as an immediate or deferred annuity, which will be administered by an insurance company. Once the annuity contract is issued by an insurance company, all risk, administrative burden and financial burden will fall on the insurance company.
WE WERE TOLD WE DID NOT HAVE TO MAKE A CONTRIBUTION TO OUR FROZEN DEFINED BENEFIT PLAN BECAUSE IT WAS OVER 100% FUNDED, BUT WE WERE TOLD THAT WE HAVE TO MAKE A VARIABLE RATE PBGC PREMIUM BECAUSE OUR PLAN IS UNDERFUNDED, HOW COULD THIS BE?
Your confusion is one of the many reasons why defined benefit plans have lost favor with corporate sponsors. There are three main regulatory bodies in the United States that require plan sponsors to disclose the funded status of their plans; The Internal Revenue Service (IRS), Pension Benefit Guarantee Corporation (PBGC) and the Financial Accounting Standards Board (FASB). Each of these regulatory bodies requires different assumptions and methods to be used in calculating the value of the benefits provided under pension plans and in valuing the assets used to pay for these benefits. These assumptions and methods can vary significantly causing wildly different answers. When a plan is frozen the sponsor should be targeting only one funded status and that relates to the funded position related to the termination of the plan. All other metrics of measuring the funded status are required to be performed but will not get you to the end game – plan termination.
WE WOULD LIKE TO TERMINATE OUR FROZEN DEFINED BENEFIT PLAN BUT WE HAVE BEEN TOLD THAT IT IS VERY UNDERFUNDED, AND WE CAN’T AFFORD TO MAKE THE CONTRIBUTION NECESSARY TO TERMINATE IT, WHAT CAN WE DO?
All situations are different regarding companies that continue to manage a frozen defined benefit plan. There is no one size fits all solution. The key is to begin developing a strategy now, stick to it, but be flexible to modify it along the way as situations change. Understanding all costs and risks associated with continuing to operate a frozen defined benefit plan versus terminating it is essential to developing the correct strategy.
There are many strategies that can be used to help plan sponsors de-risk their plans until they can afford to terminate their plan, some strategies include:
- Offering lump sum windows
- Developing Liability Driven Investing (LDI) strategies, coupled with a funding policy
- Purchasing group annuities for a retiree buy-out or a retiree buy-in
- Borrowing to Fund
INTEREST RATES ARE EXPECTED TO INCREASE, SHOULDN’T WE WAIT TO TERMINATE OUR PLAN SO THAT WE WON’T HAVE TO CONTRIBUTE AS MUCH WHEN WE TERMINATE IT?
For the past 30 years plan sponsors of frozen DB plans have been asking themselves that exact question, and for the past 30 years they have continued to “pay the mortgage, taxes and upkeep” on their defunct “property”, much to the benefit of all the advisors needed to manage these plans. This reactive approach has resulted in plan sponsors significantly overpaying for their plans. With the economy in the best shape it has been in, in years, and corporations amassing significant cash reserves on their balance sheets, the time to be proactive is now. Companies should be proactively looking at all options available, performing cost benefit analyses and having strategic discussions with all key stakeholders to put these plans on a path to termination.
WE HAVE BEEN TOLD WE COULD BORROW THE MONEY WE NEED TO FUND OUR PLAN IN ORDER TO TERMINATE IT, SHOULD WE LOOK INTO THIS APPROACH?
All companies are in different financial situations. Some have incredible balance sheets, despite their underfunded defined benefit plan, which may allow them to borrow at very low interest rates. Some are operating with net losses so the extra immediate tax deduction of funding with the borrowed funds may not be enticing, since they won’t be able to use the deduction immediately. Some have large cash reserves and may elect to use their own cash at this time. In any event all options should be considered. A combination of approaches could be utilized as well. No matter which approach is taken a comprehensive cost benefit analysis should be conducted to determine which path is most practical and beneficial for the organization.
OUR CONSULTANT HAS HELPED US IMPLEMENT A LIABILITY DRIVEN INVESTING (LDI) STRATEGY IN ORDER TO HELP MANAGE OUR FUNDED STATUS VOLATILITY UNTIL WE ARE READY TO TERMINATE, OR UNTIL ECONOMIC CONDITIONS BECOME MORE FAVORABLE FOR A FULL TERMINATION, IS THIS THE CORRECT APPROACH?
Using an LDI strategy to help mitigate funded status volatility is a viable approach. Additional funding will most likely be needed, as well, to help close the gap between plan termination liability and plan assets. An LDI strategy may be important to ensure the funded status does not lose ground, but this strategy is typically set up to play out over an extended period of time. During that time period the plan will require overhead expenses to run (i.e. actuarial, legal, accounting, HR, administrative, PBGC, investment) and the liability will continue to grow as the population ages. The question that should be asked and the analysis that should be performed is how much can be saved by getting out of the plan immediately versus running it for some extended period of time, and are other strategies available to save the company cash over the same period of time that an LDI strategy is playing out.
I HAVE ADDITIONAL QUESTIONS; WHERE CAN I GET MORE INFORMATION?
To learn more about defined benefit pension plan termination, please visit our Defined Benefit Plan Termination Consulting page. You may also contact one of our Pension and Risk Consultants at 516-683-6100 or by email at DeRisking@ChernoffDiamond.com.