DB Plan Terminations – Some Basics
The combination of higher interest rates (30-40 bps for plans with typical duration – more for shorter duration plans) and a strong stock market (the S&P 500 is up nearly 25% on the year) have significantly improved pension funding. The October Three Pension Finance Update, which tracks a typical defined benefit plan with a 60/40 asset allocation, shows plan funding up over 10% on the year.
For some sponsors looking to exit the DB system, this improvement in funding may put them in a position to consider plan termination. In this article we briefly review some of the key issues the project of terminating a plan presents.
The total cost of terminating a plan can be broken down into three components:
(1) The cost of benefits for participants whose benefit can be paid out as a lump sum. This is the most straightforward cost and is (roughly) equal to the “book value” (for GAAP financial statements) of the participant’s benefit under the plan. As discussed further below, lump sums may generally be paid without participant consent for benefits of $5,000 or less. Above that amount, they require participant consent.
(2) The cost of buying annuities.For a number of reasons, the cost of settling a benefit as an annuity – for those participants who do not elect/cannot be paid lump sums – is more than its “book value.” Insurance companies have regulatory (and business) overhead, profit margin, and generally use more conservative valuation and risk assumptions than an ongoing plan would. And Department of Labor rules require that in settling liabilities sponsors must buy the “safest available annuity,” a market limitation that necessarily increases costs. On the other side, note that “book value” liabilities do not include future overhead costs associated with maintaining a plan and calculating and paying benefits.
(3) The administrative costs related to the termination process. A plan termination may often be a complicated process. Especially with respect to a large plan, it involves gathering a large amount of data. A variety of calculations – e.g., under alternative benefit options and different formulas – must be made. The necessary elections must be communicated to and then gathered from participants. And a substantial filing must be made with the Pension Benefit Guaranty Corporation.
Roughly, all these requirements can add (vs. book value) between 15%-35% for non-retirees and 5%-10% for retirees to the cost of terminating a plan.
Developing certainty: To reduce risk (e.g., of a taxable surplus, discussed below) in connection with a plan termination, a sponsor will generally want to develop as much certainty as is possible (and that is relatively “cost free”) around these numbers. In this regard, the sponsor may consider getting (1) information about experience with similar plans with respect to lump sum elections, (2) a comprehensive estimate of administrative costs from the plan’s actuary and (3) a preliminary estimate of annuity costs.
Encouraging lump sums to reduce cost
As noted above, the cost of paying an annuity is likely to cost more than paying out a lump sum, for a variety of reasons some of which have no practical effect on the value of the benefit to the participant.
Participants with accrued benefits (on a present value basis) of $5,000 or less may be paid lump sums. The benefits of any other participant must generally be paid as an annuity unless the participant affirmatively elects a lump sum.
One obvious way to reduce termination costs (and increase their predictability) is to encourage participants with benefits valued at over $5,000 to take a lump sum by, e.g., modestly increasing their benefit if they do.
Assets: Not enough or too much
In many cases it’s practically impossible to know, at the beginning of a termination process, whether the plan will have not enough, too much, or just the right amount of money to cover termination costs. Different sorts of issues arise, depending on whether the plan has too little or too much money to meet termination costs.
Not enough money: Generally, this problem can be solved simply by the sponsor writing a check for the balance. Before undertaking a plan termination where this outcome is possible, the sponsor should review with tax counsel whether making an additional contribution will present any issues.
Too much money: Where the plan has a surplus, more complicated issues arise. Generally (and with some exceptions we’ll note below), any surplus of assets over liabilities left over after a plan has terminated must be taken back into corporate income. At that time, the sponsor must, in addition to income taxes, pay an excise tax of up to 50%. That is a significant corporate loss, among other things because in many respects that surplus was, prior to the termination, functioning (more or less) as a corporate asset (even, in some circumstances, generating “pension income”).
There are some (limited) strategies to deal with overfunding without taking the surplus back into income:
If, post-termination, the sponsor will continue to sponsor some defined benefit plan (e.g., one for another division or subsidiary), transfer of the plan surplus to that plan may be a viable option.
Even where a sponsor is going entirely out of the DB business, surplus may be valuable. Most employers can avoid income and excise taxes by transferring pension surplus to a suspense account to fund a “qualified replacement plan” (e.g., a DC plan that provides non-matching contributions) over up to 7 years. Individual sponsors may have other alternatives available to them. With respect to all these strategies, advice of counsel will be critical.
Managing the plan to termination: market effects
One significant challenge sponsors face – in trying to “sync up” assets and termination liabilities – is dealing with interest rates and asset values. Rising interest rates are likely to influence the cost of annuities in 2022, although those markets are less than fully transparent, and sponsors may see a lag between (market) interest rate increases and a decrease in the cost of annuities.
By contrast, the effect of changes in asset values on a plan’s funded status (for purposes of a plan termination) is instant. An increase in asset values of, e.g., 10% means 10% more for lump sums, annuities, and administrative expenses.
In these conditions, a plan’s funded status can change significantly in a week based on changes in asset values and interest rates, as we have seen this year.
One obvious strategy for managing the risk of overfunding is to under-contribute to the plan – to intentionally fund to a target that is less than (market rate) full funding. This approach may, for some plans close to the margin, ensure that there is no surplus. And (again, generally), the sponsor will be able, on plan termination, to make a “true-up” contribution to cover any plan deficit.
The problems with this strategy are that (1) it foregoes a number of (often valuable) tax benefits from adequately funding benefits, and (2) it is likely to trigger PBGC variable-rate premiums, which function as, in effect, a 4.8% (for 2022) tax on the underfunding.
Managing liabilities: hedging
Another strategy that may be used to reduce market-driven uncertainty as to a plan’s funded status is liability driven investments – either by undertaking a derivatives overlay strategy (which can hedge out interest rate-driven changes in funded status) or a bonds-of-matching-duration investment strategy (which can stabilize both asset and liability performance).
We would, however, in this regard, note that much of the current improvement in the funded status of DB plans is a function of the performance of the interest rate and asset markets. Plans that used a liability hedging strategy in 2021 generally did not realize the gains from interest rate increases or (if they were fully hedged) gains from the stock market.
Managing to full funding in changing market conditions
The master strategy to get to full-funding-but-no-surplus on termination is to reduce plan risk by gradually changing the plan’s asset strategy as the plan approaches full funding. That (more or less) describes the “glide path” strategy that some sponsors have adopted.
When a sponsor is getting ready to terminate a plan, however, the risk that changes in interest rates or (especially) asset values may change a plan’s funded status precipitously will generally require more “hands on” attention.
And sponsors may want to consider what steps might be necessary to permit them to act on a termination decision quickly. These might involve: Being able to execute on a decision to move plan assets into matching duration bonds immediately, once a threshold target is reached. Locking in (e.g., annually) the cost of administering the plan termination. And regularly surveying annuity carriers to get a more accurate estimate of benefit costs.
Emerging regulatory issues
There are reports that DOL wants to look at pension risk transfer transactions. And there has been pressure from participant advocates to modify current rules (Interpretive bulletin 95-1) to, for instance, require the inclusion of certain ERISA protections in annuity contracts.
Also relevant to the pension risk transfer decision, as discussed in our recent November Retirement Policy Update, as currently written, the proposed Build Back Better Act would include a corporate alternative minimum tax that, in certain circumstances, would tax corporations (at a 15% rate) on pension income on their financial statements. There are, however, proposals to carve out pension income from this treatment.
Both issues are “emerging” – they are by no means certain to become law.
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We will continue to follow this issue.