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Sticking the landing: finding a “goldilocks” solution to the plan termination deficit vs. surplus challenge

The increase in interest rates since the beginning of the year has had a dramatic effect on the funded status of many defined benefit plans. As a result, some sponsors are (as noted in the press) considering pension risk transfers, and some are considering possible exit from the DB system via a plan termination.

Terminating a DB plan presents a number of challenges. In this article we focus on a particularly tricky issue that is often a critical factor in the plan termination decision: syncing assets and liabilities so that benefits are adequately funded without generating a (potentially stranded) surplus.

The challenge of stranded surplus

Why does it matter if a plan is overfunded at termination? 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”).

Thus, if a sponsor is committed to terminating its plan, the ideal (from one point of view at least) is: just enough plan assets to cover all liabilities (and termination expenses), and no more. A “goldilocks” solution.

In what follows, we are going to consider strategies for managing to that ideal, “sticking the landing” as we’ve characterized it. We will also discuss some “Plans B” – possible options for what to do when there is a surplus. But let’s begin with a consideration of the basic math of a plan termination.

The plan termination equation

The total cost of terminating a plan can be broken down into three components:

(1)The lump sum value of the benefits for participants who elect a lump sum payment. 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. 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.

(2)The cost of buying annuities for those participants who do not elect lump sums. For a number of reasons, the cost of settling a benefit as an annuity 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.

Very roughly, all of these requirements can add between 15%-35% for non-retirees and 5%-10% for retirees to the cost of terminating a plan. In what follows, when we discuss “full funding,” we mean the value of plan liabilities plus this additional “termination premium.”

To reduce the risk of “stranded surplus” 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.

Market effects

Probably the most significant challenge sponsors face – in trying to “sync up” assets and termination liabilities – in the current environment is volatility in interest rates and asset values.

Consider that since the beginning of the year, our estimated GAAP discount rate for a duration 12 plan has risen from 3.63% to 4.39%. That translates (very roughly) to 6.2% drop in the “book value” of plan liabilities.

On the other hand, just since the beginning of October we have seen a nearly 6% correction in the S&P 500.

The consequences of changes in interest rates for the termination calculation are complicated. A plan’s lump sum valuation rate is typically set before the beginning of the year (e.g., many plans calculate all lump sums paid in 2018 based on market interest rates as of November 2017). Plans taking this approach will have to wait until 2019 to realize the effect (in a higher lump sum discount rate/lower lump sum values) of interest rate increases on lump sums.

Rising interest rates are likely to have an effect on the cost of annuities in 2018, 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. A 6% decrease in asset values means 6% less 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 recent experience illustrates.


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 full funding. Both current ERISA funding rules and the fact that plan termination adds a premium (discussed above) to the cost of settling plan liabilities make room for such a strategy.

It is true that this approach may generally 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, although sponsors will want to review this issue thoroughly with tax counsel.

The problem with this strategy is 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 tax on the underfunding. Further, because of recent increases in interest rates, and increases in asset values since 2008, many sponsors find their plans already approaching full funding, with the option of strategically underfunding the plan no longer available.


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 widespread (and widely reported) improvement in the funded status of DB plans is a function of the performance of the interest rate and asset markets. Plans that, e.g., a year ago, hedged out interest rate risk generally will not have seen an interest-rate driven improvement in funding.

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. The problem – highlighted by current market conditions – is that changes in interest rates or (especially) asset values can change a plan’s funded status precipitously.

In these conditions, sponsors may want to consider what steps might be necessary to permit them to act on a termination decision quickly. This might involve: Being able to execute on a decision to move plan assets into matching duration bonds immediately, once the 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.

Plans B

Achieving absolute certainty with respect to termination funded status – that plan assets will exactly match plan liabilities plus termination costs – is generally unrealistic.

Reducing uncertainty is certainly possible, but at the cost of reducing market exposure that may (generally) be a feature rather than a bug of plan finance.

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. And, with respect to all of these strategies, advice of counsel will be critical.

*     *    *

The asset-liability equation can – especially if there is a surplus – be a critical issue in plan terminations. It is a function of a number of complicated, independent and (in some cases) volatile variables. Reducing surplus uncertainty is possible, but some sponsors will find the trade-off (e.g., in lost exposure to markets, lost tax deductions or increased PBGC premiums) not worth the cost of doing so.

In these circumstances, sponsors will want to manage what can be managed (e.g., administrative expense) and (where possible) be prepared to act quickly to take advantage of favorable market conditions.




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