London Market Monitor – 31 May 2022
Our May review of the markets and Solvency II discount rates.
This article discusses reviewing your plan document for plan termination readiness. Key opportunities include simplifying the benefits, rights, and features offered by a defined benefit plan. Simplifying these provisions reduces plan complexity, which in turn may make your plan more favorable to insurers and thus reduce annuity placement costs.
Defined benefit (DB) plans offer nonforfeitable benefits to plan participants. In addition to these benefits, there are other rights and features that plan sponsors are obligated to provide. Benefits, rights, and features include optional forms of benefits, ancillary benefits, and other rights and features available to any participant under a defined benefit plan.
When plan sponsors consider plan termination, there are often two main motives 1) risk reduction, and 2) cost savings. Plan sponsors can achieve these goals by offering participants a lump sum or by selling the benefits to an annuity provider. However, note that benefits not distributed as a lump sum during a plan termination must be sold to an annuity provider.
For plans with ongoing benefit accruals prior to termination, plan sponsors may want to minimize the loss to participants due to a lack of future benefit accruals. For example, defined benefit plans may be amended to give a one-time increase in benefits, by way of increased service or an enhanced approach for recognizing plan compensation, in order to make up for the participants' inability to earn additional benefits. This consideration is especially important for participants near retirement age at the time of the plan termination. Increasing benefits may also have nondiscrimination implications depending on who is receiving the increase and how large the increase is.
For plan sponsors looking to achieve a cost savings, simplifying the plan prior to termination can be beneficial. Having too many benefits, rights, and features may be a deterrent to annuity providers.
Having numerous payment form options may produce several complications during a plan termination. Annuity providers are likely to tack on additional administrative fees to cover calculation costs. These optional payment forms must also be provided to participants in the Notice of Plan Benefits (requiring extra calculations).
If a plan sponsor is committed to a plan termination, but can wait for several years, then some of these payment forms may be removed from the plan. While core options are protected and permanent, both noncore options and redundant options have the possibility to be amended out of the plan. Core payment options include the following:
Note that features available in the original payment form options must be retained in one of the above core payment options. For example, a Social Security leveling feature or employee contribution refund feature could be eliminated from all payment form options except one of the retained payment forms, such as the single life annuity. Payment forms not described above are considered noncore options and have potential to be amended out of the plan. After a noncore payment form is amended out of the plan, participants retain the ability to elect any eliminated noncore option for up to four years. Plan sponsors should consider this timing when preparing for a plan termination.
Removing redundant options is more practical if a plan termination is already in motion. Redundancy is determined by classifying payment forms into one of six families of optional payment forms. A payment form not characterized by one of the six families may not be completely eliminated (such as a lump sum option). Otherwise, redundant payment forms may be removed if another option in the same family is retained. Figure 1 displays these six families along with some additional considerations. Redundant options may be eliminated after a 90-day waiting period following the amendment, which is more practical than the four-year wait for noncore option elimination.
Overall, ancillary benefits are not protected benefits. Some key ancillary benefits often seen in older defined benefit plans include certain Social Security supplements, additional death benefits, and disability benefits in excess of retirement benefits. Figure 2 lists several more ancillary benefits that are not protected.
Cost-of-living adjustments are an example of a protected ancillary benefit, as they cannot be eliminated for benefits that have already been accrued. However, plan sponsors may be able to phase out or remove cost-of-living adjustments for future benefit accruals.
These benefits generally add complexity to a plan that will inflate the bids from annuity providers. Careful review of these ancillary benefits and amending out any nonessential benefits will help reduce additional costs in the plan termination process.
Legacy benefits, sometimes known as “grandfathered” benefits, come in all shapes and sizes. In general, a legacy benefit is only available to certain participants, dependent on their entry date into the plan or on their previous employer (in the event that a prior plan was merged into the current plan). These benefits are considered protected benefits and may not be amended out of a plan.
Each legacy benefit adds a level of complexity to calculating a participant’s benefit and may add additional data difficulties during the plan termination process. Identifying all of the legacy benefits available under the plan and confirming that the necessary information is correct and easily accessible prior to the plan termination process would be prudent to avoid a scramble for this detail mid-termination.
Review of benefits, rights, and features (protected or not protected) prior to plan termination overall is a wise course of action given the complexities that come with the plan termination process. Plan sponsors with numerous optional payment forms, ancillary benefits, and legacy benefits should consider a long-term strategy for simplifying and amending their defined benefit plans in preparation for plan termination.