London Market Monitor – 31 May 2022
Our May review of the markets and Solvency II discount rates.
Under these conditions, some plan sponsors may choose to either freeze or terminate their DB pension plans and replace them with a different type of retirement plan such as a defined contribution (DC) plan, also known as a 401(k) plan.
It can be hard for plan sponsors to decide when the time has come to terminate their pension plans and to know how to go about the termination process in a way that connects the needs of both employees and the business. This article is the first in an ongoing series devoted to walking plan sponsors step-by-step through the questions that arise when considering a plan termination, and discussing the groundwork that is needed to get the plan ready for termination.
By design, a DB pension plan provides a fixed income to employees upon retirement. This fixed income or pension benefit is usually determined based on an employee’s compensation and length of service. The benefit is typically paid in lifetime monthly installments that start when the employee retires. Sometimes the benefit is paid as a single lump sum amount when the employee terminates employment, or when the employee retires. The present value in today’s dollars of all of the benefits that are expected to be paid out to all of the plan’s participants is known as the pension plan’s obligation or liability. In order to have enough money to pay all of these benefits, a pension plan sponsor sets up a trust of assets, which the employer funds periodically with contributions. These employer contributions, supplemented with the investment income earned on the assets, are what provide the future benefit payments to employees when they retire.
Terminating a pension plan marks the "end of the road." It’s at this point that all the costs and associated risks are eliminated or transferred to another party, either as lump sum payments directly to participants or by purchasing annuity contracts from an insurer. Bottom line—all of the assets and liabilities for the pension plan go to zero at termination.
Terminating a pension plan is very different from “closing” or “freezing” a pension plan. An open or ongoing DB plan allows new eligible employees to fully participate in the plan and earn added benefits each year based on their compensation and/or service. A closed pension plan allows current eligible employees to continue to earn added benefits each year, but new employees are not allowed to enter or participate in the plan. This is sometimes referred to as a soft freeze. By contrast, a hard freeze means that current employees can no longer earn further pension benefits and new employees are not allowed to enter the plan. Figure 1 illustrates this comparison.
Freezing a DB pension plan is typically used to limit the long-term costs of the plan, thereby reducing plan liabilities. It is also the first step on the path to terminating the pension plan. The decision to terminate comes with both cost and time requirements. The best way to minimize the financial impact of a plan termination is to decide to do so only if your pension plan is already either closed or frozen. A terminating plan must first be frozen, while a frozen plan may never need to terminate.
The cost of a plan termination is the amount of money that must be on hand to pay out all of the plan liabilities through paying lump sums directly to participants or purchasing annuities from an insurer. Typically, lump sums are offered to employees who are not currently receiving a monthly pension benefit. Annuities are purchased for those who choose not to elect a lump sum and for participants who are already receiving a monthly pension. Importantly, a participant’s lump sum amount is calculated based on factors specified by the pension plan provisions, but the cost to purchase an annuity for that participant is based on market conditions and can be a significantly higher amount. Because many or most of the participants will have the right to choose between a lump sum and an annuity purchase, the cost to terminate the pension plan cannot be known until the exact time of the termination, because it will depend on which participants elect a lump sum versus an annuity, as well as how market conditions will impact the cost charged by an insurer for the annuities to be purchased.
Typically, lump sums are 10% to 40% cheaper than purchasing annuities. The more participants who elect lump sums, the lower the cost of the plan termination.
In a low interest rate environment, paying lump sums and purchasing annuities can be very expensive. Both lump sum amounts and annuity purchase prices are tied to the interest rate environment, and a small change in interest rates can have a large impact on lump sum amounts and annuity purchase prices. In many cases, the plan assets are not enough to cover the payments required to terminate. It is not uncommon for a DB plan to have insufficient assets leading up to the date of plan termination, which means the plan sponsor must inject additional cash at termination in order to cover the shortfall. Note that plan sponsors also need to be careful about having too much in assets, because a surplus leads to all sorts of new complications!
In addition, a plan termination triggers a host of administrative, legal, filing, and other plan-related activities, with large price tags. There may also be a "noncash" cost to terminating a pension plan, which will be discussed in an upcoming article in this series entitled “Settlement Accounting?”.
There may never be an obvious time to terminate. The costs incurred due to terminating a pension plan are the biggest roadblock for many plan sponsors. For this reason, plan sponsors typically play "wait and see," waiting for interest rates to rise because that lowers the total cost of the termination. Absent cost considerations, some plan sponsors will terminate for other reasons such as other corporate transactions, bankruptcies, or market competition. Whether waiting it out or not, plan sponsors should take smart steps to ensure that their paths to plan termination are smooth ones. Any seemingly minor issue encountered along the way can become a major and costly problem when the time comes to terminate, and may even delay or stop the termination process. Here are some important steps that will help avoid common pitfalls:
Tackling these steps systematically in the years leading up to the plan termination will enable the termination process to proceed smoothly. Your Milliman consultant can help you navigate this tricky terrain on The Way Forward to a successful plan termination.
To see other articles in the Frozen Pension Plans: The Way Forward series, click here.