Considerations for pension sponsors before freezing/phasing-out a single employer DB plan

Kamenir-JeffBased on some recent survey information, reports on the demise of pension plans have been greatly exaggerated. A survey that I conducted in 2012 on Milliman single employer defined benefit (DB) pension plans, showed that about 50% of the plans were still accruing benefits for at least some participants. In addition, a Bureau of Labor Statistics National Compensation Survey in March 2012 indicated that 68% of private industry DB plans covering nonunion workers are still accruing benefits. Even if these survey results are flawed, it is clear that not all DB plans have frozen benefit accruals. Therefore, for many plan sponsors, the decision of how to maintain an ongoing accrual DB plan is still relevant.

The four scenarios that the plan sponsor of an ongoing accrual DB plan would most likely be considering are:

1. Maintain the DB plan as is with no changes.
2. Freeze all benefit accruals followed by a plan termination.
3. Freeze all benefit accruals without an immediate plan termination.
4. Maintain ongoing accruals for only current participants with no new participants.

The advantages and disadvantages of each scenario from a plan sponsor perspective are summarized below.

Maintain DB plan as is: Advantages
A DB plan is the best vehicle for providing monthly lifetime income to participants because it is not subject to mortality and investment risk. With defined contribution (DC) plans, participants must figure out on their own how to make their account balances last a lifetime.

For active participants, DB plan benefits can automatically adjust for inflation under a final average pay benefit formula. For retired participants, that can be accomplished with an automatic cost-of-living feature.

In many ways DB plans are more flexible in design than DC plans. DB plans can offer features such as early retirement windows, ongoing subsidized early retirement benefits, and supplemental monthly benefits to Social Security or Medicare retirement age, providing participants the opportunity to retire early. DB plans can easily be amended to update past service benefit accruals by a benefit formula improvement.

As with DC plans, DB plans can be easily amended to reduce future benefit accruals.

Maintain DB plan as is: Disadvantages
Managing the cost volatility (funding and pension accounting) that is primarily related to unpredictable investment performance and liability interest rate changes remains the biggest challenge facing any DB plan. Plan sponsors should discuss possible policies and strategies with their actuaries and investment consultants to help reduce cost volatility.

Pension Benefit Guaranty Corporation (PBGC) premium rates, both flat and variable, will be increasing under the Moving Ahead for Progress in the 21st Century (MAP-21) legislation passed in 2012. This is a plan expense that only provides a benefit to the plan sponsor in the unlikely event of a distress plan termination.

Freeze all benefit accruals/plan termination: Advantages
The plan sponsor no longer needs to be concerned about cost volatility issues.

In a plan termination situation, unlike an ongoing plan situation, active participants can be offered immediate access to the lump sum value of their accrued benefit.

Freeze all benefit accruals/plan termination: Disadvantages
The plan sponsor must commit to the plan termination process, which has many steps and stringent deadlines. In conjunction with the plan termination, the plan sponsor will need to locate all terminated vested participants and may need to cleanse data to accurately determine accrued benefits for active and terminated vested participants.

The recent low interest rate environment has increased the cost of settling liabilities (lump sums and annuity purchases).

The plan sponsor in a “standard” plan termination will typically need to make a significant immediate contribution in order to fully fund plan termination liabilities.

Most plan sponsors decide to design some type of replacement for the frozen DB plan benefit accruals, typically through new DC plan contributions. This is a time-consuming process with lots of necessary participant communications. Many times, special transitional DC plan contributions are considered for long-service DB plan participants who are most adversely affected by the benefit freeze.

Special curtailment and settlement pension accounting calculations will be required, resulting in the immediate recognition of unrecognized pension accounting losses.

Freeze all benefit accruals/deferred plan termination: Advantages
In comparison to an immediate plan termination, the plan sponsor can hope for a prospective higher interest rate environment in order to reduce the cost of settling plan termination liabilities. In addition, the plan sponsor can start gradually funding for plan termination liability, rather than having to immediately make a large contribution, and special settlement accounting is deferred.

Freeze all benefit accruals/deferred plan termination: Disadvantages
In comparison to an immediate plan termination, communications to active participants will be more difficult because they will not have immediate access to their frozen DB plan benefits. In addition, the plan sponsor will still need to annually maintain the DB plan, which entails management of cost volatility and annual payment of PBGC premiums.

As with an immediate plan termination, the plan sponsor will still need to go through a process to determine a replacement for the frozen DB plan accruals and special curtailment accounting is still immediately required.

Maintain ongoing accruals for only current participants: Advantages
The plan sponsor is able to keep the “promise” made to current participants at their hire that they could count on receiving retirement income for all company service from a DB plan.

Maintain ongoing accruals for only current participants: Disadvantages
In comparison to maintaining a DB plan for both current and new participants, the plan sponsor will need to monitor minimum coverage nondiscrimination requirements because all employees will no longer be covered under the DB plan. In addition, as fewer and fewer current participants accrue benefits from the DB plan because of eventual termination or retirement, the plan sponsor will also need to monitor minimum participation nondiscrimination requirements.

In comparison to a freeze of all benefit accruals, it will take much longer to see any significant DB plan cost reductions.

In conclusion, the plan sponsor should give consideration to all of the above presented issues before deciding to make significant changes to its ongoing accrual single employer DB plan.