One of the latest marketplace trends these days is for single-employer defined benefit (DB) pension plans to consider offering terminated vested participants a one-time lump-sum offer in lieu of a future monthly benefit. The primary reason for this recent trend is that plan sponsors are trying to “de-risk” by eliminating potentially volatile pension liabilities. Settling terminated vested participants with a lump-sum payout now means the plan sponsor no longer has any future risk associated with those liabilities.
In having various watercooler discussions over the past year, I have always wondered: If it is such a great idea to have a lump-sum window now, than why not make it a permanent plan feature?
Here are two major reasons why making the lump-sum feature permanent makes sense:
• Once a terminated vested participant is cashed out, the plan sponsor is no longer required to pay Pension Benefit Guaranty Corporation (PBGC) premiums on behalf of the participant. By making a lump-sum feature permanent a plan can continue to reduce its PBGC premiums beyond a lump-sum window period. With PBGC premium rates scheduled to increase over the next several years, which is due to recent legislative changes, it will be more expensive for a plan sponsor to maintain its terminated vested liability.
• Once a terminated vested participant is cashed out, there is no longer any concern about having to locate the participant at a future date. This is especially important if a plan sponsor is considering a plan termination where the plan sponsor is required to make a serious effort to find all terminated vested participants. By making a lump-sum feature permanent a plan sponsor has the opportunity soon after a participant terminates employment to cash them out, which eliminates the possibility they will ever become a missing participant.
One downside to making a lump-sum feature permanent is that, in a plan termination situation, insurance carriers will require that a lump-sum option be reflected in its annuity purchase pricing. This will increase the cost of plan termination annuity purchases for those participants not electing an immediate lump-sum payout at plan termination.
In both cases, there are issues that will need to be considered before amending a plan to add a lump-sum feature:
• Plan administration will need to be modified to offer terminated vested participants an immediate monthly benefit (even if the participant is younger than the plan’s regular early retirement age) in lieu of the offered lump-sum distribution. The plan will then also need to communicate to the participant the “relative value” of the lump-sum payout compared to the immediate monthly benefit. Depending on whether early retirement subsidies are included in the lump-sum calculation, the relative value could be well below 100%.
• The plan will need to be monitored for compliance with benefit restriction rules in conjunction with offering a lump-sum distribution. In general, a plan will need to be at least 80% funded in order to be able to offer a full lump-sum distribution. In addition, the highest 25 compensated employees may have to wait until greater funding thresholds are attained or the plan is terminated to receive a full lump-sum distribution.
• The plan sponsor will need to monitor the possible need to do special settlement pension accounting calculations. This type of calculation is more likely to be required in a lump-sum window situation because of the greater likelihood of a large number of lump-sum payouts in a given fiscal year.
In conclusion, plan sponsors that are considering embarking on a “de-risking” strategy by offering a lump-sum option to terminated vested participants may wish to consider making the option permanent in order to further reduce PBGC premiums and possible later headaches from trying to find missing participants.