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Pension De-Risking In 2017

As companies fine-tune their future plans for 2017 and beyond, many employers are looking to evaluate the long-term viability of their defined benefit pension plans. Due in part to low interest rates, poor investment performance, volatility of plan investments and participants living for longer periods, plan sponsors are closely evaluating two options—maintaining the pension plan but utilizing “de-risking” strategies to minimize some of the pension burden or getting out of the pension business entirely by terminating the plan. Pension plan de-risking and plan terminations can take a variety of forms and can be approached in many different ways, largely driven by the funded status of the plan. This article provides an overview of the utility and rationale for pension de-risking strategies and termination options.

The Pension Predicament

The number of ongoing traditional defined benefit plans has significantly declined over the past several years as companies terminate or freeze pension plans. The problem is simple—defined benefit plans make lofty promises to employees and employers must bear the full risk of making good on those promises. For instance, it is common for pension plans to provide employees with a stated percentage, often 60%, of their final average salary at the time they retire with payments continuing for the rest of their lives. The cost of funding those “promises” has become too unpredictable for many employers. Pension benefit liabilities must not only take into account market conditions and employer contributions but also salary inflation and employee longevity. Moreover, contributions that companies are required to make to fund their defined benefit pension plans are notoriously difficult to foretell—a less than ideal situation for company finance departments looking to avoid unanticipated strains on the company’s cash flow. Add to that, the recent update to the Society of Actuaries mortality tables clearly shows that people are living longer. Longer lives means employers must set aside more cash to make good on the promise of benefits that pay out over the course of the recipient’s lifetime.

As if market and mortality uncertainties weren’t enough, the administrative burdens associated with defined benefit pension plans are significant. Plans must engage trustees, investment advisors, legal counsel, and actuaries to assist with the plan’s day-to-day activities. In addition, traditional pension plans are obligated to purchase insurance from the Pension Benefit Guaranty Corporation (“PBGC”) to underwrite benefit promises. PBGC premiums have continued to grow and the flat-rate premium payments for participants have more than doubled since 2006.

For these reasons and others, employers are looking to get out of the pension business or minimize their exposure. Various considerations come into play when evaluating whether a plan termination or plan de-risking strategies are appropriate for a plan sponsor. In order to understand the utility of each approach, plan sponsors must first understand the alternatives.

Plan Termination

A pension plan may be terminated only by following certain specific rules. A plan that has enough money to pay all benefits owed participants and beneficiaries may utilize a “standard termination” procedure. In a standard termination, for each participant or beneficiary, the company either purchases an annuity from an insurance company to fund the pension benefit or pays the benefit owed in one lump sum payment that is actuarially equivalent to the lifetime benefits otherwise payable under the plan. Once all participants’ benefits are distributed or converted to annuities, the plan terminates and the plan ceases to operate as an ongoing entity.

A plan that does not have enough assets to pay its liabilities can only be terminated in a distress or involuntary termination. A distress termination may be used only if the employer can show that maintenance of the pension plan is putting the company in jeopardy. In other words, the employer must prove to a bankruptcy court or to the PBGC that the employer cannot remain in business unless the plan is terminated. If the application is granted, the PBGC will take over the plan as trustee and pay plan benefits, up to the legal limits, using plan assets and PBGC guarantee funds.

If an employer with a struggling pension plan does not act independently to terminate a pension plan, the PBGC may take action on its own to end a pension plan. The PBGC will often intervene where the PBGC determines that the plan must be terminated to protect the interests of plan participants or of the PBGC insurance program. For instance, if a plan does not have enough money to pay benefits currently due, the PBGC will take an active role in the plan and either act to terminate the plan or improve its financial viability.

Regardless of the type of termination, terminating a defined benefit plan will stop future benefit accruals and funding obligations, and will eliminate future PBGC premiums and ongoing administrative expenses. Employers interested in terminating a pension plan should proceed with caution; the pension termination process is a long and arduous process that requires involvement of both the PBGC and the IRS.

Minimizing the Pension Burden

In lieu of terminating a pension plan, many employers are looking to various different de-risking strategies to try and minimize the impact of the pension plan on the company’s finances. While de-risking strategies can take various different forms, the most common de-risking strategy we see is utilization of lump sum window distributions whereby the plan offers a one-time lump-sum cash-out opportunity to terminated vested participants or retirees. By reducing the number of participants entitled to benefits from the plan, a lump-sum window can help to eliminate future pension payments from the company’s balance sheet. However, the IRS has limited the utility of lump sum windows to vested participants who have not yet begun payments—pension plans may not offer lump sum windows to participants in pay status but may provide them to participants that are not in pay status.

Lump Sum Window Programs

Lump sum windows distribute the current dollar value of participants’ vested benefits from the pension plan. The lump sum distribution must be elected by the participant—the company cannot force the lump sum distribution. Window programs are generally targeted to former employees who are fully vested in their pension benefits but not yet old enough to collect them. This eliminates liability for future payments by the plan sponsor on behalf of each participant accepting the lump-sum window. A lump-sum window is a viable de-risking strategy because it transfers the plan’s liabilities to participants and decreases the assets of the plan which minimizes the impact of future market events. When considering a lump-sum window, the employer should review the plan’s current funding level because a lump-sum window may not be allowed if the plan assets are below certain funding thresholds. Similarly, companies considering window programs should also be cautious because dramatic decreases in pension assets may have unforeseen accounting ramifications.

Lump sum windows are beneficial to employees because they allow employees to enjoy greater choice in their benefits while giving participants immediate access to their retirement benefits. The more participants that elect the lump sum, the greater the company can reduce overall plan expenses and administrative costs and limit future market exposure.

Where Do We Go From Here?

Conversations around pension de-risking and plan termination may escalate if the financial markets perform well and the funded status of defined benefit pension plans increase. Healthier pension plans put businesses in a better position to implement these strategies. Additionally, a hike in interest rates may also increase pension termination and de-risking strategies because better interest rates would also lead to a rise in pension plan funding levels.

Whether to terminate a pension plan or simply de-risk is a business decision driven by various factors and should ultimately be driven by a company’s long-term goals. The only way to remove all pension plan liabilities from the balance sheet is through a full-blown plan termination. In contrast, a lump-sum window can help reduce those obligations in the short-term. While the underlying reasons for pension risk transfer strategies are well-founded, plan sponsors should have a good understanding of the full process before they proceed. Pension plan terminations are complicated and time-consuming and de-risking can yield varied results depending upon the situation. In either circumstance, the decision involves complex issues that need to be resolved and discussed; there is no such thing as a one-size-fits-all approach.