Is Your Defined Benefit Plan Ready for Termination? Part II
Part 2 – Funded Status
In last week’s post, we started with an overview of four areas pension plan sponsors need to understand about the plan termination process. This week, we will be going deeper on the first of these four areas: the ultimate cost of terminating a pension plan.
Each year, a plan’s actuary calculates different liability amounts: minimum funding requirements, PBGC premium calculations, plan audits, and financial reporting. Each of these liability measures is used for a different purpose, and each is subject to different rules and requirements. However, when gearing up for a plan termination, the only liability that matters is the cost to fully settle all the plan’s obligations. Understanding the true cost of termination allows sponsors to understand the financial shortfall for termination, and to build a plan for funding and accounting for that shortfall.
Typically, settlement of a plan’s obligations (aka liabilities) is achieved through a combination of lump sum distributions and annuity purchases. First, lump sum payments are offered to participants (both current and former employees) who have not yet started receiving their benefits. These participants cannot be forced to take a lump sum (unless their benefits are very small), and must be given the opportunity to elect to have a deferred annuity purchased by the plan. Retirees can also be offered lump sums as part of a plan termination, but for a myriad of (good!) reasons, the large majority of sponsors do not choose to make these offers.
Once lump sum elections have been made, the sponsor will purchase a group annuity contract from an insurance provider for all remaining participants – both in-pay participants (e.g. retirees and beneficiaries) as well as the not-in-pay participants who did not elect a lump sum distribution. The total cost of plan termination will ultimately depend on how many participants elect a lump sum and the cost charged by the insurer for the annuity purchase.
The lump sum “take rate” (i.e. the percentage of participants who elect a lump sum when offered) varies, but is usually well above 50% and sometimes can be close to 100%. Many factors can impact the take rate; some are under the sponsor’s control (for example, participant communications and quality of address information) and some are not (for example, the size of benefits, and the age and risk tolerance of participants). The lump sum take rate plays a huge role in determining the cost of plan termination; depending on plan provisions and complexity, lump sums are typically between 10% – 40% cheaper than purchasing deferred annuities from an insurer.
The annuity purchase premium is driven by demographics and market conditions. For deferred annuitants, the premium will also depend on plan provisions, as subsidized benefits and complicated features will increase the purchase cost. The higher the subsidies and the more complicated the plan, the higher the purchase price. Sponsors should note that some plan features may not be protected by ERISA and some other complicated provisions are unnecessary. Removing these provisions may make the plan easier to terminate (more on this in a later post).
Here are some actions plan sponsors should consider regarding their plan’s funded status:
Funding costs: Sponsors can understand the range in the cost of the plan termination by modelling termination liabilities under different lump sum “take rate” assumptions. This allows plan sponsors to understand the range of costs to fully fund the plan and devise a plan for funding the deficit immediately or over time.
Financial reporting impact: It is also important to understand the potential financial reporting impact due to fully settling liabilities, which will differ under various accounting standards. Under US GAAP, any unrecognized loss in accumulated other comprehensive income must be fully recognized as an expense in the income statement when the liabilities are settled. This can be a big number and a big surprise – more good information to know ahead of time.
Annuity buyouts: The annuity markets are impacted by the interest rate environment and market conditions. Sponsors can buy annuities for retirees before plan termination, or monitor market conditions for price changes. Increases in interest rates or new entrants to the annuity market can provide opportunities to lower the cost of termination.
Of course, any funded status estimate will necessarily be a snapshot in time based a certain set of conditions. Next week, we’ll be discussing how changes in those conditions over time can impact funded status.
Subscribe to receive news and updates in the defined benefit, defined contribution, or investment areas of the retirement industry.