In 2012, many organizations that sponsor pension plans are considering the future of those plans - especially sponsors of frozen defined benefit plans. The year 2012 is arriving with fully phased-in changes to calculating lump-sum payments that will make it more cost-effective to terminate a pension plan. Many plan sponsors are reviewing those changes, and trying to understand what those changes may mean for the future of their pension plans.
What makes 2012 special?
When a DB plan terminates, plan sponsors typically offer participants the option to select a lump-sum distribution in lieu of the annuity benefits they've earned. The benefits for participants who don't elect a lump-sum payment are settled by purchasing a group annuity contract from an insurance company.
Until 2008, the amount of a lump-sum distribution was calculated using 30-year Treasury rates, which made these distributions fairly generous for participants - and expensive for plan sponsors. The new rules, established under the Pension Protection Act, mandate a gradual transition from Treasury rates to higher corporate bond rates for these calculations. In 2012, this transition will be complete, and lump-sum calculations will be based entirely on corporate bond rates, which will make lump sums less generous for participants but more affordable for plan sponsors.
Consequently, employers will be able to terminate DB plans more cost-effectively in 2012 than they could before. Of course, the actual cost of termination depends on plan design and the makeup of the participant population, but generally, many plan sponsors with frozen DB plans will find it advantageous to move ahead with terminations after 2012 arrives.
Is 2012 the year of the plan termination?
Several circumstances could affect the timing of plan terminations, so there's no guarantee that the arrival of 2012 by itself will lead to a flood of plan terminations. If interest rates stay low and plans continue to be poorly funded, terminations could be delayed well beyond 2012. Funding relief passed by Congress in 2008 and 2010 may also extend the time until plans are funded well enough to be terminated.
But employers could also decide to voluntarily make higher contributions. And if interest rates rise or equity markets perform well, funding ratios could improve quickly. In these circumstances, some plan sponsors could be ready to terminate their plans in 2012.
Once an employer decides to terminate the plan, the company may want to seek a determination letter from the Internal Revenue Service. As more plans seek to terminate, it may take the IRS longer to respond to each organization's desire for a determination letter.
Given all of these factors, plan sponsors likely will terminate their plans over the next several years, but not rush to exit their plans in 2012.
Donald Fuerst, senior pension fellow at the American Academy of Actuaries, believes that an uptick in termination activity is likely, but he does not expect a huge spike in 2012.
"Because interest rates are low right now and asset values are depressed, plan terminations are expensive," he says. "Companies may wait until the markets recover a bit before making a termination decision. While the corporate bond rate is higher than lump-sum rates in recent years and higher than annuity rates would be, companies would not see a huge gain right now if they terminate their plans."
Fuerst adds that although many corporate sponsors see economic value in maintaining their plans, he expects the trend of employers freezing their plans and eventually terminating is likely to continue.
Develop an investment strategy
Once you decide to terminate your plan, you should immediately seek expert advice on the right funding and investment strategies. You want to avoid having surplus assets in the plan. Here's why: If any assets remain after you pay all employee benefits, you have to pay income tax and a 50% excise tax before these assets can revert to your company. There are few other options, and with this kind of tax burden not much is left after the government gets its share.
Because of the risk of losing excess assets, you'll want to keep asset levels below the levels needed to pay out all benefits. After employees have made their distribution choices - annuities or lump sums - and you've determined the actual, final cost of payouts, you can make a final contribution to cover all the benefit payments required.
Investment strategies designed to generate high returns aren't of much value if your plan is already well-funded. To maintain an appropriate asset level as termination approaches, it's a good idea to use an investment strategy that closely matches assets to liabilities - usually a bond fund or a portfolio of bonds that have expected payments similar to the plan liability.
With this strategy, the value of the assets and the value of the liability will move in sync when interest rates change, so the funded status will be quite stable. Then, once an interest rate is fixed for determining lump-sum payments, you can move a portion of the portfolio into cash to cover the estimated cost of the lump sums. With this strategy, the right amount of assets will be available when the plan actually pays out all the benefits.
Make sure employees are prepared
To maintain positive employee relations through the termination process, it's important that your employees know exactly what to expect. They should understand the consequences of termination, which aren't necessarily negative, and they need to be thoroughly educated in their distribution choices.
"For many participants, the annuity offers much greater protection against the risk of outliving your assets," Fuerst says. "Yet we find that most people tend to pick the lump sums, perhaps because they think they'll be able to produce more income managing the funds themselves. Lump sums are for people who are skilled at managing investments or have a capable adviser."
Employees who choose lump-sum payments are likely to need serious guidance in how to manage these assets. Ideally, they'll keep them stashed away for retirement by rolling them over to a tax-favored account. You may want to encourage this choice by making it possible to roll these assets into your defined contribution plan. They also have the option to roll over to an IRA or to use some of the assets to purchase a third-party immediate-income annuity.
For those who choose an IRA, you should provide access to advice on how to build an appropriate investment portfolio. For those who choose an immediate annuity, you may want to offer assistance with choosing a provider, since these contracts can be complicated.
Cathy Toner, Esq., is a member of Vanguard's Strategic Retirement Consulting Group, which consults with plan sponsors on plan design and analytics, fiduciary best practices, and compliance and regulatory updates.
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