There are generally three steps to terminate a defined benefit (DB) plan. Today, let’s take a look at the first step– evaluating the cost.
Step 1– Evaluating the cost of terminating a DB plan
The cost to terminate a DB plan is generally more than the cost to fully fund a hard frozen plan. Many plan sponsors don’t realize this. A common question I hear is “My plan is 100% funded under IRS rules. Why isn’t it sufficiently funded to terminate?” Sponsors may also not have made minimum required contributions for some time which could leave them under the impression their plan is funded enough to terminate it.
Different rules apply when determining plan termination liability. Plan sponsors can incorrectly assume if their plan is 100% funded from an ongoing perspective they are at the point that they can terminate the plan with no additional cost.
That’s not the case, because:
- At plan termination, plan sponsors must use current interest rates and asset values – you don’t get the advantage of smoothing these items over time.
- For those participants that choose an annuity as their benefit, the cost of those annuities are typically higher than their respective funding liability.
- All participants are in effect, retiring immediately – which can result in an early retirement subsidy cost.
Changes in interest rates can impact the value of plan liabilities. Since no one can predict the future movement of interest rates, any termination planning should also include calculation of costs using different interest rate scenarios.
Liabilities include retired and non-retired participants – For illustrative purposes only.
For more information specific to this chart, please download a copy of Winding down Your Hard-Frozen Defined Benefit Plan.
In this example, you can see the estimated cost to terminate the plan is higher because the termination liability is higher than the liability for the plan ongoing. Also, you can see the potential impact a change in interest rates can have on the determination of the plan’s liability. To help gain more of an understanding, consider an actuarial study that calculates possible plan costs based on certain assumptions or variables.
Knowing the possible spread between assets and the potential cost to terminate a DB plan can help plan sponsors decide whether they can afford to fund the shortfall over one year, five years or some other period. Depending on a plan sponsor’s risk tolerance and their organization’s access to capital, they may choose to fund the shortfall through contributions, investment earnings or a combination of the two.
In my next blog, I’ll be discussing the next step: developing a funding strategy.
In addition to blogging here, I also tweet regularly about DB topics of interest. Click to follow me on Twitter- @scottruba.
The subject matter in this communication is provided with the understanding that The Principal® is not rendering legal, accounting, or tax advice. You should consult with appropriate counsel or other advisors on all matters pertaining to legal, tax, or accounting obligations and requirements.
Asset allocation/diversification does not guarantee a profit or protect against a loss. Use of dynamic asset allocation does not guarantee improvement in plan funding status nor the timing of any improvement.
Insurance products and plan administrative services are provided by Principal Life Insurance Company a member of the Principal Financial Group® (The Principal®), Des Moines, IA 50392.
t13081503c8 – 8/2013