In my past few blogs, I’ve been discussing some of the strategies that Defined Benefit (DB) plan sponsors can consider in order to terminate their plan. There are generally three steps a plan sponsor can take. Today, I’d like to discuss the second step – develop a funding strategy.
Step 2 – Develop a funding strategy
After a plan sponsor has an understanding of what the cost to terminate the DB plan will be, the next step is to look at the available funding strategies for achieving this.
There are three basic funding strategies:
1. Contribute the minimum requirement for an ongoing plan each year until the year the DB plan is terminated. Then, in the year plan assets are distributed to the participants, plan sponsors have to make a contribution for the final amount to fund the plan termination.
- Advantage: Short timeframe and lower potential risk
- Disadvantage: Most expensive choice
2. Contribute a level amount each year until the year the plan is terminated. The estimated cost to terminate the DB plan is spread evenly over that time period.
- Advantage: Slightly less expensive (assuming positive investment earnings on contributions)
- Disadvantage: Must fund evenly – can’t defer large payment until year terminated
3. Fully fund the DB plan under ongoing Pension Protection Act funding rules (which are designed to fully fund the plan over a period of seven years) and then potentially let investment income make up the funding shortfall.
- Advantage: Could be least expensive choice
- Disadvantage: Risk that investment return may not make up gap as expected
Here is an illustration of these different strategies:
For more information specific to this chart, please download a copy of Winding down Your Hard-Frozen Defined Benefit Plan.
Strategy 3 is expected to be less costly than either strategy 1 or 2. However, because strategy 3 takes much longer, there is an increased risk of experiencing the negative impact of a down market. A down market could potentially cause a plan sponsor to see a decline in funded status, either adding to the ultimate cost or further delaying termination.
It’s important to discuss these options with your actuary – as each plan sponsor’s needs are different.
In my next blog, I continue this discussion with step 3 of terminating a DB plan – developing an asset allocation 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.
t13080901e6 – 8/2013