Evaluating plan hibernation vs. plan termination

For the nearly 50% of corporate pension plans that are either closed or frozen, the choice to terminate the plan is essentially a timing decision, because it is unlikely that a sponsor would elect to manage the plan until the last benefit is paid to the last surviving participant.

This decision can be evaluated based on a comparison of costs: the upfront fixed cost of plan termination compared to the ongoing and uncertain costs of plan hibernation. Below is a framework for comparing the upfront fixed costs of plan termination to the long-term costs and uncertain outcomes of plan hibernation.

Termination — An immediate purchase of annuities for all plan participants. After this action the plan will cease to exist, and a third party will inherit the obligation for all future payments. The cost is known in advance and comes with no variability.

Hibernation - Managing the plan for an extended period of time and then terminating at a later date. The cost of hibernation is defined as the net present value of the sum of all cash expenditures made with respect to the pension plan.

Which approach is cheaper will depend on (among other things):

nThe termination premium. There is typically a “premium” over the corporation's stated liability value for transferring the responsibility of ongoing payments to an insurance company. This premium covers a more conservative (and perhaps more accurate) valuation of the plan liabilities and expenses and the profits of the insurance company, to name a few of these items.

nOne-time expenses of termination, including any expense paid to facilitate the termination process.

nAnnual expenses. These include investment management, actuarial, legal and staff fees; flat rate and variable Pension Benefit Guaranty Corp. premiums; and other administrative expenses.

nOngoing plan funding. The funding requirements of the plan during the hibernation period.

nSurplus or deficit. Any surplus of the pension plan generated during the hibernation process could be used as an offset to the above costs. Any deficit would either increase the cost of termination at the end of the hibernation period or extend the hibernation period. One implication of using a net present value approach is that if at any point in time the plan has a surplus that is at least equal to the termination premium, the analysis will show that the sponsor should terminate the plan at that point because there is no additional contribution needed to terminate the plan; the NPV of termination would be zero.

To illustrate the comparison between termination and hibernation, consider a sample frozen pension plan that is fully funded with $1 billion in both assets and liabilities. The plan has chosen an investment strategy of investing in an asset that behaves exactly as the movements of the plan's liabilities.

This case study weighs two choices: 1) plan termination today; and 2) plan hibernation for 10 years.

Through the hibernation process, the plan will incur the following costs: annual plan expenses and a termination premium at the end of the hibernation period. No additional contributions (beyond plan expenses) will be paid during the hibernation period, because the liability is perfectly matched; and none of the termination premium will be offset by any surplus, because no surplus is created when investment is in the liability-matching asset. The cost of hibernation, in each case study, will be compared to the immediate termination premium.

Exhibit 1 shows that the cost of plan hibernation is $67 million, which is the sum of annual expenses plus the termination premium at year 10. This is substantially less than the $111 million cost of the immediate termination strategy, and therefore the company would pursue plan hibernation over immediate termination.

The above example shows that hibernation typically has several structural advantages over plan termination. The first is that a mature plan typically is paying off its liability at a very rapid pace. Therefore, at the end of the hibernation period, a much smaller termination premium is paid, because of the plan's decreased liability size. The second is that the act of waiting allows the population to age and therefore decrease some of the assumptions going into liability valuation. Further, the annual dollar amount of plan expenses also decreases (along with decreasing asset size), which helps hibernation. Lastly, the sponsor of a hibernating plan retains the option to eventually terminate at a later date, and options typically have a positive value.

The case study, although simplified, shows a basic structure for a sponsor's evaluation of the costs of plan hibernation relative to costs of immediate termination and should help guide analysis and decision-making processes.

Despite the advantages shown above, hibernation could involve a significant amount of investment risk that could be analyzed using stochastic modeling. Under the stochastic process (unlike the case study above) the plan might run the risk of opening a deficit that would add to the cost of hibernation or may earn a surplus, which could reduce the cost or time period of hibernation.

Because successful plan hibernation demands the minimization of the uncertainty surrounding future costs, stochastic analysis generally demonstrates that investment decision-makers should lean toward an asset mix with a high allocation to liability-driven fixed-income investments.

In practice, analysis will be more detailed than shown above, and include sensitivity analysis of factors such as plan expenses, plan demographics, termination premium and the funded status of the plan.

Implicitly, all frozen pension plans are choosing between termination and hibernation. They are opting either to run the plan into the future or to terminate today because they believe, typically, that their choice will reduce costs. Described above is how the net present value analysis that is implicit in that decision can be made explicit.

In many cases, hibernation will prove to be the cheaper option using NPV analysis.

However, plans must be judicious about taking risk during the hibernation process. Excess return derived from the taking of investment risk could reduce the cost of hibernation relative to immediate termination, but could also increase the (longer-term) cost of hibernation over that of upfront plan termination. It is important to achieve consensus among those who operate the plan and to document decisions on the investment strategies to be used during the hibernation period.

The decision processes don't take place in a vacuum, and although an NPV analysis is important, it is not the only factor. If the plan is large relative to the sponsoring organization, the sponsor might be willing to terminate — even if analysis favors hibernation — if doing so would enable the company to better concentrate on its core strategy. n