Thanks to a convergence of events — strong stock market gains coupled with rising interest rates — this might be the best time in years for companies to terminate defined benefit plans.
The use of defined benefit pensions has been in long-term decline as employers have moved away from plans that guarantee incomes for retirees, who are living longer, and instead have offered employees 401(k) or similar retirement savings plans.
All told, private companies have frozen 37% of defined benefit plans, either closing them to new employees or freezing accruals entirely, according to U.S. Bureau of Labor Statistics data. Now, many companies should consider going further: terminating defined benefit plans and giving participants the choice of either taking a lump-sum payment or a set annuity.
For years, with interest rates at generational lows, U.S. pension asset growth underperformed liability growth, causing a headache for plan sponsors that must ensure plans are adequately funded. That trend has now reversed.
The S&P 500 gained almost 10% in 2016 and almost 20% in 2017, boosting assets dramatically. At the same time, interest rates are rising, so liabilities are falling. It's a set of circumstances that makes this the best time to terminate a defined benefit plan since the mid-1980s — the last time such a convergence of circumstances took place.
While there are an enormous number of frozen pension plans, where participants are no longer accruing benefits, employers still assume the liability associated with market volatility. That can be a considerable risk: When assets dip precipitously, as happened in 2001 and 2008, plan sponsors must make up the resulting shortfall over a five- to seven-year period in order to comply with IRS regulations.
If sponsors choose not to terminate plans now, they will almost certainly pay out more in the long run than they would today. That's because, for many plans, the present value of their future expenses and fees is greater than the cost of terminating the plan now (by making up any shortfall via a company contribution or by borrowing to meet the shortfall.) And, with interest rates rising, buying annuities now is cheaper than it has been in years.
As a result, sponsors of even modestly well-funded defined benefit plans can save expenses while forever removing from their balance sheets all the risks associated with pension plans. While consultants that cater to the largest plans are helping clients assess the best path of action, countless small to midsize plans might be unaware of this opportunity. Executives at as many as 16,000 frozen plans, generally those with $100 million or less in liabilities, might be unaware of these circumstances.
Discerning whether it makes sense to terminate a plan starts with a high-level assessment of the potential savings compared to the contributions that would be needed to terminate the plan now. Liabilities comprise both payouts to participants and the present value of anticipated expenses — such things as actuarial and accounting fees, trustee fees, investment fees, Pension Benefit Guarantee Corp. premiums and other costs.
Having undertaken that high-level analysis, companies have three basic choices about how to proceed:
- Let the plan remain as it is.
- Offer a window during which employees and terminated vested participants can accept a lump-sum payment to reduce plan liabilities.
- Terminate the plan by offering a choice between a lump sum and an annuity to non-retirees and purchasing annuities for retirees.
When terminating plans, the cost of a lump sum payout is less expensive than an annuity. While most employees typically take the lump sum, those closer to retirement or who are risk-averse, will opt for the annuity. Even firms that decide to offer a lump-sum window, should gather quotes from insurance companies for annuities to have the flexibility to terminate should circumstances change.
For most companies with a modest shortfall between assets and liabilities, it makes sense to terminate a defined benefit plan. Doing so removes economic and market volatility risks, as noted above, as well as the statutory risk that comes from rising administrative fees. (For example, PBCG premiums have risen sharply in recent years.) Terminating a plan also removes the actuarial risk that liabilities will increase in tandem with rising life expectancy.
For some companies that are growing rapidly, it might make sense to retain a defined benefit plan. For example, if liabilities are projected to grow at 5% but the firm enjoys a significantly higher internal rate of return on its capital, the business leadership might decide it makes financial sense to keep its defined benefit plan.
For most firms, however, there may never be a better time to terminate than now.