Managing Surplus Funding When Terminating a DB Plan

Media reports show that defined benefit (DB) plan sponsors have enjoyed increases in funded status and as a result are considering offloading their plan responsibilities, either via pension risk transfer solutions or simply terminating their plans.

In an insightful article, Brian Donohue, partner at October Three Consulting, based in Chicago, discusses how a funding surplus can pose a challenge to DB plan sponsors’ actions and what they can do to mitigate this problem.

He points out that a surplus of assets over liabilities after a plan has terminated must be taken back into corporate income. At that time, the sponsor must, in addition to income taxes, pay an excise tax of up to 50%. The ideal, he says, is to have just enough plan assets to cover all liabilities (and termination expenses), and no more.

According to Donohue’s article, the total cost of terminating a plan has three components: the lump sum value of the benefits for participants who elect a lump sum payment—roughly equal to the “book value” (for GAAP financial statements) of the participant’s benefit under the plan; the cost of buying annuities for those participants who do not elect lump sums; and the administrative costs related to the termination process—a variety of calculations, communications and filing with the Pension Benefit Guaranty Corporation (PBGC).

Donohue says these costs can add between 15% to 35% for non-retirees and 5% to 10% for retirees to the cost of terminating a plan. Therefore, “full funding” means the value of plan liabilities plus this additional “termination premium.”

Market effects pose the biggest challenge to plan sponsors when trying to achieve full funding. Donohue explains that a plan’s lump sum valuation rate is typically set before the beginning of the year (e.g., many plans calculate all lump sums paid in 2018 based on market interest rates as of November 2017). Plans taking this approach will have to wait until 2019 to realize the effect (in a higher lump sum discount rate/lower lump sum values) of interest rate increases on lump sums. By contrast, the effect of changes in asset values on a plan’s funded status (for purposes of a plan termination) is instant. A 6% decrease in asset values means 6% less for lump sums, annuities and administrative expenses.

Strategies he suggests for managing the risk of having surplus funding include under-contributing and hedging (e.g., using liability-driven investments).

Both current Employee Retirement Security Act (ERISA) funding rules and the fact that plan termination adds a premium to the cost of settling plan liabilities make room for under-contributing, according to Donohue. And, generally, a plan sponsor will be able, on plan termination, to make a “true-up” contribution to cover any plan deficit, although Donohue suggests sponsors review this issue thoroughly with tax counsel.

However, the problem with this strategy is that it foregoes a number of tax benefits from adequately funding benefits, and it is likely to trigger PBGC variable-rate premiums on the underfunding. Further, Donohue points out, because of recent increases in interest rates, and increases in asset values since 2008, many sponsors find their plans already approaching full funding, with the option of strategically underfunding the plan no longer available.

According to Donohue, the master strategy to get to full-funding-but-no-surplus on termination is to reduce plan risk by gradually changing the plan’s asset strategy as the plan approaches full funding—the “glide path” strategy that some sponsors have adopted. The problem is that changes in interest rates or (especially) asset values can change a plan’s funded status precipitously.

“In these conditions, sponsors may want to consider what steps might be necessary to permit them to act on a termination decision quickly. This might involve: Being able to execute on a decision to move plan assets into matching duration bonds immediately, once the threshold target is reached. Locking in (e.g., annually) the cost of administering the plan termination. And regularly surveying annuity carriers to get a more accurate estimate of benefit costs,” Donohue says.

However, he concedes that absolute certainty that plan assets will exactly match plan liabilities plus termination costs is generally unrealistic. If, post-termination, the sponsor will continue to sponsor some DB plan (e.g., one for another division or subsidiary), transfer of the plan surplus to that plan may be a viable option. In addition, most plan sponsors can avoid income and excise taxes by transferring pension surplus to a suspense account to fund a “qualified replacement plan” (e.g. a DC plan that provides non-matching contributions) over up to seven years.