After all, just because no new individuals are being enrolled in the plan or earning new benefit accruals doesn’t mean that the pension plan becomes less of a management challenge. "The decision to freeze or close a pension plan is a big and difficult step," says Jim Morris, senior vice president of SEI Investments in Oak, Pennsylvania. "But once it is made, a whole new set of risks come into play for the plan that must be managed."
To terminate or not to terminate
The first question that must be answered is whether to terminate the plan or let it continue until the last participant dies. If the company is concerned about the risk exposure generating by fluctuating plan asset and liability levels, simply freezing the plan will not make those issues go away.
"The company needs to determine whether it make sense to terminate the plan," says Cecil Hemingway, managing principal with Towers Perrin in Hartford, Connecticut. "Plan termination takes risk off the table, but it can be expensive if the plan is under-funded."
Morris estimates that one third to one half of companies with a closed or frozen pension plan will terminate the plan either immediately or at some point in the future. "There is pressure from inside and outside the company to take risk out of business or to replace financial risk with industrial risk," he says. "Those companies have a specific goal to terminate the plan."
However, the ultimate answer to the termination question depends on several factors, including the plan’s funding level, the value of tax deductions received for plan contributions, the present value of future plan costs, and the company’s willingness to continue administering the plan.
"Companies need to determine whether it make sense to continue the plan or terminate it," says John Ehrhardt, a principal and consulting actuary with Milliman Inc. in New York. "If the answer is termination, it is important to develop an exit strategy" that outlines under what conditions the company will terminate the plan and what steps the company will take to achieve those conditions.
The key for companies that opt for termination is to time the termination in order to minimize total costs.
"If a company wants to terminate a plan that is under-funded, it must write a check to cover the shortfall," Morris says.
Not surprisingly, companies may be unwilling to do that, particularly if the funding shortfall is significant. But simply getting a pension plan to the point where it has funded 100 percent of its accrued liabilities will not be enough because termination liabilities are generally higher than accrued liabilities. Moreover, in addition to paying out lump sum benefits or purchasing guaranteed annuities for beneficiaries, the company will also face many other legal, administrative, and actuarial costs for the termination. Therefore, the overall cost to terminate a plan may represent 120 percent to 125 percent or more of the plan’s accrued liabilities.
That is why many companies are looking at plan termination as a long-term goal and are developing long-term investment and funding strategies to achieve that goal, even it takes 10 or 15 years of careful management to achieve.
"An intermediate step is to develop an investment policy that focuses on what the company needs to do to get the plan into shape and make it less risky," Hemingway says.
Companies can build in trigger points for changing funding and investment strategies. As the plan asset levels increase over time, say to fund 85 percent or 90 percent of plan liabilities, the investment strategy would shift at those milestones to reduce investment risk and protect plan assets. The company can also keep an eye on external factors that can affect plan costs. For example, the company can follow the annuity market and try to time its annuity purchases at a point when the annuity market is soft to minimize those costs.
"If the plan works out, the company should not have to write check to close out plan," Hemingway says.
If the company chooses not to terminate a closed or frozen plan, it still needs to make some changes to plan management. "This process is different for a frozen or closed plan than it is for an active plan," Morris says.
For example, in an active plan, there is no concern about over-funding the plan because any excess assets can be used to fund future accruals. However, a frozen plan will have either no or fewer future accruals than an open plan.
Therefore, the company needs to carefully plan its funding strategy and continually monitor funding levels to ensure that there is no surplus. A significantly over-funded plan represents wasted money to the company. To discourage companies from terminating over-funded plans to get at the assets, federal law imposes an excise tax of up to 50 percent of excess pension assets when a company terminates a pension plan and does not set up a replacement plan and comply with certain other requirements.
Consider the future
Planning aside, a company should think carefully before it makes the decision whether to terminate a pension plan after freezing it.
"It can be shortsighted to get completely out of the defined benefit pension plan business," says Ehrhardt. "The company circumstances could change in five or 10 years and it might become advantageous for the company to unfreeze the pension plan as a tool for managing the workforce by offering subsidies for early retirement or enhanced benefits for delaying retirement."
Moreover, in those coming years, companies may find that the defined contribution plans that replaced closed or frozen define benefit plans are not providing a level of asset accumulation that will allow employees to retire.
"These companies may need to find new tools for managing employees toward retirement," says Ehrhardt.