A new paper from Russell Investments, “Hibernation Versus Termination: Evaluating the Choice for a Frozen Pension Plan,” details the decision-making process for plan sponsors of frozen plans.
A lot of plans are currently frozen, Gannon tells PLANSPONSOR. “They operate under what we call hibernation,” he says, which he describes as the act of managing the plan for a period of time while preparing for termination at a later date. “Part of the paper’s purpose is to alert plan sponsors that they should have some idea about how to evaluate costs.”
It is tempting for plan sponsors to simply fall into a defaulted hibernation mode, he notes, but this is not an optimal way to handle the plan. Plan sponsors should assess the fixed costs of managing the plan, compare these costs with termination and decide when the plan should cross over.
A plan cannot remain in hibernation indefinitely, Gannon says, because it means managing the plan and paying the costs until the final benefit is paid to the last surviving participant. “Every frozen pension plan sponsor is presented with a choice,” he says, “or a series of choices, between immediate termination and hibernation. Plan sponsors should develop a way to evaluate the relative costs of these choices.”
Hibernation contains a structural advantage, Gannon points out, because the benefit liability for most frozen plans decreases with every passing year. A small plan will have a smaller termination premium relative to a larger plan. Because the termination premium decreases over time, temporary hibernation may look attractive, Gannon says.
But it’s important to realize that, while the plan sponsor waits for the liability to decrease, the plan continues paying administrative expenses, which can wear away savings established in the termination discount, Gannon says. Markets are also uncertain, he says, which pushes a plan to pursue lower risk liability-driven investing to make sure that adverse markets don’t further erode any savings in the termination premium.
The paper outlines two case studies. Gannon says the first, a stable pension plan, is meant to set up the various ways to compare termination and hibernation. “The cost of termination is the termination premium, and the cost of hibernation is the annual expenses plus the eventual termination premium,” he explains.
This first plan models a stable liability to show a baseline example, Gannon says. “I did not want to introduce the structural advantage embedded in hibernation for most frozen pension plans until the reader had a baseline on how to compare the two options,” he says.
The second case study illustrates how the decreasing liability can make hibernation more attractive. “For this new topic, each additional piece of the puzzle should be introduced individually,” Gannon says. “First, the base case, then the advantage of the decreasing liability and lastly, the impact of market risk in the stochastic analysis.”
Plan sponsors should bear in mind that cost is most influenced by the size of the termination premium, Gannon says, which is dependent on the size of the liabilities as well as the market for annuity purchases; the expense of running the plan during the hibernation period; and the impact of the market on the assets and liabilities during the hibernation period.
“Note that the [market impact] could lower expenses to the extent that assets grow faster than liabilities and will increase expenses if assets do not keep pace with liabilities,” Gannon says. “However, we typically recommend that the investment strategy be closely matched to the movement of plan liabilities [liability-driven investing] so as to minimize the market risk during the hibernation period.”
Unfortunately, there is no way to predict with certainty that the costs of hibernation will be lower than immediate plan termination, Gannon says. “We believe that there are certain elements of the cost that favor plan hibernation,” he says. “Most importantly, the termination premium will be lower for a pension plan with a lower level of liabilities. And it is common for frozen pension plans to have a profile where liabilities will decrease year after year. Eventually, they have to decrease all the way to zero.”
The key is to realize how much of an advantage is built in through the predictable decline of the plan liabilities, given the plan’s demographics, Gannon says. “Once this structural advantage is quantified, it is important to see if it is possible to limit plan expenses and investment risk so that hibernation is less expensive than plan termination.”
Russell’s analysis showed that hibernation is less expensive for many plans than plan termination on average, Gannon says. But the research also showed plan sponsors should not ignore the risk of hibernation potentially costing much more than termination.
“Plan sponsors should take the time to evaluate these choices to see if this is a risk they want to take,” Gannon says. “There are many frozen pension plans that continue to operate. Nearly a third of all pension plans are frozen, and under our definition they have chosen to be in hibernation mode because they didn’t terminate. I wonder if they fully evaluated this choice and are taking the necessary steps to lower plan expenses and investment risk.”
“Hibernation Versus Termination: Evaluating the Choice for a Frozen Pension Plan” can be accessed from Russell Investment’s website.