Active defined benefit plan participants—those employees still working for an organization and enrolled in its plan—and particularly participants younger than age 59.5, can pose challenges for sponsors considering pension risk transfer strategies.
Unless the sponsor has frozen the plan, active participants’ benefits continue to accrue and will vary over time based on the plan’s benefit formula, which typically considers length of employment and final salary. That variability makes it more difficult to estimate a pension benefit’s present value and settle a plan’s liabilities, which are key steps in calculating lump-sum and annuity payouts.
In addition, from a legal perspective, plans generally can’t cash out active employees, notes Matt McDaniel, U.S. leader, financial strategy group with Mercer in Philadelphia. However, he adds that there are exceptions to the rule—including plan terminations, partial spin-offs and terminations, and in-service distributions–which allow sponsors to target active participants.
Terminate the Entire Plan
McDaniel says plan terminations give active participants the option of taking a lump-sum payout or accepting an annuity from an insurance company. “That kind of activity’s been happening for 30 years, as long as plans have been terminating,” he says.
Termination isn’t an option for all plans, though. Bill Henry, head of plan terminations and annuity purchases with Willis Towers Watson in Philadelphia, explains that participants’ benefits must be frozen first to halt ongoing benefit accruals under a full, standard termination. In this type of termination, all benefits must be fully funded at the end of the process with no changes in either benefit amounts or payout options for the plan participants. The results can differ with distress terminations where the plan is turned over to the Pension Benefit Guaranty Corporation, Henry notes. Participants in those cases might experience changes in payout amounts or options.
Henry estimates that almost all sponsors give active employees an opportunity to take lump-sum distributions in a plan termination. If an employee declines that option, their benefit is transferred to an insurance company. Participants can roll their lump- sum distributions to other tax-deferred plans, often including the company’s defined contribution plan, and employers save on pension administration and insurance costs, so it’s usually a positive outcome for both parties, Henry says.
With a full, standard termination, any deficit between the plan’s assets and the liabilities must be funded immediately. Depending on the plan’s funding level, a termination could require a significant infusion of cash to cover the shortfall. “That’s the decision that a lot of sponsors face,” says Henry. “In order for them to pursue that strategy, it may accelerate any funding of a pension shortfall that exists in the plan.”
Pursue a Partial Spin-Off and Term
Michael Clark, managing director and consulting actuary in River and Mercantile’s (soon to be Agilis) Denver office, says DB plans’ initial PRTs often involve retirees and vested terminated participants. After dealing with those groups, an analysis of remaining participants might show a large number of active participants still in the plan. If the plan has been frozen for a while, many participants can have small benefits that have stopped accruing. At that point, the sponsor realizes it’s “paying a lot in administrative fees for having them in the plan for a very small benefit that’s promised to them way into the future,” says Clark.
If the company is not prepared to terminate its plan completely, spinning off a segment of the plan and then terminating it can give participants access to their accrued benefits. The procedure results in two plans, temporarily. The terminating plan will include active participants, but it also can hold vested, terminated participants and retirees, says Clark. Once the plan is terminated, its participants are offered the same option as those available in a full termination: Take a lump-sum payout or the plan will transfer their benefit to an insurance company to be paid out in the future.
The strategy works particularly well with plans that have been frozen for years, Clark maintains. Those plans often have sizable numbers of participants with small average benefits. The small-benefit cohort has been “the target of pension risk transfers over the last decade,” says Clark, particularly in light of rising PBGC insurance premiums.
McDaniel observes that spin-offs and terminations can generate a very good return on investment for employers in terms of reducing costs and risks, but he cautions they’re not simple transactions. “You need to go through a spin-off process with an appropriate asset allocation and then go through the full plan termination process for the new plan, which itself is fairly onerous,” says McDaniel. “I think that’s been the big hurdle there and probably one of the reasons why we’re never going to see spin-offs and terminations become quite as prevalent as some of the other forms of risk transfer we’ve seen in the past.”
Henry also strikes a cautious note on spin-offs and terminations. It’s a big decision for an organization to terminate a plan, he explains, but spin-off and termination strategies are much more complex decisions. “And quite frankly, the process of spinning participants out of the plan into a new plan carries a number of legal and regulatory considerations that sponsors have to evaluate as well. So, in those types of cases where sponsors that really want to get a lump -sum offer in the hands of their active employees, for example, pursuing a spin-off and termination is a relatively complex solution to the situation.”
Consider Expanded In-Service Lump-Sum Buy-Outs
The Setting Every Community Up for Retirement Enhancement Act’s passage created another option for sponsors to work with active participants. Prior regulations allowed plans to offer in-service, lump-sum distributions to employees age 62 and older. The SECURE Act lowered the qualifying age to 59.5 and McDaniel believes that change will benefit numerous participants. In his experience, it’s not uncommon for plans that have been frozen for a long time to have more than half their participants older than 59.5. “You have a very mature population and so for groups like that, these in-service, lump-sum distribution windows start to look really attractive,” says McDaniel. “If you’re a plan that just froze two years ago, you might not have as many older participants in your plan to make that lump-sum offer worthwhile.”
PRTs as an Employee Benefit?
There’s another consideration with buy-outs, says McDaniel. Participants, particularly those in long-frozen plans, generally welcome access to their accrued benefits. He cites the hypothetical case of an active employee who has been with a company for decades and whose pension benefit was frozen 10 years ago. The idea of getting a lump sum without having to leave the company and rolling over that distribution to their 401(k) or other retirement vehicle is attractive to them, McDaniel says.
“We talk about these pension risk transfer transactions as a way to reduce plan risk and size and manage costs,” says McDaniel. “The other side of that coin, for active participants particularly, is they tend to be very popular with participants. So, in addition to being potentially a win on the financial side, it can also be a win on the employee relations side. A lot of times that extra oomph, if you will, is what’s needed to get the human resources side of the house excited about these kinds of projects, too.”
« The Role of Stable Value Funds as QDIAs or Otherwise