Research Report Describes Best Way to End Frozen Pensions

December 1, 2009 ( – The Principal Financial Group has released a new research paper emphasizing the need for proper planning when winding down a hard-frozen defined benefit pension plan.

The paper, “Best Practices: Winding Down Your Hard-Frozen DB Plan,” points out that employers have the option of either pulling the plug on their plan entirely or maintaining it until it is properly funded and then instituting an liability-asset matching asset allocation with some potential for equity growth.

However, Principal researchers recommend going with the first option because it helps eliminate financial risk and plan expense after the termination.

Even with a termination strategy in mind, Principal says, sponsors need to keep both assets and liabilities on their radar screen. “Doing so promotes the development of a strategy that allows the plan sponsor to move the hard-frozen plan toward termination in a cost-efficient, timely manner,” Principal asserts.

Paying Benefits

According to the research paper, a standard termination requires that all benefits earned by plan participants be provided in full. There are two ways to provide benefits at a plan’s termination. Sponsors can:

  •  pay participants a single lump sum amount (if the plan allows), or
  •  purchase an annuity for them from an insurance company.

Participants who are already receiving benefits must receive the annuity. For participants not receiving benefits, sponsors must offer the annuity but can choose to offer a lump sum payment as an additional option.

Annuities are likely to cost more than the same liability measured under the funding rules for an ongoing, frozen plan, since the insurance company will be assuming the mortality and investment rate risk for these benefits.

The cost used to pay lump sums to participants at termination varies over time. Generally, this amount is based on corporate bond rates. This can lead to a cost that is either higher or lower than the ongoing plan funding liabilities, though it is generally lower than the cost associated with buying annuities, Principal says.

The final cost to terminate is ultimately set at the date of distribution, because the cost is established based on the interest rate at the time of the final distribution, Principal says in the research paper.

For most plans, any extra assets returned to the plan sponsor after all the benefits are paid are taxed: both an excise tax and federal income tax apply. While there are some actions sponsors can take to minimize the amount subject to taxation, it is generally desirable to terminate without extra assets.

The Principal researchers warn that sponsors can’t simply put a termination process in place and forget about it; the winding down needs to be carefully monitored .

“Termination may take years to complete, so monitoring your progress is critical,” the researchers wrote. “A change in the markets may necessitate either a change in your strategy or a change in your timetable, or, possibly, both. It is important to keep an eye on your plan’s progress toward termination and be prepared to make adjustments as needed.”

 The research is available here.