What to Know Before You Consider Terminating Your DB Plan
Wen Hong joinedThe Retirement Advantage, Inc. TRA in 2021 as a Senior Actuary in Defined Benefit Actuarial Services. Prior to TRA, she served as an actuary at Ascensus for 1.5 years after working as an actuarial analyst for 6.5 years. In this article, Wen examines the challenges of terminating a DB plan for small business owners.
What are the major reasons employers look to terminate a retirement plan?
Generally, the employers want to terminate their plan when they are not able to make contributions to it. If the plan is reaching its limit such that further contributions will cause the plan to be overfunded and keeping the plan longer doesn’t improve the overfunding situation, the plan sponsor will consider terminating the plan. If the employer is facing a business downturn where they can’t afford future benefits anymore and they don’t expect the financial situation to improve, they will consider terminating the plan as well. And of course, if the employers are selling their business, usually they’ll want to terminate their plans.
If the plan is doing really well and they are overfunded, what do you counsel them to do?
Some plans’ overfunded status is temporary. We say a plan is overfunded when the value of plan assets is greater than the present value of plan benefits. When this happens, if the employer slows down the growth of plan assets (i.e. stop making the contributions) and waits for the plan benefits to grow, then the plan’s overfunded status will change. At TRA, we regularly check the Internal Revenue Code (IRC) Section 415 limits for the participants and notify the plan sponsors when their plan assets are getting close to the owners’ current IRC Section 415 limits. If plan sponsors monitor their assets closely and don’t go over IRC Section 415 limits, their plans’ overfunded status will most likely be temporary. It's also possible to have a plan where overfunded status is not temporary. When there are excess assets in the plan, the plan sponsor will need to consider redesigning the cash balance plan to bring more participants into the plan (if possible) and increase the benefits to other participants. Also, the plan sponsors should consult with their financial advisors regarding their investment strategies.
If the owners have reached their maximum lifetime IRC Section 415 limits such that the limits are going to decrease from year to year as they age, they may also want to consider plan termination. If the plan assets continue to grow, and the limits on owners’ benefits continue to decrease, the excess assets issue will worsen.
What are an employer’s responsibilities to their employees when a plan terminates?
All active participants will be 100% vested at plan termination. Under standard termination, the plan sponsor must fully fund the plan and pay all participants’ accrued benefits in full amount.
If there are not enough funds in the plan at plan termination, the plan sponsor must make necessary contributions prior to distributions.?There will be an alternative option if the plan has a majority owner. If there is a majority owner when plan assets are not enough to cover all accrued benefits, the majority owner can elect to forgo any benefits which are entitled to this majority owner under the provisions of the plan and receive the value of plan assets remaining after all plan liabilities have been paid to the rest of the participants in the plan.
What do employers typically overlook in deciding to terminate a plan?
From my experience, there are a few things that employers seem to be surprised to learn when they decide to terminate their plans:
When thinking about termination, what should advisors and plan sponsors do first?
When the advisors and plan sponsors tell us they are planning to terminate the plan, our client relationship managers always reach out to find out the reason of plan termination and discuss about plan permanency. Plan Termination may not be the best option, so we highly recommend the advisors and plan sponsors to always consult with the actuarial services team before they consider going down the path of plan termination.
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Do you ever talk them out of termination, or show another option?
When plan sponsors reach out to us for plan termination, they have various concerns. We listen to their concerns and offer all available options to them. We remind them that Defined Benefit Plans are intended to be permanent and should be kept for the long term. If they are having concerns about temporary business downturn, a plan freeze could be an alternative. It takes a lot of work to terminate a Defined Benefit Plan and it also takes a lot of work to set up a Defined Benefit Plan. The plan sponsors should be more considerate about plan termination.
Do you ever talk to plan sponsors about a pension freeze instead?
Yes, we counsel clients on what their best option is. Defined Benefit Plans are intended to be permanent. If the plan sponsors started their plans only a few years ago, and they are having difficulties to catch up with funding because of current economic environment, but they are optimistic that their financial situation will improve later, they should consider plan freeze instead of plan termination.
What tax considerations impact a plan termination?
The plan sponsors need to be careful when there are excess assets in the plan at plan termination. If they want to revert the excess assets back to the employers, they need to check if their plans allow for the reversion or if their plans have been amended to allow reversion for at least 5 years. If their plans allow for the reversion, they should know excess assets reverted to the employer are generally subject to 50% excise tax plus the reversion is taxed as business income. The excise tax can be reduced to 20% if either: 1) at least 20% of the excess assets are allocated to participants on nondiscriminatory basis and not violating the IRC Section 415 limits; or 2) at least 25% of the excess assets are transferred to a Qualified Replacement Plan.?A Qualified Replacement Plan must cover at least 95% of active participants from the terminating plan, and the transferred assets must be put in a Suspense Account and allocated to participants within 7 years in ratable amounts not violating the IRC Section 415 limits.
Are the challenges for employers considering plan termination different today than pre-COVID?
We do see changes for the reasons of plan terminations. Pre-COVID, most of the plan terminations occur when the owners are retiring or selling the company. Today, we see an increasing number of plan termination requests due to adverse business conditions. There are employers considering plan termination because they are unable to keep up with the funding due to reduce in profit or investment loss on plan assets. Some of them have changed their minds to freeze the plans instead, but some of them unfortunately do not see financial improvements in the near future.
Are the rules governing DB plan termination different from those for DC plans?
Yes. Defined Benefit plan terminations take much longer due to various notices and filing requirements. For example, if a plan is covered by PBGC and it’s going through standard termination process, the plan must provide the Notice of Intent to Terminate to all participants and beneficiaries at least 60 days but no more than 90 days prior to the date of plan termination. The plan needs to provide Notice of Plan Benefits to all participants and beneficiaries, pay PBGC premiums up-to-date, and then file Form 500 with PBGC within 180 days from the date of plan termination. After PBGC receives Form 500, there is a 60-day review period. After the 60-day review period ends, the plan can then proceed with distributions if PBGC doesn’t issue a Notice of Noncompliance. The distributions must be completed within 180 days from the date when the 60-day review period ends. After distributions are completed, the plan needs to pay PBGC premiums up-to-date and file Form 501 within 30 days.
Also, the benefits in a Defined Benefit Plan are defined according to the specific terms in the plan document. At plan termination, all participants’ benefits are calculated at the payment date and usually don’t align with the current balance of the plan trust account. The employer may need to make a final contribution to make the plan sufficient for plan benefits. Sometimes, there may be excess assets that need to be either reverted to the employer or reallocated to all participants on a nondiscriminatory basis. Then the plan sponsors need follow the rules regarding excess assets.
What does TRA bring to the table for employers thinking about a plan termination?
TRA makes sure the plan is in compliance with the law and regulations. TRA assists the employers in meeting the various notices and filings requirements for plan termination.
At TRA, our business is knowing your business. Whatever challenges you face or goals you want to reach as a plan sponsor or advisor, TRA’s Actuarial Team has the expertise, partnership and integrity to create a customized defined benefit solution.
Interview Conducted by?Roberta Hess?of?Princeton Marketing