by Douglas Dahl II
With increased business costs, overseas competition and worker mobility, U.S. employers have sought all sorts of ways to minimize risk in their businesses, including changes to employee benefits. In the healthcare space, this has resulted in the prominence of consumer-driven healthcare (e.g., high-deductible health plans and health savings accounts). In the retirement plan space, most notably, this has led to the continuing and rapid decline in private defined benefit pension plans. According to recent numbers published by the U.S. Department of Labor, from 1978 to 2014 the rate of defined benefit pension plan offerings decreased by approximately 80%. Despite this decline, there are still roughly 45,000 defined benefit plans in the United States today. This article discusses the various ways in which employers seek to decrease the risk associated with these plans and what HR and benefit professionals should know about the process.
Defined Benefit Pension Plans vs. Defined Contribution Plans
In general, defined benefit pension plans are plans that offer participants a defined benefit at retirement age. For example, under a defined benefit plan, a participant may have accrued a benefit of $1,000 per month beginning at retirement age. This benefit is owed to the participant irrespective of whether the plan’s assets can cover plan liabilities. The participant’s benefits are not held in an “account” in the plan. Rather, benefits are paid from the general pot of assets held in trust for all plan participants. Ultimately, the plan sponsor is on the hook for properly funding the plan, investing the assets, and ensuring that participants receive the promised benefits.
This is in stark contrast to the defined contribution model (e.g., a 401(k) plan), which, instead of promising a defined benefit at retirement age, simply offers a defined contribution by the employer while the participant is actively-employed. For the vast majority of defined contribution plans, once the employer’s contribution is made, it is the participant’s responsibility to invest the assets and ensure that these assets will be sufficient to fund the participant’s retirement.
De-Risking to Lower Costly Sponsorship of Defined Benefit Plans
Employers that sponsor defined benefit plans also incur significant costs in maintaining the plans. Unlike defined contribution plans, defined benefit plans are expensive to maintain and often require significant actuarial work, as well as per-participant premium payments to the Pension Benefit Guaranty Corporation (PBGC), the federal agency that partially insures pension benefits in the United States. As a result of these economic realities, employers have sought to reduce their financial obligations and exposure under defined benefit plans by engaging in what is referred to as “pension de-risking.” Pension de-risking can take many different forms, but all are designed to reduce the financial risk associated with defined benefit plan sponsorship, often in anticipation of eventually terminating the plan.
Two Sides to Pension De-Risking
Pension de-risking can generally be approached from two different sides, the asset side and the obligation side. The asset side focuses on managing the investment risk of pension plan assets by aligning the investments more closely with plan liabilities. The obligation side, which this article focuses on, involves reducing the overall financial obligation borne by plan sponsors. Three of the most common de-risking strategies on the obligation side include freezing the plan, offering lump sum buyouts and purchasing annuities.
When someone refers to a “frozen” defined benefit plan, that person is referring to a plan that has been closed to new participants and/or a plan under which no additional benefits can be earned. The term “frozen” is used because although nothing in the law requires an employer to continue allowing benefits to accrue, participants’ benefits under a defined benefit plan can never be reduced or cutback. A plan undergoes a “soft-freeze” when the plan is closed to new participants or when benefit accruals cease for some but not all participants. In a soft-freeze, at least one group of participants continues to accrue benefits following the freeze. A plan undergoes a “hard freeze” when the plan is closed to new entrants and rehires and when no additional accruals can be earned under the plan. In general, a hard freeze stops a plan’s liabilities from continuing to increase.
For HR and benefit professionals who are involved with freezing a defined benefit plan, one of the most important aspects is proper communication to affected participants. While amending the plan to reflect the freeze may be relatively simple, communicating exactly what the freeze means to a particular group of participants can be challenging. Plan freezes are often the source of confusion among participants. In addition, pension laws require that a formal notice go out to participants in advance of any changes that will result in a significant reduction in future accruals. Companies may wish to send along an informal Q&A document, in addition to the formal notice, to address some of the questions that participants will likely have.
Reducing Future Liability with Lump-Sum Buyouts
The second, common pension de-risking strategy involves lump-sum buyouts. With this strategy, a defined group of participants is given the option during a specific time period to receive their accrued benefits in one lump-sum payment, as opposed to a monthly annuity for life. This strategy reduces the number of plan participants and removes the liability associated with paying lifetime benefits for this group under the plan. This strategy also reduces the premiums payable to the PBGC, which are calculated on a per-participant basis.
For HR and benefit professionals involved in a lump-sum buyout, again communication is important for a number of reasons. First, participants likely only have a limited period of time during which to elect the lump sum. Once the window closes, the ability to receive a lump sum goes away. Therefore, making sure participants are fully aware of when the window opens and closes is very important. Second, participants need to understand the effect of a lump-sum payment (i.e., full payment of their benefit and no future payments) as well as their right to waive the lump sum and receive monthly annuity payments according to the plan. Third, a number of administrative tasks need to be accomplished in order for a lump sum to be elected. If these tasks are not completed before the window closes, the participant may have missed the opportunity. For example, election forms need to be properly completed and received by the plan sponsor. For married participants, this includes securing the signed and witnessed consent of their spouses in order elect a lump sum payment in lieu of a joint and survivor annuity.
Liability Transfer to Annuity Providers
The final common, de-risking strategy involves the purchasing of annuities from an insurance company. Under this strategy, the plan sponsor selects a group of participants and transfers the plan’s liability to make annuity payments for this group to an insurance company. After the annuities are purchased, the individuals are no longer participants in the plan. Similar to lump-sum buyouts, this strategy not only transfers benefit liability but it also reduces the PBGC premium payments and other costs attributable to each plan participant. However, unlike lump-sum buyouts, purchasing annuities for a group of participants involves an extra layer of concern for plan sponsors because the selection of the annuity provider is a fiduciary act that must be made in the best interests of plan participants. In other words, the annuities purchased must retain all the same rights and features of the participants’ accrued benefits, and the party responsible for selecting the annuity provider must take steps to obtain the safest annuity available. Once the plan’s liabilities for the select group are transferred to the annuity provider, the participants generally lose the protection of assets held in trust as well as protections under applicable pension law.
HR and benefit professionals will likely be involved in the administrative process of transferring liabilities and participants to an annuity provider, and due care should be taken throughout. The ability of the annuity provider to ensure that participants’ accrued benefits are appropriately accounted for in the annuities purchased depends very much on the quality and completeness of the information transferred from the plan to the provider. HR and benefit professionals can add value to the process by identifying any errors or holes in the information being transferred and attempting to correct the incorrect or missing information. In addition, these professionals can help ensure that plan participants understand the change to how their benefits will be provided, as well as whom to contact in the future regarding any questions.
Final Considerations for De-Risking
It is important to point out that decisions to de-risk – in terms of whether it makes financial sense for an employer – depend a lot on the interest rate environment and how a reduction in pension liabilities will be treated from an accounting perspective on the employer’s books. Despite a decrease in the number of active pension plans, pension plan de-risking activity continues to rise. Once an employer decides to engage in a de-risking strategy, HR and benefit professionals who understand de-risking and the importance of communication throughout the process will be in good position to help their employers navigate the process.