Approximately 46,500 defined benefit pension plans existed as of 2022, according to the Employee Benefits Security Administration. Each plan carries inherent risk because assets, liabilities, and funding costs to employers are dependent on market trends, economic conditions, and interest rates.
“De-risking” a defined benefit pension plan is a common way for companies and pension plan administrators to mitigate such risk while balancing plan liabilities and assets. When determining whether to de-risk or terminate a pension plan, sponsors will want to consider the effect that significant rate changes could have on the timing and cost of payouts.
While various de-risking strategies exist — including buy-in agreements and liability-driven investments — this insight will focus on approaches involving the termination of the plan and annuity buy-outs. We will look at why this may be a prime time to consider these pension stripping strategies because current economic conditions, such as higher interest rates, could offer a more cost-effective option for plan sponsors to mitigate financial risk.
Interest Rates: Catalyst for De-risking?
Pension plan sponsors are tasked with monitoring any economic conditions that might affect their ability to balance plan assets and liabilities. This includes interest rates, where fluctuations and trends can cause corresponding fluctuations in a pension plan’s liabilities, assets, and costs.
Interest rates can have both positive and negative impacts on a pension plan. When rates drop, pension obligations may rise. Future pension plan payments may be discounted to today’s rates, which, in turn, changes the lump sum payment or annuitization for participants. But lower interest rates can increase the plan’s costs for de-risking. On the other hand, higher interest rates tend to decrease the costs associated with cashing out or annuitizing pensions.
Navigating the ebb and flow of interest rates can be a constant challenge. While economic conditions cannot be predicted, rates over the past year or so have remained higher than anticipated by those in the pension plan industry. Even a slight increase or decrease can have a significant effect on a plan’s liabilities and costs, making plan termination or participant cash outs and annuitizations more favorable. Just as varying obligations affect plan termination costs, the plan’s asset valuation is equally important and is also subject to interest rates.
Decision Time: Is Pension Plan Termination the Right Move?
Based on recent news, plan sponsors appear favorable to plan termination. In 2023, the transfer of pension plan assets to group annuity contracts topped $45 billion, with an uptick in other methods of de-risking. For example, a group annuity risk transfer product, such as a buy-out product, allows a sponsor to transfer all or a portion of its pension liability to an insurer. In doing so, a sponsor can remove the liability from its balance sheet and reduce the volatility of the pension plan’s funded status. When considering whether to terminate a pension plan by offering to cash out or annuitize participants, strategy is key.
Discussions about potentially terminating a pension plan should be done well in advance since there are a number of considerations to evaluate. It’s also important to recognize that a complete termination of a pension plan may take a year or more so shifting economic conditions could impact the resulting cost.
The following actions may be taken when terminating a plan:
- Analyze the current pension plan, including liabilities, assets, and costs.
- Consider current interest rates and the lump sum interest rates dictated in the plan document, as well as the potential for change.
- Consider any administrative costs that might be incurred, including assistance from third-party administrators and ERISA counsel.
- Determine the timing for the plan, while still monitoring market and regulatory environments.
- Amend plan documents as necessary.
- Request required approvals from the Pension Benefit Guaranty Corporation and the IRS.
- Prepare and send appropriate notifications to participants, as required by law, once a de-risking strategy is determined.
- Execute the planned reduction or termination.
Planning is crucial. Generally, we encourage plan sponsors to develop de-risking strategies well before they might be implemented, and then monitor economic triggers before choosing to begin plan termination or cashing out/annuitizing participants. Reversing course is usually possible early in the termination process.
Could De-Risking Be Part of Your Plan’s Future?
The decision here depends greatly on the pension plan’s individual circumstances. And, yes, any action that changes a pension plan involves complicated financial strategies, as well as the need to comply with applicable laws and regulations. It’s important to consider all factors before deciding to terminate a pension plan by cashing out or annuitizing participants, including current economic conditions, upfront costs that might be incurred, and the company’s future business plans.
Before stepping through any potential pension-related window of opportunity, talk to professionals whose understanding of the complexities stems from real life experience.
BDO’s Global Employer Services team helps guide clients as they make tough decisions about their pension plans. We analyze the client’s current plan documents, offer recommendations for consideration, and then help them achieve their objectives.
Contact BDO's Employee Benefit Plan Audit team for more information.