Rising Interest in Terminating Pension Plans

Although the majority of private sector qualified retirement plans are now defined contribution (DC) type plans (i.e. 401(k), 403(b), profit sharing etc.), there are still some legacy defined benefit (DB) pension plans being maintained by employers. It has long been known that these pension plans can become a runaway train of costs and corporate liabilities that can threaten and even sink a company. In an effort to contain the ongoing pension costs and to ensure long term financial health, around ¾ of the corporate pension plans have been “frozen” so no new benefits can be accrued by employees. Outright pension termination is a more involved and costly endeavor that few companies have been able to afford, especially in the low interest rate environment of the recent years. But as Bob Dylan would say, “The Times They are A-Changin’.”

$13.1 trillion of the $16.8 trillion assets currently in pension plans exist to benefit state, local, and federal government workers. The remaining 18% of pension assets are maintained by private sector companies that obviously have to operate with different fiscal accountabilities. The private sector response to limit the financial strain DB plans can apply to the balance sheet has been twofold. The first has been driving the adoption of DC plans as the main vehicle for employee saving and retirement preparation. Savings in these 401(k) type plans have exploded over the recent decades. Private sector retirement plan assets now represent $9.4 trillion or 87% of all DC plans, with government employers contributing the remaining $1.4 trillion.

DB plan termination has been the other arrow in the quiver. Beyond the relatively common pension freezing actions, the rapidly increasing interest rates are elevating the attention around outright plan termination. To avoid any misconceptions, the words freezing and termination do not indicate that participants are robbed of any benefits they have already accrued. ERISA law has strict anti-cutback rules to ensure that accrued benefits can never be taken away from participants. The Pension Benefit Guarantee Corporation (PBGC) also exists to ensure and guarantee that private sector workers are covered in the case of corporate bankruptcy. Rather, employers can stop future accruals (freezing) and/or expedite the financial payouts required to close up the plan instead of waiting for all participants to pass away (termination).

There are many technical steps and notices required to initiate plan termination, but this article focuses on some of the financial aspects. Every year pensions require an actuarial audit assessing their assets and liabilities to arrive at the plan’s funding rate. If the plan assets are less than the promised liabilities, the plan is deemed to be “underfunded” and vice versa. Due to several factors, such as life expectancy increases, investment returns, benefit discount rates, and perceived trapped costs, it is fairly rare for smaller companies to consistently maintain a pension plan in a fully or overfunded status. In order to terminate a plan, the employer has to be willing and able to fully fund all the termination liabilities.

Termination costs are different depending on participant elections between a lump sum payout or a future annuity payout. Regardless, a key factor in determining the current cost to payout future benefits is the assumed interest (discount) rate. The higher the discount rate, the lower current benefit (e.g. lump sum) amount. In 2022 alone, the spiking discount rate has reduced the calculated DB liabilities by ~20%. Of course, the recent stock and bond market declines have counterbalanced the mathematical gain from the discount rate for the time being. If the investment markets mount a comeback while interest rates remain elevated, small employers may consider a DB plan termination opportunity that may have been out of reach for quite some time.

Qualified retirement plans exist to attract, retain, and retire employees. DB plans have been one approach to help American workers on their retirement journey, but the burgeoning annual maintenance costs over the years have left many private sector employers on unstable ground. On the heels of rapid interest rate hikes, pension plan termination may become a more attractive option for many employers, allowing them to redirect expenses to 401(k) plans and other employee benefit-related programs.