Little-known Pension De-risking Spinoff/Termination Twist
February 5, 2018
The continuing increases in PBGC premiums have caused defined benefit plan sponsors to consider and reconsider de-risking strategies.
Plan sponsors of frozen defined benefit plans of a certain size (around 500 active employee or retired participants) and funded status ($1M or more in PBGC variable premium) can experience significant savings in PBGC premiums by implementing a de-risking strategy in a slightly different way.
How is this special de-risking strategy different?
Under standard de-risking strategies, plan sponsors experience the benefits of and/or savings in the years following a de-risking event. For example, buying annuities for retired participants when the plan is at
the variable premium cap will reduce future PBGC Premiums (Option 1 below).
The special de-risking strategy or, “de-risking with a twist,” is implemented through a plan spinoff and allows the plan sponsor to reap the benefit of lower PBGC premiums in the same year the de-risking strategy is implemented.
The key is to evaluate the cost of implementing the special de-risking strategy versus the potential savings in PBGC premiums. For some plan sponsors, the benefits largely outweigh the cost and provide cash savings immediately. The steps to de-risking with a twist (Option 2 below) are further described in this article.
What is the new twist to de-risk a pension plan?
Most de-risking strategies result in PBGC premium savings in the years following the implementation of the strategy. This is because the liability, asset, and participant count measurements typically only occur once a year, at the beginning of a plan year.
Therefore, any strategies implemented in the current year typically aren’t reflected in PBGC premium calculations until the following year. However, with a new twist in the way we implement the de-risking strategy, we can accelerate the savings and reduce the current year PBGC premium as well.
The strategy is to:
1. Identify the group of participants to include in a de-risking strategy (whether it be a group of active participants who will receive a one-time lump sum payment or a group of retirees who will receive an annuity from an insurance company)
2. Spin off all the other participants into a new plan. The original plan will then be terminated to implement the desired de-risking strategy.
This spin-off and then termination of the original plan will, if done properly, reduce the PBGC premium in the current plan year.
How does this work, and how do we get a reduced overall premium?
As background, note that there are two portions of the PBGC premium: (1) the flat-rate premium, which is charged for each participant in the plan and (2) the variable-rate premium, which is based on the plan’s level of underfunding.
There are two reasons why this strategy works. First, for the original plan that is being terminated, there is a rule relating to the variable-rate premium that allows a plan being terminated to be exempt from paying the variable- rate premium in a plan year if all assets are distributed by the end of that plan year.
Second, for the new plan that is spun-off from the existing plan, the PBGC rules allow the premium for this plan to be prorated for the portion of the year the plan is in existence.
As an example, if the plan spin-off occurs midway through the year, the plan would pay half of the full year premium. It is the combination of these two rules that results in an overall reduction in the PBGC premium in the current year in addition to impacting subsequent years.
This all sounds great, why isn’t every plan sponsor going to apply this new twist?
As stated earlier, plan sponsors of frozen defined benefits plans of a certain size (about 500 active employee or retired participants) and funded status ($1M or more in PBGC variable premium) can benefit most. It does not make sense to consider an active lump sum strategy for plans that are actively accruing benefits. However, it does makes sense to consider a retiree annuity purchase in active plans. Also, there is a cost associated with this strategy, and for smaller plans or plans with little or no variable rate premium the cost of implementation would outweigh the savings.
If a plan sponsor is considering the overall benefits of a de-risking strategy, this twist will allow the sponsor to achieve additional savings, but note the following hurdles:
- It is imperative that the terminating plan distribute all payouts by the end of the plan year. If this doesn’t happen, the terminating plan will pay a full year’s PBGC premium and the spun-off plan will pay a partial year PBGC premium resulting in an overall higher premium. Timing is of the essence with this strategy, and a well thought out process needs to be put in place.
- There are costs to spinning off a plan and terminating a plan:
- ERISA is strict on how assets are allocated between two plans when a non de minimis spin-off occurs, and it requires an additional liability calculation that is not part of the normal valuation process.
- A plan termination1 is a process-oriented project with strict deadlines that require strong project management (see A Pension Sponsor’s Guide to Plan Termination).
- A new plan will be established at the spinoff date that will require an initial short plan year valuation.
- Finally, additional contributions may be required for the terminating plan as well as one-time settlement accounting charges; however, this may not be a negative outcome. Any cash requirements can be viewed as an acceleration of future cash requirements; any settlement charges reflect the accelerated shrinking of the plan. With the recent tax law change reducing corporate tax rates, many tax paying plan sponsors will be looking to accelerate pension plan contributions to their 2017 tax year in order to take advantage of the higher tax deductions under old tax law.2 Once we get beyond the deadline for 2017 tax year contributions, there may still be advantages to accelerating contributions based on the plan sponsor’s tax position in a particular year.
How do I know if this is a good strategy for my plan, and how much can the plan save in PBGC premiums?
Your Findley Davies | BPS&M consultant is well-versed in pension de-risking strategies, including this new plan spin-off and termination twist. We can model the impact of any de-risking strategies to outline the one-time savings in the current year as well as the savings in future years.
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1 This strategy requires the use of an accelerated plan termination process. In this accelerated process, the plan sponsor will distribute benefits prior to receiving a determination letter from the IRS.
2 Plan sponsors with a calendar tax year have until September 15, 2018 to make a 2017 tax year contribution.