Magazine article HRMagazine

De-Risking Pension Plans

Magazine article HRMagazine

De-Risking Pension Plans

Article excerpt

Ratchet down the risk in defined benefit plans.

Before 2012, many plan sponsors attempted to lower the costs associated with maintaining defined benefit plans by freezing their plans, either entirely by ceasing future benefit accruals or partially by excluding new hires. Beginning in 2012, another technique, known as "de-risking," became popular. This article explains what de-risking is and why it has become popular, and discusses some considerations for implementing a de-risking strategy.

What Is De-Risking?

The purpose of de-risking is to shrink a defined benefit plan's liability to make future benefit payments. This is accomplished by distributing benefits to terminated participants, either by paying them lump sums or by transferring liability for their benefits to an annuity provider.

By shrinking a plan's liability for future benefit payments, significant risks associated with market volatility are reduced. For example, because of market volatility, a plan's assets might not increase in value in line with a plan sponsor's projections; as a result, the plan sponsor might have to make an unanticipated contribution to cover future benefit liabilities.

If some future benefit liabilities have been distributed, any unanticipated contribution should be smaller.

Why Is It All the Rage?

De-risking became popular because of a change made to the interest rate that the Pension Protection Act of 2006 made, as required by the Internal Revenue Service, to determine the value of lumpsum distributions.

The act replaced the prior rate used to calculate lump sums with a rate based on investment-grade corporate bonds. This new rate better reflects actual market rates of return and is more consistent with the rate used to determine the funding necessary to cover a plan's benefit liabilities. Accordingly, the value of lump sums calculated based on the act's interest rate more closely reflects their actual market value, as well as the value of assets intended to fund them.

This means that a plan can offer lump-sum distributions without its funded status being disproportionately decreased. This change was phased in over five years. The first year it was fully implemented was 2012-the year de-risking became popular.

Another reason for the popularity of distributing the benefits of terminated participants: The Pension Benefit Guaranty Corp. has increased by 20 percent the premium that a plan must pay for 2013 and 2014. By lowering the number of plan participants, a plan will lower its PBGC premium.

De-risking involves distributing the total benefits payable to terminated participants. There are two ways to accomplish this-by paying lump sums to terminated participants or by annuitizing their benefits. In either case, myriad legal considerations must be addressed. The discussion below focuses on some significant ones.

Paying lump sums. One option in making lump-sum distributions is to increase the limit on the mandatory cash-out of small benefits to the maximum $5,000.

Many plan sponsors lowered the cash-out limit to $1,000 in 2005 to avoid a new IRS requirement whereby a mandatory cash-out of $1,000 to $5,000 had to be rolled into an investment retirement account of the sponsor's choice unless the participant elected otherwise.

At that time, many third-party administrators were not set up for this requirement. Accordingly, many plan sponsors amended their plans to lower the cash-out limit to $1,000. However, most third-party administrators can now manage this feature, and raising the limit to $5,000 might allow a plan to make lump-sum distributions to a portion of its terminated participants.

To distribute lump sums to a larger group of terminated individuals, a plan sponsor might consider adding a lumpsum distribution option for amounts above $5,000, either as a permanent plan feature or under a temporary "window" when eligible participants would be permitted to elect lump-sum distribution. …

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