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Employee Benefits Alert: Tough economy creates tough decisions for pension plans

The defined benefit pension plan is one of the little discussed casualties of the economic and financial crisis in recent years (“Pension Plan”).

Pension Plans are subject to various funding requirements.  Very simplistically, Pension Plans must utilize the services of actuaries who determine the value of the benefits that have been accrued under the Pension Plan and the level of contributions required to fund the accrued benefits.  Pension Plans are defined benefit plans in that they provide a specified benefit payable to the participant, or his or her beneficiaries, beginning upon the participant’s retirement.  Unlike a 401(k) Plan or a Profit Sharing Plan, which have individual investment accounts for each of the participants, a Pension Plan’s assets are held in a single pool.  The sponsoring company or entity remains responsible for ensuring that sufficient assets are in the pool to pay the benefits that have been earned under the Pension Plan.

Funding future pension obligations is basically a factor of determining the amount of assets that are needed to fund the stream of future pension benefits.  As such, funding is greatly dependent on the interest rates used by the actuary to determine the present value of the future benefit payments and investment assumptions used to determine the likely return on assets set aside in the Pension Plan.  Low interest rate assumptions increase the amount of funds one presently needs to fund a future benefit.  Low investment return assumptions reduce the expected value of the assets that have already been set aside in the Pension Plan.  In addition, there are other assumptions, such as mortality, compensation increases and expected retirement ages, that impact the amount of funds required in the Pension Plan; and thus, the level of contributions required to be made to the Pension Plan.   These assumptions also factor in the actual return earned by the Pension Plan’s assets to determine funding.

The actuaries are responsible for helping the plan sponsors keep the Pension Plan in compliance with the funding rules required by federal law and regulations.  In general, the funding rules have gotten stricter over the years.  These rules require employers to book profits and losses relating to the Pension Plan funding and to increase their contributions to underfunded plans.  Failure to keep the Pension Plan funded up to certain levels will automatically result in various benefit restrictions up to and including a freezing of future accruals.

Pension Plans as a whole had funding difficulties for many years.  This funding issue has been exacerbated by extremely low interest rates and the under-performance of the market in recent years.  Poor investment performance despite perhaps the best efforts of sophisticated investment professionals increases the funding gap between the Pension Plan’s liabilities and its assets.

Options for sponsors

There is no single “solution” for sponsors of Pension Plans that are underfunded.  The best answer is to have the Pension Plan make very good investment returns.  But that is cold comfort to plan sponsors.  Many plan sponsors are simply waiting for interest rates to significantly increase, the financial markets to rebound, and then the Pension Plan would recoup its losses and perhaps increase its assets.  But rather than simply waiting for better times, there are some options employer sponsors may choose to consider.

Reduce future benefit accruals

Every Pension Plan has a formula which determines the benefit payable under the Pension Plan.  While it is impermissible under the Employee Retirement Income Security Act of 1974 (ERISA) to reduce benefits that have already been earned under the Pension Plan, it is permissible to amend the Pension Plan to reduce future benefit accruals.  This would help to lower the liability faced by the Pension Plan.  Any such reduction must be done with required written advance notice to the Pension Plan participants.

Merge the Pension Plan with another Pension Plan

Despite the tough economic environment for Pension Plans over the past five years, there are some Pension Plans that have more assets than are presently needed to fund the benefits accrued under the Pension Plan.  The options that are available to deal with an overfunded Pension Plan are outside the scope of this article.  However, the Internal Revenue Service imposes a very stiff penalty on plan sponsors that terminate a Pension Plan with excess assets.  The penalty, when added to ordinary income taxes that apply to a reversion of the excess assets in the plan, basically consumes a large portion of the excess assets that were in the overfunded Pension Plan.  Thus, rather than terminating the overfunded Pension Plan, one option would be to merge the overfunded Pension Plan into an underfunded Pension Plan.  If the sponsor of an overfunded Pension Plan does not also have an underfunded Pension Plan, it can package up the Pension Plan into a company and sell the stock of the company.  The significant asset of the company would be the overfunded Pension Plan.  The plan sponsor of a Pension Plan that is significantly underfunded could purchase the stock of the company and then merge the overfunded Pension Plan with its underfunded Pension Plan.  The combination of the two plans may help to bridge the funding gap.  This can be a tax-efficient way to utilize the excess assets in the Pension Plan.  Note, however, the Internal Revenue Service has privately ruled that transferring a Pension Plan to a subsidiary with few or no employees and subsequently selling the subsidiary to an unrelated entity, where the primary purpose of the sale is a transfer of the Pension Plan, violates the “exclusive benefit” requirement necessary for the Pension Plan to maintain its tax-exempt status.  Any consideration of a transaction of this type needs careful legal and tax analysis.

Freeze the Plan

Partial freeze – In lieu of simply reducing future accruals, the employer may “freeze” the Pension Plan.  One method often used is to amend the Pension Plan to prevent new employees from becoming participants.  Another method is to cease future benefit accruals for existing participants who do not meet certain requirements (e.g., non-union employees or employees of a particular division or subsidiary) or have not achieved a stated age and/or service (e.g., participants that have not attained either age 50 or 10 years-of-service with the company) as of a certain date.  Participants that have met the criteria (sometimes referred to as “grandfathered participants”) will continue to accrue benefits in the Pension Plan.  The non-grandfathered employees are usually eligible to participate in another plan, such as a 401(k) Plan, and may receive additional employer contributions under the other plan. Under this option, future accruals for non-grandfathered participants are stopped.  Whatever benefit the participant has accrued in the Pension Plan as of the time the Pension Plan is frozen is locked in.  Implementing a partial freeze requires periodic testing to ensure that the plans continue to meet the non-discrimination and coverage tests imposed under the Internal Revenue Code.

Full Freeze – Another method is a “full freeze,” under which all benefit accruals under the Pension Plan are frozen.  A full freeze eliminates all new accruals for existing participants and prevents new participants from entering the Pension Plan.  Most Pension Plans are fully frozen in connection with the Pension Plan’s pending termination.  However, if the plan does not have sufficient assets to terminate, it can remain in existence indefinitely in a frozen state.

A Pension Plan that has been frozen or has been amended to reduce future accruals still must be funded based on actuarial calculations. The advantage of amending or freezing the plan is that accrual of additional liabilities have either been reduced or more or less fixed.  In either situation, the Pension Plan continues to operate; it must still be amended for tax law changes (unless otherwise exempted), comply with obligations imposed by the Pension Benefit Guaranty Corporation (the “PBGC”), which is a quasi-governmental agency that provides insurance for defined benefit pension plans), file Forms 5500, and pay benefits out when a participant is entitled to receive a benefit.

Any freeze also requires written advance notice to the participants.  If the sponsor reduces future accruals or freezes the Plan, it retains the ability to amend the Pension Plan in the future to “unfreeze” the Pension Plan and resume accruals or to even increase benefit accruals to potentially make up for the lower accruals while the Pension Plan was frozen.

Termination

Another option that may be available for the employer sponsor is to terminate the Pension Plan.  If the Pension Plan is underfunded, the sponsor will need to contribute an amount sufficient to fully fund the Pension Plan upon its termination.  Depending on the distribution options available under the Pension Plan, the cost to fund the plan upon termination may be more expensive than the cost to bring the plan to full funding status as an ongoing plan.

These extra costs relate to the increased costs of paying benefits in the form of lump-sum distributions (if available) or purchasing annuity contracts.  Lump-sum distributions are calculated as the present value of the future stream of payments and the payments one discounted by using the relatively low interest rates associated with a combination of the interest rates paid under 30-year U.S. Treasury Bill notes and corporate bond rates. The distribution will earn interest at the lower interest rates and thus, requires a higher lump-sum to meet the stream of payments.

This distribution amount may be beyond the ability of the sponsor to pay at the present time.  Thus, many employers have no available option other than to freeze the Plan so as to limit liability and wait for interest rates and investment returns to rise.  In the interim, the sponser must continue to make contributions to the Pension Plan to reduce the underfunding to a manageable amount.  Once the amount needed to fully fund the Pension Plan on a termination basis becomes manageable, the employer may then choose to terminate and contribute the funding shortfall.

Terminating an underfunded Pension Plan

If the employer is in serious distress, it may be possible to terminate the Plan in a “distress termination.”  Under a distress termination the employer files notice with the PBGC.  Among other things, the employer must meet one of the following criteria:
  • Liquidation in bankruptcy or insolvency proceeding;
  • Reorganization in bankruptcy or insolvency proceeding, and the filing has been made as of the proposed termination date and the appropriate court has determined that the employer is unable to pay its debts under the plan of reorganization if the plan is not terminated; or
  • Termination is necessary to enable the payment of debts while remaining in business or to avoid unreasonably burdensome pension costs caused by a declining workforce.

For purposes of meeting these requirements, ERISA treats all trades or businesses that are related to the plan sponsor as part of its “controlled group of corporations” as one employer.  The PBGC will carefully review the situation to determine whether the plan sponsor and its related controlled-group members meet the distress termination criteria.  If they do, the PBGC will accept financial responsibility for the Plan.  It will reduce benefits under the Pension Plan to the amounts guaranteed by the PBGC. The actual amount insured is determined based on a number of factors, such as a participant’s age, the participant’s beneficiary’s age, the form in which the plan benefits are distributed, and the date of the plan’s termination. The PBGC will treat the date the plan sponsor files for bankruptcy as the date of the Pension Plan’s termination. By way of example, for Plans terminating in 2011, the maximum PBGC-insured amount for a benefit paid for a 65 year old in the form of a straight life annuity is $4,500 per month ($54,000 per year).  However, if the participant takes his or her benefit as a joint and survivor benefit beginning at age 60 (assuming the spouse is also 60), the maximum PBGC benefit goes down to $2,632.60 per month.

The PBGC will attempt to obtain as large a contribution as possible from the sponsor.  If the sponsor has related entities that may be in better financial condition, the PBGC will hold them responsible for the underfunding and may seek to have such entities retain responsibility for the Plan.  In addition, the PBGC will impose an additional premium based upon the number of participants in the Pension Plan at the time of its termination.

Collective bargaining considerations

In general, if the employer’s Pension Plan includes employees that are covered by a Collective Bargaining Agreement, the options discussed here — reduction of future accruals, freezing or termination — may not be implemented without bargaining those matters.

Conclusion

Unfortunately, there is no magical solution to the problem of underfunded Pension Plans.  But sponsors can take some steps to control liability while waiting for stronger economic times.  Working with your benefits attorneys and pension actuaries, plan sponsors can make prudent choices to handle pension liabilities in challenging economic times.

For more information, please contact:

John M. Wirtshafter
216.348.5833
jwirtshafter@mcdonaldhopkins.com

Antoinette M. Pilzner
548.220.1341
apilzner@mcdonaldhopkins.com

or any of our Employee Benefits attorneys by clicking the link below:

Employee Benefits

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IRS CIRCULAR 230 DISCLOSURE: To ensure compliance with requirements imposed by the Internal Revenue Service, we inform you that any tax advice contained in this communication (including any attachments), was not intended or written to be used, and cannot be used, by any taxpayer for the purpose of (1) avoiding any penalties under the Internal Revenue Code or (2) promoting, marketing or recommending to another party any transaction matter addressed herein.

© 2011 McDonald Hopkins LLC All Rights Reserved. This Alert is designed to provide current information for our clients, friends and their advisors regarding important legal developments. The foregoing discussion is general information rather than specific legal advice. Because it is necessary to apply legal principles to specific facts, always consult your legal advisor before using this discussion as a basis for a specific action.