Rising interest rates and regulatory changes have helped raise funding levels of DB plans enough to make unfreezing them a sensible option for many sponsors.
Defined benefit (DB) plans, once the gold standard for employee retirement perks, sometimes feel like relics from an earlier era. At the turn of the 21st century, asset losses coupled with low interest rates led many plan sponsors to freeze their DB plans—that is, to close the pension plan to new hires or end future benefit accruals for current plan participants. Today, some sponsors with frozen plans are engaging in risk-transfer transactions or looking for a way to exit plans altogether.1
But there may be significant implications to terminating a frozen DB plan, especially if the plan is overfunded. Specifically, what do employers do with the plan’s excess assets? IRS regulations provide for a 50% excise tax with respect to any employer reversion from a qualified plan unless the employer establishes or maintains a qualified replacement plan or the plan provides pro rata benefit increases.2 This means that if your plan has excess assets of $1 million and you terminate the plan and take a reversion, your company will first pay an excise tax to the IRS of $500,000. The remaining $500,000 is taxable as ordinary income, so your organization may only retain a few hundred thousand dollars of that million-dollar excess.
Another option is to leave the overfunded plan frozen, but this approach could create costly accounting issues in the future. From an accounting perspective, the plan should continue to generate income, which will increase the prepaid asset on your company’s balance sheet. Future recognition of a larger prepaid asset (previously unrecognized loss), perhaps upon a plan termination, could have a substantial negative impact to your company’s balance sheet.
Why it’s the right time to consider unfreezing your DB plan
Due to economic and regulatory changes, the environment has come full circle in such a way that unfreezing DB plans and using their surplus funding now makes sense in many cases. Interest rates have been on a major upswing, resulting in significant improvements in the funded status of DB plans and in accounting surpluses on the balance sheets of plan sponsors. In fact, the 2022 Milliman Corporate Pension Funding Study showed a rise in the aggregate funded percentage of the largest U.S.-sponsored DB plans from 88.1% to 96.3% at the end of 2021. Despite asset declines in 2022, funded status gains have continued due to sharp rises in discount rates, pushing many plans into surplus funding territory. Furthermore, surplus funding levels can be preserved using modern investment strategies that match pension assets with plan liabilities.
Additionally, recent landmark regulatory relief significantly reduced the minimum cash funding requirements of DB plans, extended interest rate smoothing provisions, and provided future funding relief for plan sponsors. These acts make it much more likely for plans to maintain their funded status or even run into surplus positions from a minimum funding perspective without having to take risky asset positions.
Take an innovative approach to reopening your plan
In the past, traditional DB plan design often resulted in costly pension benefits, especially for long-tenured employees. However, DB plans aren’t inherently flawed. With better plan design and risk-management oversight, they can drive business benefits in the right set of circumstances and when properly administered.
Newer hybrid plan designs such as cash balance plans and variable annuity plans feature more balanced cost-sharing relationships between the employer and the employee and allow plans to maintain full funding going forward.
Rather than a burden, DB plans can serve as a way for employers to reduce cash outlays, manage their workforces, and differentiate their companies in a tight labor market. Here are specific case studies where plan sponsors worked with Milliman consultants to reopen their DB plans in ways that were advantageous to their business.
Case studies: Two banks reopen DB plans to attract and retain talent
When it comes to hiring, anything that makes your company stand out from the competition is an advantage. A traditional pension can make the difference in a job candidate choosing one company over another, especially because this is an anxious time for many workers trying to plan their retirements. In the first half of 2022, U.S. market volatility erased $3.4 trillion in assets from 401(k)s and IRAs, and the retirement savings shortfall among U.S. households worsened from its $7.1 trillion valuation in 2019.3
To create a hiring advantage, Milliman worked with C-suite executives and human resources (HR) managers at two community banks to help them evaluate the best way to unfreeze their DB plans. Both banks had the same goal: to attract and retain high-quality employees. In the hiring environment of the COVID-19 era, the banks’ branch managers faced talent shortages and were challenged to keep employees from moving to other banks offering hiring bonuses. In both cases, management decided to both maintain their 401(k) matches while also reopening their DB plans as cash balance plans—an added benefit to help differentiate the bank from other local employers.
“Every new high-level executive recruit we interview is surprised that we also offer a cash balance DB plan. Adding it to our benefits plan has helped employee recruitment and retention for sure. After our Milliman consultants explained our options to us, this stood out as the right approach. It’s gone smoothly ever since, and it’s a relief to work with a group that knows exactly what they’re doing.”
Timothy W. Dickey, President and CEO, Bank of Holland New York, Erie County, New York
As a hybrid retirement plan, cash balance plans blend the features of a traditional pension plan with the look and feel of a 401(k). The benefit under the cash balance plan is determined based on the formulas in the plan document. Participants receive an annual pay credit equal to a percentage of compensation that may be tied to their length of service. Participants don’t bear investment risk, as the interest crediting rate is stated in the plan document, and cash balance plans are insured by the Pension Benefit Guaranty Corporation. The benefit is portable and is typically paid out as a lump sum at termination of employment. Alternatively, participants may elect to convert the balance to a life annuity and thereby have lifetime income. Unlike traditional DB plans, cash balance plans have accelerated vesting requirements, and plan participants must be 100% vested in their benefits no later than after completing three years of vesting service.4
From an employee’s perspective, a 401(k) matching plan combined with a cash balance DB plan can create a solid foundation for retirement planning. Depending on their individual situations, employees might feel comfortable taking more risk with their 401(k) or other investments if they know they have the security of the cash balance DB plan to rely on. In any event, the added benefit of a cash balance DB plan might go a long way toward promoting employee engagement, satisfaction, and retention.
“Our employees are very appreciative of the added cash balance DB plan, the predictable contributions by the bank, and the growth in their pension earnings. New hires are often surprised to hear that we offer a pension plan, and it’s a compelling and attractive benefit to prospective employees. From a cost standpoint, it’s also very manageable and predictable. Our Milliman consultants made the transition seamless, and they were very responsive and attentive during the process.”
James Dodd, Chief Financial Officer, Ballston Spa National Bank, Saratoga County, New York
Case study: Large bank reduces its cash outlay by reopening its DB plan
A third Milliman client—in this case, a large regional bank—sponsored a DB plan that had been closed to new participants for some time. It covered only about 30% of current active employees, and as a result most staff members were eligible only for the 401(k) plan, which offered an employer matching contribution.
Management was interested in reviewing alternative retirement program designs. The DB plan was in a well-funded position with a large prepaid asset that the bank was reporting on its financial statements. Terminating the DB plan would generate a large excise tax and initiate unfavorable accounting consequences recognized as an additional expense. The bank’s executives did not believe it was a prudent financial decision to absorb that expense in a single year.
To resolve the issue, Milliman worked with the bank’s C-suite executives to design a solution that gradually and predictably reduced the DB plan’s prepaid asset each year via a moderate increase in annual pension expense—until it reached a point where it was a good financial decision for the bank to absorb the prepaid asset all at once, if so desired. At that point, the bank’s executives could work with Milliman to reevaluate plan considerations.
Furthermore, the Milliman solution effectively transferred the accounting expense generated each year by the DC plan’s matching contribution to the DB plan. This was done by amending the DC plan to eliminate matching contributions and, at the same time, reopening the closed DB plan with a cash balance plan design. The cash balance employer pay credit was slightly larger than the 401(k) match that was eliminated.
The strategy used the plan’s existing surplus efficiently. First, it avoided potential excise taxes and insurer costs associated with a plan termination. Secondly, because the DB plan was well funded before the changes were made, the bank has not yet needed to make a required cash contribution, and additional accruals have been self-funded. Furthermore, by eliminating the DC plan match, the bank freed additional cash on hand to use for other purposes.
Lastly, the new plan design is mostly expense-neutral on an accounting basis when looking at the DB and DC plans combined, and the bank can deal with the DB plan’s large prepaid asset on its own terms and schedule.5
Next steps for plan sponsors
Every plan is different, and each company has its own approach to employee benefits. Not every business will be in a position where it makes sense to reopen its frozen DB plan. However, it is prudent for plan sponsors at for-profit companies to consider all their options as part of their retirement benefits and risk-management strategies. To get started, consider the following questions:
Is my frozen DB plan overfunded or nearing a surplus funded position?
If so, you might start exploring the advantages of today’s favorable economic and regulatory environment for reopening your DB plan in lieu of terminating or maintaining your frozen plan.
Is the recruitment and retention of high-quality employees a priority for my business?
Reopening your DB plan while continuing your DC plan might be a cost-effective or even cost-neutral way to differentiate your company and attract and retain the best candidates.
Will reopening my DB plan reduce cash outlays?
It’s likely that your business will pay less by shifting your DC budget to your DB plan because DB plans are generally more tax-efficient. However, a detailed analysis will determine whether replacing what you’re paying annually for your 401(k) matching contribution expense with a corresponding expense from your overfunded DB plan would be advantageous for your business.
What’s the best approach for my employees?
It’s important to note that you don’t have to completely eliminate your 401(k) matching contribution. For example, you can potentially reduce the match from 5% to 3% and still free up cash for other purposes, depending on how much your DB plan is overfunded and what size match you want to offer your employees. Regardless of your approach, it’s important to effectively market and clearly explain the change to your employees, so they understand the benefits of a DB plan and are encouraged to continue their 401(k) contributions, with or without the match.
If you have a frozen plan that is nearing full funding or is in a surplus position, consider taking advantage of today’s optimal conditions and determine whether reopening your plan makes financial sense for your company.
1 Wadia, Z. (June 27, 2022). The Big Thaw: Why Now Is the Time to Consider Unfreezing Your Defined Benefit Plan. Milliman Insight. Retrieved October 5, 2022, from https://www.milliman.com/en/insight/the-big-thaw-consider-unfreezing-your-defined-benefit-plan.
2 Internal Revenue Service. Section 4980 – Tax on Reversion of Qualified Plan Assets to Employer. Rev. Rul. 2003-85. Retrieved October 5, 2022, from https://www.irs.gov/pub/irs-drop/rr-03-85.pdf.
3 Gamble, M. (August 16, 2022). Worsening $7 trillion retirement savings shortfall stirs second thoughts. Becker’s Healthcare. Retrieved October 5, 2022, from https://www.beckershospitalreview.com/compensation-issues/worsening-7-trillion-retirement-savings-shortfall-stirs-second-thoughts.html.
4 Peatrowsky, M.J. & Townsend, L. (April 20, 2022).Cash Balance Plans: Frequently Asked Questions. Milliman Insight. Retrieved October 5, 2022, from https://www.milliman.com/en/insight/cash-balance-plans-faq.
5 Ellsworth, T.R. (July 6, 2020). Case Study: Reopening a Closed DB Plan to Help Facilitate a Potential Plan Termination. Milliman Insight. Retrieved October 5, 2022, from https://www.milliman.com/en/insight/case-study-reopening-a-closed-db-plan-to-help-facilitate-a-potential-plan-termination.