Put simply, when companies terminate defined benefit pension plans, they’re looking to save money. But: they still may not be able to afford it.
First, the cost of the termination will typically exceed the book value of plan liabilities by 15% to 35% for non-retirees and 5% to 10% for retirees.
The exact amount of this cost will depend on plan provisions and how many participants accept a lump-sum offer. (Plan-sponsoring employers typically offer participants a lump-sum payout in lieu of their accrued benefits, then buy annuities from an insurer to settle the liabilities pertaining to participants who didn’t accept the lump sum.)
The write-up of liabilities reflects several things related to the cost of buying the annuities:
- The annuity carrier’s regulatory and business overhead and profit margin
- Carrier underwriting practice, which generally uses more conservative valuation and risk assumptions than the sponsor has been using
- The Department of Labor requirement that sponsors must buy the “safest available annuity.”
There will also be additional administrative costs related to the termination process.
But even where a plan is sufficiently overfunded to finance these additional costs, the sponsor may still not be able to afford a termination, because of the effect it would have on the sponsor’s financial statements. (While most pension plans are currently underfunded, almost 1,600 plans filed for standard termination in fiscal 2018, including those of such large plan sponsors as AutoZone, Dana, Avery Dennison, and Sherwin-Williams, according to the Pension Benefit Guaranty Corp.)
Four Plan Termination “Hits” to Financials
When a sponsor terminates an overfunded DB plan (a sponsor generally can’t terminate an underfunded plan) and buys annuities to settle plan liabilities, it may take up to four “hits” to its financials:
Hit #1: Plan liabilities may have to be written up (as discussed above), reducing the company’s net worth as reflected on its balance sheet.
Hit #2: That write-up typically will have to be run through the company’s income statement, generating a non-recurring expense that reduces net income.
Hit #3: Unrecognized losses may also have to be run through the income statement. The long-run decline in interest rates (from 1982 to the present) has, for DB plan sponsors, generated interest rate-related losses on plan liabilities. These have been compounded by subpar asset returns (5% returns on stocks over the past 20 years).
Accounting rules allow sponsors, in most cases, to defer recognition of these unrecognized losses over a number of years. However, upon termination of a plan, any remaining deferred losses must be recognized on the sponsor’s income statement.
Hit #4: Any pension income generated by the plan surplus will disappear, reducing future net income.
These financial hits — particularly for earnings-sensitive companies — may make the cost of terminating an overfunded plan prohibitive.
To illustrate how significant this issue may be for the sponsor of an overfunded plan, let’s walk through a typical example.
ABC Company sponsors a plan that has (as of year-end 2019) $12.5 billion in liabilities and $15.0 billion in assets. So, ABC’s plan is generally understood to be “overfunded” by $2.5 billion.
The plan also has $3.0 billion in unrecognized losses. This is the typical situation for pension sponsors today, resulting from declines in market interest rates and underperformance of plan assets over the past two decades.
The table below illustrates how a plan termination would affect ABC’s plan balance sheet.
Absent plan termination, the plan provides the sponsor with a $2.5 billion balance sheet asset (the funding surplus). With a termination, these surplus assets are used to finance the additional cost of annuity purchases (also $2.5 billion — a 20% write-up, which is typical, based on the composition of plan liabilities).
Both the $2.5 billion additional cost of annuities to settle plan obligations and the plan’s previously existing unrecognized loss of $3.0 billion must, on plan termination, be run through the sponsor’s income statement. In total, the company must record a $5.5 billion pre-tax charge to terminate the plan at the end of 2019.
On top of this, the pension income the overfunded plan was generating will, after the 2019 plan termination, disappear from future income statements.
The table below illustrates the pension income that the plan would generate if it were not terminated in 2019. (We assume the plan uses a 4.0% discount rate to measure liabilities, a 5.5% expected return on assets, and minimum amortization based on 15 years of average expected future service.)
Thus, if the plan is terminated in 2019, the sponsor loses $230 million in pre-tax annual pension income in 2020 and beyond, on top of the $5.5 billion pre-tax charge in 2019.
Thus, as we described above, the sponsor here has taken four financial statement “hits”:
Hit #1: Plan liabilities are written up, reducing sponsor net worth by $2.5 billion.
Hit #2: That write-up is run through the income statement, generating a non-recurring expense of $2.5 billion.
Hit #3: Unrecognized losses from prior years must also be run through the income statement when the plan is terminated, generating a non-recurring expense of $3.0 billion.
Hit #4: $230 million in pension income, a recurring item generated by the (no-longer-existing) plan surplus, disappears.
Plan B: Maintain an Ongoing Plan
If the sponsor does not assign any value to the pension surplus (a view propounded by many consultants), there may be little objection to using the surplus to fund the incremental cost of terminating the plan. But even in that case, the accounting impact can be prohibitive. What is the alternative?
The most obvious Plan B is for the sponsor to continue to maintain the plan.
The question for sponsors then becomes, what are the best asset-liability management and plan-design strategies for the ongoing plan?
In that regard, three objectives will be of overriding importance: minimizing (1) PBGC premiums, (2) plan administrative costs, and (3) financial statement volatility.
Brian Donohue is a partner and actuary at October Three Consulting, a retirement plan adviser. Mike Barry is a senior consultant at the firm and president of O3 Plan Advisory Services LLC.