January 23, 2018
When it’s time to say goodbye to your Defined Benefit Plan
Defined Benefit/Cash Balance (DB/CB) Plans can be a terrific component of a firm’s retirement program. But with every good thing there is a time and place in which to say “goodbye”. This article discusses three common situations plan sponsors might face when deciding to terminate their retirement plan.
Each of the scenarios though are affected by one fundamental issue – how well funded is the plan on a termination basis. Even if the plan looks like it is well funded year after year, it might not be when the actuary calculates the plan’s liabilities on a termination basis and is required to use more conservative actuarial and investment assumptions. Knowing the “true” funded status will help determine the plan sponsor’s next steps.
Situation 1: The business owner is contemplating retirement or the sale of the business – the plan, over the course of the years has been well funded with an eye towards this termination date.
- The owner should reach out to his actuary to determine how well funded the plan really is on a termination basis and if any additional contributions will be required to fully fund the plan to shut it down.
- Once this amount is known, the financial advisor should consider moving the plan’s investments to a cash-like position to secure it from any potential loss in the market.
- The actuary will be required to provide notices to all participants letting them know that the plan is shutting down, the value of their benefits, as well as distribution options. In addition, an amendment needs to be drafted that officially terminates the plan.
- If the plan is not covered by the PBGC (Pension Benefit Guaranty Corp.) – typically your smaller plans, the benefits are easily rolled over to an existing 401(k) plan, personal IRA, or distributed as “cash”. Very rarely does a participant request a monthly annuity though it is a required option regardless of the type of plan.
- If the plan is covered under the PBGC (larger plans and professional service organizations) a lengthier process for termination is the norm, with specific deadlines and wait periods for notices and PBGC submissions that can last upwards of one year.
- Once all assets in the trust are distributed, the actuary can file the final government forms (IRS Form 5500 with attachments) and the plan is now official terminated.
Situation 2: The plan is just not appropriate for the business and unfortunately is underfunded – this can be the hardest conversation to have with an owner. Before any plan is terminated, the IRS requires it be brought up to a fully funded status on a termination basis. If there are insufficient trust assets, the business owner will be required to sufficiently fund the plan before it can be terminated. Many times the reason the owner wants to terminate the plan is because it has become unaffordable. The only potential remedy, short of contributing more to the plan or waiting for the next stock market boom, is for the owner to waive his right to full benefits. As long as the staffs’ benefits are fully covered by trust assets and paid out, the owner can shut down the plan by signing a resolution agreeing to receive a reduced benefit based on whatever the remaining assets will provide. Not the ideal ending of a defined benefit plan but it will get the job done. The rest of the plan termination process will be identical to Scenario 1.
Situation 3: The plan has met the owner’s objectives but it is overfunded – most business owners don’t understand why this would be a problem. However, the IRS sees it differently. Every dollar in excess of what is needed to satisfy the distribution requirements for the participants is subject to normal income tax as well as a 50% excise penalty. Therefore, at least 80-90% of every excess dollar in the trust is taxed away. Some potential solutions to this overfunded situation are:
- Trying to increase benefits to the owner (if possible) and the staff. This will have the effect of eating up extra dollars in the trust.
- Paying expenses out of trust assets. Most expenses associated with the termination of the plan are deductible from the Trust.
- Funding a profit sharing plan. The IRS allows a plan sponsor to use the excess funding to contribute to a profit sharing plan over seven (7) years. This can be an attractive solution however the plan sponsor will not receive any additional tax deductions stemming from these contributions. Any remaining assets after the seven year period will once again be subject to federal and excise taxes.
- Identifying an underfunded DB/CB Plan sponsored by another organization. This is not an easy task. The plan sponsor will need to find another organization in a related field with an underfunded plan that is willing to buy his firm including the retirement program. The participants (owner included) will get their full payout of benefits and the plan sponsor, depending on the negotiated agreement, will receive a long term capital gain payment of between 40-70% of the overfunding. This process will require an attorney and actuary to properly represent the seller’s interest.
At the end of the day, terminating a defined benefit plan does not have to be complicated. With carefully monitoring over the life of the program an experienced actuary is able to walk you and your client through the process from start to finish helping to avoid any potential pot holes along the way.
To learn more about Defined Benefit/Cash Balance Plan Terminations and whether it is the right solution for your client please contact your Retirement Sales Director at The Benefit Practice or call (203) 517-3502.
