Closed DB Plans: Managing to a Mid-Term Exit

1. The sponsor is not prepared operationally—for example, the sponsor has made commitments to current members to maintain the existing design for a specified period;

2. The sponsor is not prepared to accept the economic impact—for example, upon termination, in order to settle all member benefits, the plan’s windup deficiency would require a one-time immediate cash contribution significantly beyond the level the company is willing to accept; or

3. The sponsor is not prepared to accept the accounting impact—for example, the windup of the plan would result in a significant additional accounting charge

If the sponsor is holding off terminating the plan for operational reasons, the sponsor may be able to estimate the period until the windup will occur. On the other hand, if the sponsor is deferring termination of the plan until the economic or accounting impact (or both) is more palatable, there may be significant uncertainty around the remaining operating life of the plan.

Without a good sense of the termination time horizon, it can be a challenge to appropriately manage the pension fund. A suboptimal approach would be to manage the fund as usual and hope for economic conditions to surface in support of a plan windup. A more efficient approach would be for the plan sponsor to establish the financial conditions that would need to be met in order to begin the termination process, and then develop an action plan to achieve those conditions. This plan could involve changes to the sponsor’s investment policy and/or contribution policy, with the changes designed to maximize the likelihood of meeting the termination threshold conditions, while still keeping the plan’s level of risk within the sponsor’s tolerance.

As an example, if the sponsor is unwilling to fund the current windup deficit in a single installment, the following steps could be taken by the sponsor to manage to the termination:

• Review the investment strategy of the plan. Consider immunization of a portion of the plan’s liabilities, or other liability-based risk-management techniques, to reduce the plan’s exposure to financial risks. In particular, the plan sponsor should maintain a reasonably stable funding level during the pre-termination period.

• Determine the maximum amount of terminal funding the plan sponsor is willing to make. Next, establish a target funding status, which could include a margin for adverse deviation, such that if an actuarial valuation or other estimate shows the plan is above this target level, the sponsor will begin the windup process.

• If the latitude exists, consider increasing the company contributions to reduce the time needed for the plan to reach the target funded level. To the extent additional contributions allow the sponsor to terminate the plan sooner, the plan sponsor will benefit by (1) saving several years of ongoing plan administration costs, including trustee fees, investment management fees, etc.; (2) saving on regulatory fees and premiums, including PBGF assessments (for plans with Ontario members); (3) saving on internal costs to govern the plan; and (4) systematically spreading the terminal funding requirements over the period leading up to plan termination.

When developing a pre-termination contribution and investment strategy, plan sponsors should keep in mind that the ongoing administration costs to maintain a closed DB pension plan can be substantial, particularly when measured on a per member basis. When setting the action plan and target timetable to plan windup, ensure that ongoing administration costs are considered.

For many plans, the level of unrecognized experienced losses is often the accounting measure that causes sponsors to avoid a plan termination. If the plan sponsor is concerned with the accounting impact that occurs following a curtailment/settlement of a DB plan, then the plan sponsor should determine the level of accounting charges that can be absorbed without causing too much pain. Ongoing monitoring/forecasting can be used to identify when the termination accounting charges will be manageable.

In addition, the sponsor may want to revisit the plan’s actuarial assumptions, particularly if the circumstances of the plan or fund have changed since the last assumption review. If there has been a change in the investment strategy, it may be time to revisit the expected return on assets (EROA) assumption employed for pension expense. In many plans, key demographic assumptions are out of date, leading to lower current expense and increased amounts of experience losses and deferrals of expense. To the extent any of the actuarial assumptions are deemed to be aggressive, updating these assumptions will tend to restore the expense to a best-estimate level, reducing the rate of experience losses taken by the plan.

Management of a closed DB plan in its final years before windup requires the plan sponsor to develop and implement a strategy to ensure it is operationally and financially prepared to exit the plan at the optimal time. Leaving these conditions to hope or chance may increase both risk and cost—the two hazards plan sponsors are often seeking to avoid through DB plan closure.