Legal Trends: De-Risking Business

De-risking has become a popular management technique for defined benefit plans.

By Kendall Daines May 1, 2013
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Before 2012, many plan sponsors attempted to lower the costs associated with maintaining defined benefit plans by freezing their plans, either entirely by ceasing future benefit accruals or partially by excluding new hires. Beginning in 2012, another technique, known as “de-risking,” became popular. This article explains what de-risking is and why it has become popular, and discusses some considerations for implementing a de-risking strategy.

What Is De-Risking?

The purpose of de-risking is to shrink a defined benefit plan’s liability to make future benefit payments. This is accomplished by distributing benefits to terminated participants, either by paying them lump sums or by transferring liability for their benefits to an annuity provider.

By shrinking a plan’s liability for future benefit payments, significant risks associated with market volatility are reduced. For example, because of market volatility, a plan’s assets might not increase in value in line with a plan sponsor’s projections; as a result, the plan sponsor might have to make an unanticipated contribution to cover future benefit liabilities.

If some future benefit liabilities have been distributed, any unanticipated contribution should be smaller.

Why Is It All the Rage?

De-risking became popular because of a change made to the interest rate that the Pension Protection Act of 2006 made, as required by the Internal Revenue Service, to determine the value of lumpsum distributions.

The act replaced the prior rate used to calculate lump sums with a rate based on investment-grade corporate bonds. This new rate better reflects actual market rates of return and is more consistent with the rate used to determine the funding necessary to cover a plan’s benefit liabilities. Accordingly, the value of lump sums calculated based on the act’s interest rate more closely reflects their actual market value, as well as the value of assets intended to fund them.

This means that a plan can offer lump-sum distributions without its funded status being disproportionately decreased. This change was phased in over five years. The first year it was fully implemented was 2012—the year de-risking became popular.

Another reason for the popularity of distributing the benefits of terminated participants: The Pension Benefit Guaranty Corp. has increased by 20 percent the premium that a plan must pay for 2013 and 2014. By lowering the number of plan participants, a plan will lower its PBGC premium.

De-risking involves distributing the total benefits payable to terminated participants. There are two ways to accomplish this—by paying lump sums to terminated participants or by annuitizing their benefits. In either case, myriad legal considerations must be addressed. The discussion below focuses on some significant ones.

Paying lump sums. One option in making lump-sum distributions is to increase the limit on the mandatory cash-out of small benefits to the maximum $5,000.

Many plan sponsors lowered the cash-out limit to $1,000 in 2005 to avoid a new IRS requirement whereby a mandatory cash-out of $1,000 to $5,000 had to be rolled into an investment retirement account of the sponsor’s choice unless the participant elected otherwise.

At that time, many third-party administrators were not set up for this requirement. Accordingly, many plan sponsors amended their plans to lower the cash-out limit to $1,000. However, most third-party administrators can now manage this feature, and raising the limit to $5,000 might allow a plan to make lump-sum distributions to a portion of its terminated participants.

To distribute lump sums to a larger group of terminated individuals, a plan sponsor might consider adding a lumpsum distribution option for amounts above $5,000, either as a permanent plan feature or under a temporary “window” when eligible participants would be permitted to elect lump-sum distribution.

Either way, the lump sum could be payable immediately after termination of employment, instead of after eligibility for retirement, to maximize the number of participants whose benefits would be distributed. The availability of the lump sum also can be restricted to the window period. If the lump sum is added permanently, it can be taken away only with regard to benefit accruals earned after the lump sum is eliminated.

Before proceeding with any lumpsum feature, it is important to determine how it will affect the plan’s funded status. The value of a lump-sum distribution is now consistent with the plan’s funding liability for that lump-sum distribution. In other words, such a distribution will reduce the plan’s funding liability by an equivalent amount. Yet the distribution will also reduce the underlying plan assets that might increase in value if market rates rise. It is important to keep a plan’s funded status above 80 percent to avoid Internal Revenue Code restrictions on lump-sum distributions and benefit accruals.

In addition, the availability of lump sums from a plan that has not previously offered them will require a new investment strategy to provide a sufficient level of liquidity to pay the lump sums. Increasing a plan’s liquidity might reduce its future investment earnings. Liquidity might be challenging if the lump sums are offered in a temporary window: The plan will have to estimate the value of potential lump sums that might be payable under the window and make sure the plan has sufficient liquid assets to cover them.

One way to control the amount of lump-sum distributions and minimize issues with a plan’s funded status or investment strategy is to restrict the eligibility for lump sums or restrict the amount of any lump-sum distribution. Although offering lump sums to all current terminated vested participants would maximize de-risking, lump sums

could be offered to a smaller group of participants as long as the smaller group meets nondiscrimination requirements. For example, lump sums could be made available only to active employees who terminate employment after a stated date. This would not immediately reduce plan liabilities, but it would reduce them over time.

In designing the lump-sum feature, it is important to keep in mind an IRS requirement that a plan must offer annuity options whenever a lump sum is made available. The required annuity options are those that would be payable if the participant failed to elect a distribution option.

Generally, this means that an unmarried participant must be permitted to elect a single life annuity and that a married participant must be permitted to elect a 50 percent joint and survivor annuity with his or her spouse as the surviving annuitant. A married participant must also be permitted to elect the “qualified optional survivor annuity,” typically a 75 percent joint and survivor annuity, with his or her spouse as the surviving annuitant. In fact, a married participant may not elect a lump-sum distribution without spousal consent. If a plan generally does not permit distributions until early retirement age and the plan sponsor decides to permit lump-sum distributions prior to early retirement, it will be necessary to determine the actuarial adjustment for annuities paid before early retirement because the plan will not address this. Some plan sponsors choose to actuarially reduce the normal retirement benefit, or the early retirement benefit, using the same factors used to calculate lump sums.

Other reasonable factors may be used. One practical consideration is whether the monthly annuity payments that would be payable before early retirement based on the method selected to calculate these benefits would be greater than the monthly annuity payments that would be payable at early retirement age under the plan’s current terms. This situation can occur, based on the interaction between the lumpsum actuarial factors and a plan’s criteria for reducing payments.

If a plan provides a subsidized early retirement benefit, the plan sponsor must decide whether to include the value of this subsidy in the value of the lump sum for participants eligible for the subsidy. This is not required. To avoid legal action by participants, employee communications should clearly address whether the value of the subsidy is included.

After the plan sponsor determines the design of the lump-sum feature and amends the plan, business leaders will have to communicate the feature to participants. If lump sums will be offered as a permanent feature, the summary plan description and distribution forms will have to be modified. If lump sums will be offered in a temporary window, the sponsor will have to prepare the necessary election materials and decide how long to keep the window open (90 daysis typical but not required).

Annuitizing benefits. Another technique for reducing plan liabilities is to annuitize participant benefits by purchasing an annuity to cover the plan’s liability for benefit payments. Participant consent is not required. Once the liability for the participants’ benefits has been transferred to the annuity provider, the plan has no more liability for them.

This approach works well for participants who are still working and “in pay status.” It can be better than allowing them to elect lump sums—which would be permissible—for several reasons:

It is not as expensive to purchase a group annuity covering participants already in pay status.

While permitting retirees to elect lump sums might lower the costs of providing benefits to these individuals,

it might increase the cost of purchasing an annuity for the other retirees on account of actuarial considerations.

It is administratively complex to offer participants in pay status a new election.

This approach can also be used to fund the benefits of terminated participants who are not in pay status. In this case, the annuity must mirror the plan’s benefits and distribution rights. Typically, plans do not take this approach for these participants but instead permit them to elect lump sums because it is usually less expensive than paying the cost of the annuity.

De-risking should be popular for several years, especially in light of recent IRS guidance that makes it easier for plans to meet their funding requirements.

The author is a benefits attorney at Groom Law Group Chartered in Washington, D.C.

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