From Defined Benefit to Defined Contribution: A Systematic Approach to Transitioning Retirement Plans

Defined benefit (DB) pension plans have fallen out of favor. Despite superior performance in providing retirement income, employers are turning away from DB vehicles and toward the use of defined contribution (DC) plans such as 401(k)s and 403(b)s as the sole savings/retirement vehicle for their employees. This change in sentiment derives from a number of perceived disadvantages of DB plans:

• High employer costs.
• Volatility and unpredictability of cash contributions and accounting expenses.
• Administrative burdens attributable to complexity of applicable law and regulations.
• Responsibility for uncertain obligations.
• Appeal of an immediate, portable benefit for a mobile workforce.

The trend toward DC retirement plans has been underway for 30 years. It started with the origin of the 401k plan and the common observation that the post-war generation was not interested in a promise of a distant benefit at age 65. Ironically, times have changed, and those formerly young employees are marching toward an uncertain retirement. Yet the shift to DC continues unabated.

The Conversion Process

A systematic approach to the conversion process does not guarantee that everyone will be happy with the outcome. It will, however, produce the best possible solution for the money spent. The key elements in the evaluation are:

• Effects on plan sponsor. The primary effect will be the cost of the new program (including the cost of the DB plan after it is frozen), but the new program may affect retention and hiring if the organization has had a philosophy of long service in exchange for retirement benefits.
• Effects on participants.Inevitably, some will win and some will lose. DB and DC plans deliver benefits differently. The DB plan channels most of the contributions to those who eventually will retire from the organization, while the DC spreads the money, with relatively more going to young employees and those who have short careers.
• Effects on the DC plan.The organization might decide to provide additional contributions within the DC plan to a grandfathered group of participants who are particularly vulnerable to the transition. While maintaining two DC programs, nondiscrimination testing might be needed.
• Effects on the DB plan. Unless the organization decides to continue the DB plan indefinitely, it will be frozen and will need to be maintained and funded until the time at which it is terminated and all benefit obligations satisfied through the purchase of annuities or payment of lump sums. Until then, the organization will need to administer the plan and decide on an investment strategy that is appropriate for a frozen plan.
• The budget. The main reason that DB to DC-only transitions fail to reach a successful conclusion is a failure to define an acceptable budget number. The budget has long-term and short-term aspects. In most cases the DB plan must be continued for some time because participants are accruing benefits or because the plan is not well enough funded to be terminated. During this time, the plan sponsor normally will be supporting DB and DC plans with commensurately higher costs. Ultimately, the DB plan will terminate and the only cost will be the DC plan. The target budget will guide the design of the replacement DC plan and quantify how far the sponsor can go in providing additional benefits to participants who are adversely affected by the transition.

How and When to Modify a DB Plan

As of year-end 2011, most DB plans were underfunded and cannot be terminated. Furthermore, the additional contributions needed to make the plan sufficient for termination are likely to be too high. Consequently, as noted above, the DB plan will need to be maintained for some time, at least until it is completely frozen and the underfunding has been reduced or eliminated.

Eventually the DB plan will be phased out. The question is when? Among the approaches:

• Close the plan to new participants but continue benefit accruals for existing participants (“soft freeze”).
• Close the plan to new participants and freeze benefit accruals for existing participants immediately or at a future date (“hard freeze”).

The advantage of a delayed freeze is that it softens the blow for those close to retirement. For example, with a five-year delayed freeze, participants currently 60 and older will reach age 65 under the current program. Those aged 55 to 60 will see partial reductions in their projected benefits.

In order to understand the impact of a plan change on the organization, it is essential to perform multi-year projections of the cash contributions and accounting expense under the continuing plan scenario and each of the alternatives, taking into account the cost of the DB plan and contributions to the DC plan. The projections will allow a comparison of the new program to the target budget and provide a guide for fine-tuning of the DC alternatives.

Identifying the Winners and Losers

The next step is to compare the effect of the currently projected DB plan benefits to the expected benefits under alternative scenarios:

• Assuming that the current DB plan continues without change.
• Assuming that DB benefit accruals are stopped or curtailed at some point and the switch is made to a DC plan.

The analysis will compare projected benefits under the DB plan to the combination of the frozen DB plan benefit (that is, the amount accrued under the DB at the time of the freeze) and the benefit derived from the contributions to the new—or newly enhanced—DC plan.

Plan Termination

Once a plan is frozen, it is almost certain that it will be terminated. In order to terminate a plan, the plan sponsor must settle all benefit obligations to participants by purchasing annuities from a qualified insurance company or by of­fering lump sum payments that are equivalent in value to the vested annuity. Starting in the 2012 plan years, the cost of lump sum payments will be roughly equal to the actuarial liability calculated for IRS purposes, so a plan must be fully funded on the IRS basis in order to minimize the needed additional contribution at termination.

Plan sponsors cannot force participants to take lump sums, and some participants might wish to retain the annuity. Annuities are likely to be more costly than lump sums. To the degree that participants prefer annuities, or if the plan sponsor decides not to offer lump sums, the cost of plan termination might be significantly higher than the IRS funding liabilities.

It takes about 12 to 18 months to terminate a DB plan, and the Pension Benefit Guaranty Corp. requires certain procedures be followed. In addition, when a plan has been in existence for a while, additional issues are likely to surface on termination. For example, some participants cannot be located or others might come forward who previously had not been known.

Summary

For good or ill, organizations are moving away from their traditional DB plans and adopting DC plans as their sole retirement/savings program. It is worthwhile to undertake a thorough analysis of the effects of such a transition on the finances of the organization and its participants. Aside from quantifying the impact, the primary purpose of a study is to educate decision makers about the tradeoffs in making a transition. They should be comfortable in making a compromise that all parties can live with.

Rich Berger is managing actuary, retirement, at Cammack LaRhette Consulting, which provides health care, HR, employee benefits, retirement, actuarial and communications services.

Related Articles

• Active, Frozen or Terminated: Year-End 2011 Pension Snapshot, SHRM Online Benefits Discipline, January 2012
• Retiring a Defined Benefit Plan: Freeze vs. Terminate, SHRM Online Benefits Discipline, July 2007
• How to Weigh Alternatives for Defined Benefit Plans, SHRM Online Benefits Discipline, April 2007
• Pension Plans: Freeze 'Em and Forget 'Em Is Not a Practical Strategy, SHRM Online Benefits Discipline, February 2006

Related Resources—External:

• Best Practices for Executing a Termination Strategy; Winding Down Your Hard-Frozen Defined Benefit Plan, Principal Financial Group, April 2012
• Preparing Your Employees for a DB Plan Termination, Vanguard, April 2012