The dramatic and widespread decline of the defined benefit pension plan over the last few decades has changed the retirement landscape and caused a mental shift in responsibility from employers to employees. But despite the fact that nearly three-quarters of Fortune 500 companies have closed and/or frozen pension plans, the pension obligations remain on their balance sheets and the compliance requirements linger on their to-do lists. While freezing a pension plan does help to reduce future costs, other strategies are being sought to transfer additional risk. The ultimate de-risking strategy, of course, is plan termination, but given the perfect storm of economic factors – namely a coincident drop in interest rates and market returns – the time may not be ideal to pull the trigger. But when it is, companies will want to be ready.
Termination means calculating, communicating and distributing benefits to every participant in the plan. The plan termination process itself can be complicated and lengthy and typically ends with an audit by the Pension Benefit Guaranty Corporation (PBGC) – automatic for plans with 300 or more participants – which will require individual data supporting accrued benefit and lump sum distribution calculations. Preparing well ahead of time, by conducting an internal plan audit, can advance you along the termination timeline and insure that the inevitable PBGC audit is quick and straightforward.
Engaging the help of an independent actuary can provide an objective review of administrative practices and plan calculations. Here are some of the issues to focus on when conducting an internal audit:
• Quality of data and calculations – As part of the plan termination process, final accrued benefits must be certified and illustrated for all plan participants – active and terminated vested. At the same time, retiree and beneficiary data must be complete prior to an annuity purchase. This requires a comprehensive review of the underlying data and plan provisions to make sure benefits are accurately calculated in accordance with the plan document. The cleaner the data, the better able you are to predict funded status and additional contribution requirements. And finally, insurance companies will scrutinize the data and their quotes will reflect its quality.
• Plan document review – A review of the plan provisions and administrative procedures should be conducted in advance of a plan termination. That way, any administrative inconsistencies can be addressed through plan amendments and compliance resolutions before the plan is submitted to the IRS. A sample of highly audited issues to look out for includes:
o Definition of compensation – The definition of compensation, as described in the plan document, must be accurately reflected in actual plan administration, including the calculation of an employee’s benefit accrual, adherence to compensation limitations, performing nondiscrimination testing, and determining whether a plan is considered top heavy.
o Plan amendments – Review the plan document carefully and consider amendments to eliminate certain optional forms that might otherwise complicate an annuity purchase. If the plan does not already include $0 deemed cash-out language for non-vested terminations, it can be added if done five or more years prior to a plan termination. Otherwise, upon plan termination, you may be required to automatically vest participants who have not yet met the vesting requirements. Make sure your plan document is up-to-date with all interim amendments to comply with changes in tax law requirements for qualified plans, regardless of whether you have a prototype or custom designed plan document. While not required, the plan document is typically submitted to the IRS upon plan termination for a final determination letter. Any inconsistencies between the plan language and plan administration should be addressed upfront.
o Employee eligibility – To confirm that plan eligibility has been properly applied, a representative sampling of employees (new hires, transfers, rehires, and part-time employees) should be audited and compared to the eligibility procedures.
o In-service distributions – If a plan does not permit payments to participants while they are still employed, the census should be reviewed to insure there are no impermissible distributions or premature payments.
o Small cash-outs – Oftentimes, a plan administrator fails to properly handle small benefit cash-outs under $5,000. It is best to clear these out in advance to avoid the added administration upon plan termination and guarantee that the terms of the plan are being followed.
o Payments beyond normal retirement age – Most plans require that benefit payments commence at normal retirement age, but no later than a participant’s date of termination or age 70 ½. If a plan fails to commence payments at that time, significant tax penalties are assessed to the participant. Reviewing the plan census to identify any such participants and addressing them in advance of a plan termination will again allow for a smooth transition of benefits to the insurer.
o Vesting – Vesting failures can include a number of different errors, including (1) failure to provide for 100 percent vesting at normal retirement age, (2) failure to properly account for vesting for employees with breaks in service, inter-company transfers, and acquisitions, and (3) failure to calculate and vest employees affected by partial terminations. If any of these circumstances apply, you should review your plan’s compliance with these issues by checking a representative sampling of employees.
o Minimum Required Distributions (MRDs) – The MRD rules are commonly misapplied because they are tricky to administer. Plan participants who have terminated employment must begin receiving their benefit by age 70-1/2. This is one reason why it is so important for an employer to keep in good contact with the participant population, to find these people and start paying them out on time. Commencing or correcting these distributions will prevent qualification errors upon termination.
o Qualified Domestic Relations Orders (QDROs) – A QDRO is a court order that is used to divide up a participant’s benefits in the event of divorce or legal separation. It is important to make sure that alternate payees are also accounted for when providing data for insurance carrier quotes.
• Locate missing participants – As part of a plan termination, it must be demonstrated that the plan administrator has performed a diligent search for missing participants – living and deceased. This can be done well in advance of a plan termination to allow time to find missing participants via various search firms and government databases.
The timing of a plan termination is somewhat dependent on circumstances outside a plan sponsor’s control. But once interest rates begin to rise in a meaningful way, many companies will want to pull the trigger and begin the termination process. Those who are ready will be the first to the annuity market, giving them a competitive price and provider advantage. Having a game plan in place now will allow you to act more swiftly when the time is right. Take the first step and audit your plan…before someone else does.