Most plan sponsors appreciate the value that a traditional defined benefit (DB) pension plan brings to their total rewards package. Yet managing this type of DB plan comes with challenges that have led many sponsors to consider plan termination to mitigate risks and reduce costs. Plan termination, however, is a big decision that can have significant implications for both the sponsor and plan participants. Before moving forward, it's crucial to explore alternatives that address the underlying pain points while preserving retirement security for employees.

Why may plan sponsors want to terminate their plans?

Plan sponsors face several challenges that make maintaining a traditional DB pension plan increasingly burdensome:

• Unpredictable costs: Market fluctuations can significantly affect the funding status of a DB plan. If assets underperform, for example, sponsors could be required to make contributions and insurance premium payments they did not plan for.
• Financial volatility and balance sheet impact: The annual expense and funded position of a DB plan are often reported on a company’s financial statements. Volatility in either—that is inherent in traditional DB plans—can affect credit ratings and investor perceptions. Sponsors generally prefer to report stable and predictable financial positions.
• Regulatory and compliance burdens: DB plans are subject to complex regulatory requirements under ERISA and the IRS code. Compliance with funding rules, reporting obligations, and fiduciary responsibilities demands substantial administrative effort and expertise for sponsors that also offer a defined contribution (DC) plan to their employees.

Terminating a DB plan and replacing it with an enhanced DC plan is a long process that often comes at a cost—a cost that sponsors of historically underfunded DB plans are not willing to incur. In addition, terminating a DB plan could lead to financial accounting charges on the employer’s financial statements or taxation of any excess assets reverted to the employer.

Alternatives to plan termination

Given the renewed interest in lifetime income options, the inadequacy of many DC plans for adequate retirement income, and the known value of a DB plan offering, sponsors are looking at strategies that address many of their concerns without a plan termination:

• Enhanced funding policies: Accelerating contributions to improve the plan's funded status can reduce future required contributions and insurance premiums.
• De-risking strategies: Liability-driven investment (LDI) strategies are designed to align plan assets with liabilities, reducing volatility of funded positions and costs. Other de-risking tactics involve the transfer of liabilities to shrink the plan footprint and could include lump-sum windows or annuity purchases for certain participant groups.
• Design modification or plan conversion: Transitioning to alternative DB plan designs like cash balance or variable annuity plans (VAP) can lower risk and costs while continuing to offer valuable benefits.
• Shift in spending: Using surplus in the DB plan and/or shifting retirement spending strategies from DC plans to DB plans could result in significant cash savings.

High-level plan design alternatives

Innovative DB plan designs offered with DC savings vehicles can strike a balance between sponsor objectives and participant needs. A few commonly considered DB designs include:

• The cash balance plan: A plan that defines the benefit in terms of a hypothetical account balance. Participants receive annual pay credits (a percentage of compensation) and interest credits (that can be linked to predictable fixed or variable rates). Benefits can be taken as a lump sum or lifetime income. Sponsors get predictable and stable costs while participants enjoy portable benefits that are easy to understand.
• The variable annuity plan (VAP): A plan that adjusts benefits based on investment performance. Both accruals and payouts vary, sharing investment risk between the sponsor and participants. Sponsors reduce risk and align costs with plan performance. Participants are exposed to downside risk but also enjoy upside benefits of inflation-adjusted lifetime income options.
• The sustainable income plan: A type of VAP that provides a target or hurdle return for the asset portfolio. Returns above the hurdle are placed in an account to make up for years where returns are below the hurdle to minimize participant benefit decreases while still providing some inflation protection with excess return. Sponsors get predictable costs tied to plan performance while participants enjoy inflation-protected lifetime income options with more downside protection than they receive from a traditional VAP.

Offering a plan like any of these can reduce both volatility and cost. When provided in combination with a DC plan, alternative DB plan designs can offer employees the opportunity to have sufficient retirement savings with lifetime income protection. Termination of the DB plan can eliminate the opportunity for both.

Effect of plan termination on participants' retirement security

Terminating a DB plan can have profound effects on participants:

• Loss of future accruals: Participants of plans still accruing benefits will no longer earn additional benefits, potentially leaving them with insufficient money for retirement unless a substantial DC replacement plan is implemented concurrently.
• Timing challenges: Older employees nearing retirement may find it difficult to adjust their savings strategy in response to plan termination.
• Trust in employer promises: The loss of a DB plan can affect employee morale and trust in the employer, potentially influencing productivity and retention.

Before deciding to terminate a DB pension plan, sponsors should thoroughly evaluate alternative strategies that address their pain points while preserving participants' retirement security. By thoughtfully considering de-risking measures or nontraditional plan designs, sponsors can achieve a sustainable balance between financial objectives and employee benefits. Given recent improvements in DB plan funded percentages and the favorable economic environment, it has never been more important to carefully review all options and long-term implications for both an organization and its employees.