Case study: Planning for a plan termination

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By Rebecca A. Sielman | 19 April 2010

The challenge

A manufacturing company froze its defined benefit pension plan in 2005, but the plan did not have enough assets to terminate. In late 2009, the firm received some good news: It was sitting on a sizeable amount of cash, and its accountants informed it that for a variety of financial reasons it would be advantageous to make a large, deductible contribution to the pension plan. But the company's Milliman actuary gave it some bad news: The large contribution it could afford would not be quite enough to terminate the plan right away. The favorable financial situation would not last beyond early 2010, so how could the firm best take advantage of the opportunity to fund up its pension plan?

The solution

The pension plan had an unlimited lump-sum provision, and nearly all participants elected to receive a lump sum when they left. This meant that the bulk of benefits would likely be paid as lump sums when the plan terminated, rather than as annuities. The Pension Protection Act of 2006 (PPA) changed the interest rates that are used to determine lump sum amounts. Prior to PPA, lump-sum interest rates were based on 30-year Treasury rates. With PPA, lump-sum interest rates are based on yield rates for higher-quality corporate bonds. The PPA lump-sum interest rates are generally higher than 30-year Treasury rates, which means they produce generally lower lump-sum amounts. But for 2008 through 2012, there is a transition from the 30-year Treasury rates to the corporate bond rates, with the corporate bond rates phased in by 20% each year. For example, 2009 lump-sum amounts are based on 60% of 30-year Treasury rates plus 40% of corporate bond rates. By 2012, the PPA lump-sum interest rates will be fully phased in. This means that, all other things being equal, lump-sum amounts will be lower in 2012 than they are in 2009.

The Milliman actuary suggested that the company take advantage of the lower lump-sum amounts that will apply in 2012. The actuary determined the amount that would be needed to fully fund the plan on a termination basis in 2009, but based on the fully phased-in lump-sum interest rates that would apply in 2012 rather than the partially phased-in lump-sum interest rates that actually applied in 2009. The company was able to contribute and deduct this amount, plus a cushion to cover the expected administrative expenses of the plan termination. The company could then sit back and wait for 2012 and the fully phased-in lump-sum interest rates that year would bring, knowing that it would be able to terminate the plan at that point without needing to contribute additional funds.

But in order for the future to unfold in this rosy fashion, the company needed to take one crucial additional step: change how the plan's assets were invested. There were two significant risks that the plan would face between 2009 and 2012. The first was equity risk, or the risk that the stock portion of the plan's portfolio would not perform as expected over the next few years. It is obvious that poor stock performance would be a problem, as it would cause the plan to return to an underfunded position. On the other hand, good stock performance could create a surplus that would not provide the plan sponsor any advantage because when it terminates, the surplus would either need to be allocated to the participants or be returned to the company and be subject to not only income tax but also a 50% excise tax. As neither outcome was desirable, the company decided to avoid equity risk completely by selling all of the plan's stock holdings.

The second risk facing the plan was interest rate risk, which affects both the plan's assets and the plan's liabilities. On the asset side, the plan's bond holdings would fluctuate in value based on how bond rates change over time. On the liability side, the lump-sum amounts that would be paid in 2012 would be higher or lower depending on corporate bond rates at that time. The Milliman actuary advised the company to change the plan's portfolio so that it consisted of the same types of high-quality corporate bonds upon which the lump-sum interest rates were based, and so that the mix of bonds at different durations matched the durations of the plan's liabilities. For instance, 15% of the plan's liability was for benefits expected to be paid within the next five years, with an average duration of 2.3 years; the plan’s portfolio should therefore be restructured so that 15% of the assets are invested in high-quality corporate bonds with an average duration of 2.3 years. This liability-driven investment (LDI) approach means that the plan's assets and liabilities would be affected to the same extent—up or down—by changes in bond rates, so the full funding achieved in 2009 would remain in place through 2012.

The outcome

The company made the large, deductible contribution and shifted the plan’s portfolio into high-quality corporate bonds with the right mix of durations to match its liabilities. Whether bond rates rise by 2012 as many economists are predicting, bond rates fall, or bond rates stay about the same, both the plan's assets and the plan's termination liabilities will move in tandem, preserving the current funding level and ensuring that the company will be able to terminate the plan in 2012. Are all risks eliminated by the LDI approach? No—there is always the chance that the laws governing pension plans will change, that the plan will experience many more deaths or retirements than anticipated, that participants will elect more annuities than lump sums, or that the company will decide to restart its pension plan rather than terminate it. But the strategy devised by the Milliman actuary gave this company the comfort that it was controlling the risks it could control, and also put it in a position to terminate the plan in 2012.