Plan Freezes - The New Ice Age

1
Plan Freezes -The New Ice Age

• Session 602
• Stephen McGivney, FSA, EA Aon Consulting
• Laurie Vance, FSA, EA, CFA Fidelity Employer
  Services

2
Recent Pension Articles

• EBRI Issue Brief (March, 2006)
• DB Plan Freezes Whose affected, How much and
  Replacing Lost Accruals
• Pension Investments (Jan, 2006)
• DB Plans Eroding in Japan
• Plan Sponsor (Feb, 2006)
• Banks more committed to DB Plans
• Benefits News (March, 2006)
• Aerospace Corp reactivates Pension Plan after 13
  years
• Pension Investments (Feb, 2006)
• Wanted to Buy pension plans (UBS)

3
Recent Pension Trends

• IBM
• Cash balance
• Soft freeze January 1, 2005 with grandfathering
• Hard freeze January 1, 2008
• Verizon
• Hard freeze June 30,2006
• Hewlett-Packard
• Hard freeze January 1, 2006 with grandfathering
• Sears
• Hard freeze January 1, 2006
• NCR
• Hard freeze September 1, 2004 with grandfathering

• Soft freeze plan frozen to new entrants
• Hard freeze plan frozen to new entrants and new
  benefit accruals

Alcoa,.
4
Recent Pension Trends (continued)

• The number of Fortune 1000 firms freezing or
  terminating their DB plans skyrocketed in 2004
  according to new Watson Wyatt data (6/22/2005)
• 2004 71 plans were frozen or terminated
• 2003 45
• 2002 39
• The number of DB plans has decreased from 170,000
  to just 29,000 in the last twenty years
• The PBGC and airlines pension crisis has
  heightened concern over the broken promises and
  burdens to tax payers

5
Recent Pension Trends (continued)
Current Trend In Retirement Plans Is The Movement
From DB To DC Plans
Early
Flat Cash Balance
Freeze DB move to DC only
Flat Percent DC
Career Average DB
Accrual Pattern
Transition to Cash Balance
Graded Cash Balance
Floor Offset Profit Sharing DB
Graded DC
FAP Plan
Final Average DB
Late
Employer
Employee
Investment Risk and Reward
Bottom left If an employee spends their career
with company, the company takes care of their
retirement more paternalistic Top right Put
money in employees hands early and often and let
them manage their retirement planning less
paternalistic
6
Related Data Decline in DB
Related Data Decline in DB
7
Reasons for Plan Freezes

• Competitive Corporate Pressures
• Pressure to reduce costs and enhance
  competitiveness in todays economy
• Pressure to reduce volatility
• Pension plan financial performance is now a key
  board-level issue for many companies
• Other Comprehensive Income charges (shareholder
  equity)
• Debt covenants
• Profit and loss volatility
• Pension assets are now an increasingly large
  portion of balance sheet

8
Reasons for Plan Freezes (continued)

• Perfect storm declining interest rates,
  downturn in markets and limited recovery
• Increased costs (ERISA and FAS 87)
• Deterioration of funded status
• Funding holidays are over

9
Low Interest Rates
Low Interest Rates

JCWAA and PFEA relief
10
Limited Recovery

• After the peak, there was the valley

11
Problem Underfunding has Skyrocketed
Total Underfunding of Insured Single-Employer
Plans
Billions
12
Reasons for Plan Freezes

• Increased complexity in defined benefit
  administration
• New regulations increase administrative burden
  and cost
• Increased scrutiny from DOL/IRS/SEC/PBGC
• Uncertainty about future of cash balance plans
• Proposed Pension Reform
• Proposed FASB Reform

13
Reasons for Plan Freezes
Shift in Retirement Responsibility
Employer Paternalism
Go
Employee Responsibility
14
Sources of Retirement Income
15
Reasons for Plan Freezes

• Changing views of employees
• Defined benefit generally less appreciated by
  employees
• Harder to understand
• Less valuable to shorter service/younger
  employees
• Workers change careers more frequently (Gen X
  Y)
• Benefit not portable under traditional DB plans
• Traditional DB plans not usually best vehicle for
  rewarding short service employees

16
SOA Retirement Preferences Survey 2003

• 50 of DC workers, and 34 of DB workers, do not
  understand their plan well enough to be able to
  estimate their eventual retirement benefit
• 22 of DC workers, and 12 of DB workers, do not
  know the basic method used to determine their
  retirement benefit
• 8 of DB workers did not answer

17
Types of Plan Freezes

• HARD
• HARD w/indexing
• SOFT

18
Types of Plan Freezes

• Freeze future service and pay accruals (HARD)
• Freeze only service accruals future pay
  increases continue (HARD w/indexing)

19
Types of Plan Freezes

• Freeze plan to new entrants with accruals
  continuing for current participants (SOFT)
• Freeze plan for certain employees and maintain
  for others (Grand-fathered approach - SOFT)
• Common approach is to move salaried employees
  into an enhanced DC arrangement while maintaining
  DB plan for union/hourly employees

20
Employer actions

• Allow Employee Choice
• One-time option to exit plan and select
  alternative Enhanced -DC benefit program
• Usually includes a freeze of participation, no
  new entrants
• Delayed Freeze
• Announce intention to freeze the plan at a
  predetermined future date

21
Objective of Plan Freezes

• Plan sponsors goal in a traditional plan freeze
  is to ultimately exit defined benefit plan
  (Termination with Payout)
• Target is plan termination when plan funding
  and/or economic factors are more favorable
• Essentially a plan termination with cost spread
  out over time (Funding strategy)
• Mitigation, but not elimination, of financial
  risk
• Accounting and Funding impact

22
Accounting Implications of Plan Freezes

• Initial freeze could trigger a curtailment under
  FAS 88
• FAS88 Curtailment occurs when future benefit
  accruals are eliminated for a significant
  number of employees
• Significant is a term that must be agreed upon
  by auditors
• Typically significant is somewhere between 5
  and 10 of employees previously earning benefits

23
Accounting Implications of Plan Freezes
(continued)

• FAS 88 Curtailment continued
• Two issues to address
• Change in PBO
• Accelerated recognition of unrecognized prior
  services costs and any remaining unrecognized
  transition obligations

24
Accounting Implications of Plan Freezes
(continued)

• FAS 88 Curtailment continued
• Decrease in Projected Benefit Obligation
  resulting from the freeze
• Curtailment gain is recognized to the extent that
  it exceeds any previously existing unrecognized
  loss, or the entire gain is recognized if an
  unrecognized gain already exists
• Unrecognized gain or loss should include any
  unrecognized net asset

25
Accounting Implications of Plan Freezes
(continued)

• FAS 88 Curtailment continued
• Accelerate recognition of unrecognized Prior
  Service Cost (and Transition Obligation)
• Based on reduction in remaining future years of
  service
• Usually proportional reduction of each
  unrecognized PSC base

26
Accounting Implications of Plan Freezes
(continued)

• FAS 88 Curtailment continued
• Timing of recognition
• Net curtailment loss - Recognize when reasonably
  estimable
• Net curtailment gain Recognize when plan freeze
  amendment is adopted
• Remeasurement
• Update assets, assumptions and data

27
Accounting Implications of Plan Freezes
(continued)

• Ongoing FAS 87 expense after initial freeze
• For a traditional freeze (frozen pay and
  benefits)
• PBO equals ABO
• No Service Cost
• No unrecognized Prior Service Cost
• Pension cost is equal to Interest Cost plus
  Amortization of Gains/Losses less Expected Return
  on Assets

28
Accounting Implications of Plan Freezes
(continued)

• Ongoing FAS 87 expense after initial freeze -
  continued
• Issues to consider
• Amount of prepaid (accrued) liability
• Is company trying to manage unfunded ABO and
  resulting charge to shareholder equity?
• Time-frame to terminate pension plan (ASAP?)
• If near-term, consider potential settlement
  charge/credit under FAS 88
• Upon plan termination, all unrecognized
  gains/losses would need to be recognized
• Any prepaid liability needs to be reversed

29
Funding Implications of Plan Freezes

• Funding Method
• HARD freeze (freeze pay and service)
• Must change funding method to unit credit
• Automatic approval for this situation
• No Normal Cost
• Required minimum contribution (before application
  of Additional Funding Charge) equal to
  amortization of unrecognized bases with interest
• Other Freezes
• No requirement to change Funding Methods

30
Funding Implications of Plan Freezes (continued)

• Review assumptions
• Actuary is responsible for setting assumptions
• Each assumption must be reasonable
• Assumptions must be reasonable on an aggregate
  basis
• Analyze demographic assumptions in light of new
  program design
• Composition of group can change quickly when
  there are no new entrants and/or benefits have
  been frozen
• Will behavioral patterns change?
• Has company investment philosophy changed?

31
Funding Implications of Plan Freezes (continued)

• Review assumptions - continued
• Interest rate
• Has duration of liabilities changed?
• Are lump sums being offered?
• Has investment strategy changed?

32
Funding Implications of Plan Freezes (continued)

• Recognition of Freeze
• Individual Funding Methods
• Recognize plan amendment to freeze and amortize
  over 30 years
• Recognize change in funding method and amortize
  over 10 years
• Recognize any assumption changes and amortize
  over 10 years

33
Funding Implications of Plan Freezes (continued)

• Recognition of Freeze continued
• Setup bases to the extent there is an Unfunded
  AAL i.e., Unfunded AAL (preexisting bases
  Credit Balance Accumulated Reconciliation
  Account)
• Per QA 15 of the 1990 Gray Book, there is no
  guidance on the required order of recognition
  when a plan amendment, assumption change method
  change occur at the same time

34
Process to Dissolve the Plan Phase One

• Concerns
• How to minimize continued volatility
• How to maximize readiness to terminate plan
• Ongoing funding and communication obligations
• Key
• Review asset and funding policy in light of
  freeze
• Quantify shortfall and develop strategy
• Ongoing evaluation

35
Process to Dissolve the Plan Phase One
(continued)

• Review of Investment Policy Statement
• Recommendations for improving its effectiveness
• Document changes, if any, arising from asset
  allocation review
• Review of Asset Allocation Strategies
• Review actuarial reports to develop
  recommendations for the Plan
• Discuss probable risks and returns of various
  allocations
• Estimate probability of meeting goals based on
  expected return assumptions

36
Process to Dissolve the Plan Phase One
(continued)

• Meet with Pension Committee to review our
  analysis and recommendations
• Agree on target allocation / proposed exit date
• Establish Asset / Liability forecast
• Formalize methodology for rebalancing

37
Proposed Work Plan Phase Two

• Quantify Shortfall, Develop Strategy
• Obtain illustrative bids from insurers
• Discuss interest rates sensitivity (duration) of
  liability
• Quantify rate change required to achieve funded
  status
• Monitor changes in markets, yields to refresh
  shortfall estimate
• Retest market when close
• When sufficient, annuitize or immunize

38
Proposed Work Plan Phase Three

• Ongoing Evaluation to obtain assets to allow exit
• Semiannual, comprehensive performance reports
• Quarterly Executive Summaries of performance and
  asset allocation relative to target
• Semiannual meetings with Pension Committee to
  review performance, funded status (based on
  insurance company estimates) and other relevant
  issues
• Annual review of appropriateness of asset
  allocation strategy
• Ensure Plans Investment Policy Statements are
  current

39
The Overall Process

• Invest / contribute to achieve 100 funded status
  on termination (annuity purchase) basis
• Immunize asset portfolio against interest rate
  movement
• Begin the PBGC termination process
• Apply for receive IRS favorable determination
  letter
• Purchase annuities
• Finalize termination
• Steps 3 4 can take one year or longer.
• Immunize the asset portfolio to maintain the 100
  funded status in the interim despite interest
  rate or stock market movement.

40
Achieving 100 Funded StatusThe External Factors

• Future economic environment
• GNP, inflation, and interest rates
• Returns of various asset classes
• Stock, bonds, cash, etc.
• Valuation interest rates, which affect
• Minimum required contributions
• FAS 87 pension expense
• Annuity prices
• Future legislative changes

41
Achieving 100 Funded StatusThe Decision Factors

• Funding policy.
• Level and pattern of future contributions (if
  any)
• Asset allocation.
• Initially geared towards capital accumulation
• Increase the funded level to 100 on a
  termination basis
• Significant stock allocation
• Ultimately geared towards capital protection
• Immunize to preserve funded level through
  termination and annuity purchase process,
  regardless of economic developments
• Predominantly bonds

42

• ABC Corp Pension Plan
• Approximately 90 million in assets
• Investment allocations early 2004
• Equities
• Domestic Equity Index 33
• International 0
• Fixed income
• Domestic high quality bonds 33
• Cash equivalents 33
• Funded status (Estimated)
• Five to eight million underfunded on a CL basis

43
Preliminary Annuity Bids

•  

44
Solutions
45
1M Contribution/yr, 60/40 Allocation, 2010
Funding Solution
46
1M Contribution/yr, 60/40 Allocation, 2010
Funding Solution
47
Funding Conclusions

• Delaying targeted annuitization date reduces PV
  of contributions at all percentile levels
• Gives investment return assumptions more time to
  increase the funded level
• Allows reduced funding levels to be made over
  longer horizon
• Increases the effect of 12 (firms cost of
  capital assumption) discounting

48
Next Steps

• Ongoing A/L monitoring
• Are they ahead or behind target
• Update A/L study
• When new funding rules are known
• When closer to annuity purchase funded status
• Update retarget asset allocation / funding
  strategy
• Prepare for switch to full immunization

49
Immunization

• When desired funded status is attained
• Underfunding costs 100 dollars overfunding
  gains 15 dollars hardly an even bet, hence
  hedge the risk
• Match duration (length) of asset portfolio with
  duration of liability portfolio to protect
  funded status
• As value of liability changes with changing
  interest rates, value of assets changes by a
  similar amount
• Value of liability (premium) is very sensitive to
  changes in rates. A 1 decrease in rates will
  usually raise premium 10 or more

50
Other Considerations

• Coverage testing under IRC Section 410(b)
• Non-discrimination testing IRC Section 401(a)(4)
• Other Implications
• 204(h) Notice Employee Communications
• Top-heavy Testing
• PBGC premiums
• PBGC Reportable Events

51
Nondiscrimination Implications 410(b)

• Coverage testing under IRC Section 410(b)
  Continued
• Soft Freeze
• Must pass either ratio percentage test (70
  threshold) or Average Benefits Test (ABT) and
  Nondiscriminatory Classification Test
• By passing ABT, Nondiscriminatory Classification
  Test allows plan to pass Ratio Percentage Test
  with a lower threshold (range between 20 to 50
  depending on controlled groups NHCE
  concentration)

52
Nondiscrimination Implications 410(b)
(continued)

• Coverage testing under IRC Section 410(b)
  Continued
• As closed group matures, risk of higher
  proportion of HCEs and lower proportion of NHCEs
  as compared to present state
• May not pass ratio percentage test
• For ABT, may aggregate DC and DB accruals and
  test on a benefits basis
• For population where new entrants are receiving
  higher DC benefits as compared to employees in DB
  plan, DC test well on a benefits basis

53
Nondiscrimination Implications 401(a)(4)

• Hard Freeze (no additional accruals)
• No test required
• May have an issue if another plan depended on
  aggregation with the frozen plan in order to pass
• Make sure that plan satisfied amounts testing at
  point in time when accruals were frozen

54
Nondiscrimination Implications 401(a)(4)
(continued)

• Soft Freeze (no new entrants)
• As long as benefits are accruing, must complete
  amounts testing
• If plan is safe harbor, general test is not
  required
• If plan is not safe harbor, plan must pass
  General Test

55
Nondiscrimination Implications - 401(a)(4)
(continued)

• Soft Freeze (no new entrants) continued
• Aggregating DB and DC plans and testing on a
  benefits basis
• Preferred approach, DC accruals for younger
  participants test well on a benefits basis
• Can always combine and test on a benefits basis
  for Average Benefits Percentage Test (even if not
  testing on a combined basis for General Test)

56
Nondiscrimination Implications - 401(a)(4)
(continued)

• Soft Freeze (no new entrants) continued
• For General Test, must meet at least one prong of
  a three-prong test
• Must prove that plans are predominantly DB in
  nature for NHCEs, or have minimum DC accruals for
  NHCEs

57
Nondiscrimination Implications - 401(a)(4)
(continued)

• As closed group matures, risk of higher
  proportion of HCEs and lower proportion of NHCEs
  as compared to present state
• May not pass General Test since some rate groups
  may fall below safe harbor and unsafe harbor
  midpoint
• May not be able to cross-test (combined DB and DC
  using benefits basis) for General Test
• May fail benefits, rights and features

58
Other Implications

• 204(h) Notices and Employee Communications
• If reduce or eliminate future benefit accruals
  for participants, then must issue 204(h) notice
• Must be issued at least 45 days prior to the
  effective date of the plan amendment
• 15 days prior to amendment effective date if
  reduction results from an acquisition or
  disposition
• Provide Accrued Benefit Statements to Employees

59
Other Implications (continued)

• Top Heavy Requirements
• SOFT Frozen plan treated as any non-frozen plan
• Not exempt from providing top heavy minimum
  benefit
• For the top heavy minimum benefit, neither
  service or pay is counted for years where no key
  employee is benefiting
• HARD Frozen Plans exempt from top heavy (EGTRRA)
• PBGC Premiums
• If freeze benefits, must still pay PBGC premiums

60
Other Implications (continued)

• Reportable Events
• 50 million Underfunding Filing - ERISA 4010
• New requirement to report if plan has been frozen
  and nature of freeze.
• A traditional freeze is not a PBGC reportable
  event
• However, because plan freezes are often part of
  larger events, its a good idea to evaluate each
  individual situation