Terminating a pension plan: what the final year involves

Terminating a defined benefit plan is a project with a fixed sequence, several hard deadlines and one decision at the center that is usually made too late: what to do if the plan has more money than it needs, or less. This article walks through the sequence for a standard termination of a single-employer plan covered by the PBGC, with the questions that come up at each stage.

Before anything is filed: can the plan afford to terminate?

A standard termination requires the plan to have enough assets to pay every benefit in full on the termination date. The test is not the accounting liability or the funding liability. It is what the benefits will actually cost to settle: lump sums at the Section 417(e) rates in effect for the distribution, and annuity purchase prices for everyone who does not or cannot take a lump sum. Insurer pricing for retirees in payment is typically above the accounting liability for the same people, and lump sum values move with the 417(e) rates, which reset each year on the plan's lookback month.

This is the first piece of work: a termination-basis valuation that projects the funded position to the expected distribution date under a range of interest rate scenarios, so the sponsor knows whether termination is affordable now, affordable with a contribution or not yet.

The sequence and the deadlines

1. Board resolution and plan amendment setting the proposed termination date, freezing accruals if they are not already frozen and providing full vesting as of that date.
2. Notice of Intent to Terminate to participants, beneficiaries and any union, at least 60 and no more than 90 days before the proposed termination date.
3. Notice of Plan Benefits to each participant, showing the benefit to be paid and the data used to calculate it, no later than the date Form 500 is filed.
4. Form 500 to the PBGC within 180 days after the proposed termination date, with the enrolled actuary's certification that assets are sufficient. The PBGC has 60 days to review and may extend.
5. Election packages to participants, with the lump sum and annuity options, spousal consent requirements and the relative value disclosure.
6. Annuity provider selection for participants who elect or default to an annuity, following Interpretive Bulletin 95-1 with a documented review.
7. Distribution of all assets within 120 days after the PBGC review period ends, or within 120 days after an IRS determination letter is received if one was requested before Form 500 was filed. Lump sums are paid, annuity contracts are purchased and missing participants are handled through the PBGC's Missing Participants Program.
8. Form 501, the post-distribution certification, within 30 days after the last distribution, followed by the final Form 5500.

The PBGC may audit the termination, and selects plans for audit on a sampling basis as well as by size. The audit asks whether every participant was paid the right amount, which is why the data work early in the project is the part that cannot be rushed.

The data

Every plan termination is, underneath, a data project. Service and pay histories, vesting, beneficiary designations, dates of birth for spouses, addresses for people who left twenty years ago and the benefit calculations themselves all have to be right, because each participant receives a notice of the benefit they will be paid and signs an election based on it. Errors found after the annuity contract is placed are corrected under the contract's terms, and those corrections are the sponsor's cost. Reconciling the data before the Notice of Plan Benefits, not after, is the difference between a clean termination and a long one.

Surplus: the question to answer first

If assets exceed what is needed to settle every benefit, the excess reverts to the employer, and the tax on that reversion is severe: a 50 percent excise tax under Section 4980, in addition to ordinary income tax. The excise tax falls to 20 percent if the employer either provides pro rata benefit increases totaling at least 20 percent of the surplus to participants, or transfers at least 25 percent of the surplus to a qualified replacement plan.

A qualified replacement plan is a defined contribution plan, which can be the sponsor's existing 401(k), in which at least 95 percent of the terminated plan's active participants who remain employed are participants. The transferred amount is held in a suspense account and allocated to participants over no more than seven years, and the sponsor can use it in place of its own contributions during that period. In practice many sponsors transfer the entire surplus, pay no excise tax and fund their 401(k) match for years out of money that would otherwise have been taxed at effectively 80 percent or more.

The decision has to be made before distributions begin, the replacement plan has to be in place and the transfer has to be documented. Sponsors who discover a surplus late in the process have fewer options.

Deficit: the other outcome

If assets are short, the sponsor must contribute the difference before distribution, or a majority owner may agree to forgo part of their own benefit to make the plan sufficient. The alternative is a distress termination, which is a different process with different consequences and is not covered here.

Accounting

A plan freeze is a curtailment under ASC 715, recognized when the amendment is adopted. The termination itself is a settlement, recognized when the obligation is irrevocably discharged, which is usually the distribution date. Settlement accounting pulls the unrecognized gains and losses in accumulated other comprehensive income through the income statement in that period, and the amount can be large. The sponsor's auditors and the board should see a projection of that charge well before it lands.

Our approach

We run the termination-basis projection first so the sponsor knows whether, when and at what cost the plan can terminate. We then manage the sequence: the filings, the participant notices and calculations, the annuity provider review and the final reconciliation, with the surplus or deficit strategy settled at the start. Final-year disclosures reconcile every balance to zero and are prepared for audit.

This article is general information about the topics discussed and is not actuarial, legal or tax advice for any specific plan or employer.