Freezing DB Plans

There are several reasons a plan sponsor may freeze its defined benefit (DB) plan, and there are several decisions the adviser should help his client work through when it is about to do so, as well as show the sponsor how it should manage the plan afterward.

Sabrina Bailey, global head of retirement solutions at Northern Trust in Chicago says financial considerations are usually the main objective in freezing a defined benefit plan. The volatility in funding is shown on a sponsoring firm’s financial statement, so, often a plan will be frozen for that reason—to better manage volatility that shows up in these statements. Other cost factors that may lead a plan sponsor to freeze its plan include the cost of running it and the Pension Benefit Guaranty Corporation (PBGC) premiums.

“When plan sponsors look at their overall spend on employee benefits, they question the best way to spend to give the maximum value to employees,” Bailey notes. Advisers can show them that “the cost of a DB plan relevant to value may be less than spending on health care or a DC [defined contribution] plan match.”

Bailey also contends some DB plan sponsors freeze their plans because these are not necessarily valued by employees as highly as they were in the past. “With employees changing jobs every four to five years, they may not reach the benefit a DB plan offers,” she says.

Reaching the Decision
Stewart Lawrence, national retirement practice leader for the Segal Group, in New York City, says there is no right or wrong way in deciding to freeze a defined benefit plan; it is a value judgment for plan sponsors. They just need to review and evaluate their options before they follow through.

While many plan sponsors want to manage their balance sheet volatility, Segal lets them know there are other ways to do that besides freezing the plan. There are things they can do with their investment portfolio, and, if they have excess cash, they can put that into the plan and also get a tax deduction.

According to Lawrence, some plan sponsors think that by freezing their plan they are escaping the volatility of required contributions. “We explain that the only way to do that is to terminate the plan and buy an annuity, and that’s very expensive,” he says. He further explains that if the plan is underfunded, the plan sponsor still has to fund it. Freezing only gets rid of the funding requirement for new accruals. Lawrence observes that the funding requirement has a numerical as well as a volatility value; if the market crashes, the plan’s funding will suffer further.

He adds that advisers must emphasize to sponsors that work force implications are important to keep in mind. Usually, freezing the plan hurts older, longer-tenured employees the most. “So, what are the savings implications? As more and more employees cannot afford to retire, they ‘retire on the job,’ creating havoc on productivity and succession planning,” Lawrence says. “Not only do older folks stay around, but others see no possibility for moving up, so they may leave.”

Once the Decision Is Made
Lawrence says freezing a plan is not an elaborate process; the plan sponsor has to make a resolution to amend the plan to freeze it. But some legal disclosures are required.

He notes that plan sponsors will still have to manage investments and fund the plan. Advisers, accountants and actuaries will still be involved on an ongoing basis, but the role of advisers may change. “When participants are not accruing benefits, the profile of the plan’s liability changes,” he says.

According to Bailey, the most critical thing an adviser can do is help DB plan sponsors understand the long-term impact of freezing their plan on its investment portfolio. “They can create a road map of where it is today and how to anticipate the shift, over time, in liability and payments. How should allocations align to fit that need?” she says. “This will help the plan make asset changes at the right time and at the most cost-effective time.” Bailey also says the allocation plan should consider how to best manage volatility relative to how much the plan sponsor will contribute in cash. An adviser should understand the plan sponsor’s budget and how to integrate that with making benefit payments.

She points out that the liability profile will shift as participants maintain their balance but increase in age. It is important to invest assets to match liability as much as possible, she says. The plan will still need equities and real assets for growth, but ultimately sponsors of frozen defined benefit plans should manage liability with long-term duration bonds.

If there are any alternatives in the portfolio—particularly if the plan is frozen—as the plan pays benefits, the sponsor will need to wind down alternatives. “It will no longer be able to support the illiquidity of these assets [because it has retired participants to support. Thus,] it should invest in long duration bonds, corporate bonds, equities, etc.,” Bailey says.

Mitigating Participants’ Loss
In many cases, defined benefit plan sponsors will think about how to view their defined contribution plan from an overall retirement outcome perspective, according to Bailey. “They want to keep participants’ retirement savings outcomes as similar as possible to when the DB plan was not frozen,” she says. Things they might do are increase the company match and add plan design features such as automatic enrollment and automatic deferral escalation to enhance the advantage of the company match. “They cannot only implement plan-sponsor-funded design changes, but features that overcome behavioral hurdles and inertia,” she says.

Bailey adds that Northern Trust’s Path Forward study found 70% of participants appreciate auto-enrollment, and the vast majority said they would have saved 10% or more into their defined contribution plan if they could go back and do it differently.

Noting again that freezing a defined benefit plan often hurts older, longer-tenured employees the most, Lawrence says sometimes plan sponsors add a special contribution to their DC plan. For example, everyone in the plan gets 3% of pay, but, depending on a participant’s age plus years of service, he may get an additional benefit. A new hire gets only 3%, those with a low age plus years of service will get a bit more, but someone with a high age plus years of service may get 6% or 9%. “It’s a common way to transition or to mitigate the hurt to employees,” he says.

Bailey concludes that decisions to freeze a defined benefit plan have centered around how to enhance the value of benefits to employees and how to allocate costs for better benefits. She observes that when moving from a DB to a DC plan, as the latter’s assets grow, plan sponsors have the ability to lower fees through institutional-type products, and that can improve outcomes for participants.

Key Takeaways

• Cost, portfolio volatility and PBGC premiums are often the catalysts for sponsors’ decisions to freeze their defined benefit plan.
• Advisers can help plan sponsors decide on the type of freeze that makes the most sense for their company and determine what changes to the defined contribution plan might make sense post-DB-plan changes.
• After freezing their DB plan, plan sponsors are still obligated to fund and pay existing accruals.