Introduction
Have you ever said “yes” to something only to realize that with changing circumstances, you really need to back out? Sometimes this happens with employer-sponsored plans, too. Business conditions are always changing and sometimes, the best of intentions are rendered toxic to the health of a company’s finances. There are mechanisms to terminate a plan. There are also alternatives to simply deconstructing a plan. But if the plan is too far gone, the regulators might not permit these alternatives and simply shut the plan down by operation of law. Before you say “yes” to a new plan, be sure to understand how to unwind it, if conditions change.
Learning Goals
Identify the commonly cited reasons for a plan termination.
Describe a few alternatives to a plan termination.
Identify the steps for terminating a defined-contribution (DC) plan.
Identify the steps for terminating a defined-benefit (DB) plan.
Understand the available options when a DB plan has excess assets.
Describe when a plan could be terminated by the operation of law.
Commonly Cited Reasons for a Plan Termination
When an employer establishes a retirement plan, their intention is for the new plan to be a lasting legacy for all the plan participants. Their initial quest for the attraction and retention enhancement that a retirement plan offers is noble, indeed. But, sometimes, business conditions change and what was once feasible is now not.
Technically, a termination is equal to a complete dissolution of the retirement plan being offered. This is very different from freezing a plan, which will be discussed later in this chapter.
As you might easily guess, the typical reason for a plan change is that the plan sponsor can no longer afford the contributions and ongoing administrative costs. Although, it could be that the company simply wants to offer a different, and perhaps better, benefit. May be they are doing very well, and they want to increase participant benefits. The stigma of a weak company needing to terminate its plan is not always the case. Another common cause of needing to dissolve a retirement plan is the merger or sale of a company. When one company buys another, typically only one company’s retirement plan survives. The other must be in some way adjusted.
Alternatives to Plan Terminations
The most common alternative to the outright termination of a plan, where everything comes to a grinding halt, is freezing a plan. When a plan is frozen, all benefit accruals stop. This means that any service provided beyond the point of freezing a plan will not accrue any additional retirement contributions or benefits from the employer. This option requires that the participants be notified 15 days in advance of the freezing point.
For a DB plan, any benefits earned, based on the formula specified in the plan document, must remain intact. Those benefits were already earned and must now be provided. If the employer has not made contributions to fund accruals based on past service, then they must still do so in a frozen plan. A frozen plan will still incur ongoing administrative costs, including the Pension Benefit Guaranty Corporation (PBGC) coverage expenses.
If the employer offered a DC plan, then they must make any contributions required for services already provided. Then they can stop making further contributions. This employer will still have ongoing administrative costs as well, but since they are not a DB plan, they do not have the added expense of the PBGC coverage.
Another alternative to the full-on termination is to amend the plan. It is possible to amend (convert) one plan type into another plan type. For instance, an employer could change their 401(k) into a profit-sharing retirement plan (PSRP). An employer can amend any DB plan into another DB plan. They can also amend any DC plan into another DC plan. However, a DB plan cannot be amended into a DC plan. This transaction requires a full termination and then, a new plan installation.
Limits on Plan Termination
Since retirement plans are intended to be facilitators of long-term retirement savings, the Internal Revenue Service (IRS) especially watches for terminations that appear to suggest that the employer was actually scheming a temporary tax shelter instead. In particular, the IRS gives great scrutiny to any plan that is terminated within 10 years of its installation. If the plan is deemed a temporary tax shelter, then the IRS will disqualify the plan and the retroactive tax nightmare will commence.
What if business conditions change in the first 10 years and the company simply has no choice but to terminate its plan? If an employer, who desires to terminate their retirement plan within the first 10 years, can show to the IRS that the termination is the result of a legitimate change in business conditions that is beyond their control, then the IRS will often not disqualify the plan.
Would a DC plan ever terminate due to insufficient funding? In an extreme case, they could. The employer might not have enough money to make their current year contribution, and hence the motivation to either freeze or terminate their plan.
Would a DB plan ever terminate due to insufficient funds? The answer to this question is a resounding yes! DB plans most often terminate due to insufficient funds. When the plan assets dip too low (due to missed contributions in the past or poor market performance), the plan’s temptation to freeze or terminate becomes substantial.
It is important to note that a plan cannot use a plan termination to avoid a compliance issue. When a plan goes through the formal termination process, the IRS will look extremely closely at any possible regulatory infraction. The employer will be held financially responsible if one is found.
Steps to Terminate a DC Plan
Terminating a DC plan is relatively easy than terminating a DB plan. The first step in the process is for the company’s Board of Directors to formally pass a resolution to terminate the plan. At this point, benefit accruals will cease and all the participants must become 100 percent vested. The actual “termination” will take effect 15 days after the plan participants have received notice of the intended termination.
Once a notice has been delivered, is the employer new retirement plan expense-free? No, under normal circumstances (nonbankruptcy), the employer must be current on any retirement contributions. After the retirement contributions are current, the employer can consider the plan asset liquidation options. Sometimes, the company will sell (liquidate) everything within the plan and proceed to distribute the proceeds to the various plan participants. The alternative is called an in-kind distribution. With an in-kind distribution, all assets are transferred to a different plan type as is. The assets are not sold in the process. The other plan type could be another DB plan, another DC plan, or a direct rollover to an individual retirement account (IRA).
The employer will then begin to process the various paperwork needed to physically distribute the plan assets. One such form is their annual 5500 form, which must be labeled as a “final” form. Another piece of paperwork is entirely optional, but 100 percent recommended. Just based on this description, you might be thinking of the IRS’s advanced determination letter (ADL), and you would be right. Why would an employer need an ADL to terminate? Isn’t that an installation step? It is actually used for both installation and termination. Submitting for an ADL during the termination phase allows the IRS to, in essence, rubberstamp the process. There is no guarantee that the IRS will not audit a plan after an ADL has been issued, but if they are subsequently audited, the audit will typically be a much smooth process. If an employer chooses to neglect filling for an ADL, then it is almost always a guaranteed audit trigger for the IRS.
Steps for a DB Plan Termination
What about a DB plan? How easily are they able to be terminated? In order for the employer to initiate a plan termination, it must fall into one of the two categories. The first category is called a standard termination. In a standard termination, the plan assets are equal to or greater than the projected benefit obligation (PBO), which is the estimate of the plan’s liabilities. This plan is fully funded and may even be overfunded. Good for them! Perhaps, they simply want to switch to a different type of retirement plan for whatever legitimate business reason. The second category is called a distress termination. In a distress termination, the employer’s plan is usually underfunded. The employer must demonstrate that their ability to stay in business is substantially in question if their plan remains intact. Think of General Motors. These are the two allowable, company-initiated plan terminations if the plan is covered by the PBGC.
After the Board of Directors passes a resolution to implement a standard terminate in a DB plan, which is covered by the PBGC, the employer must then notify all the participants. For a DB plan, the notice of intent to terminate must be sent 60 to 90 days before the proposed plan termination. This is substantially different from the 15-day notice given to the DC participants. The employer will also need to notify all the participants that the PBGC coverage over their retirement benefits will cease as soon as the plan is formally terminated.
Often in a DB termination, the employer will transfer all the plan assets to an insurance company that will then provide a retirement annuity to the participants. You will learn about the annuity-based option later in this chapter. The participants must be given the name and contact information for the insurance company, and all the relevant benefits must be thoroughly explained.
Because the DB plan is covered by the PBGC “insurance,” the employer must promptly notify the PBGC of their intent to terminate. This step is uniquely applied to DB plans. The notice to the PBGC must contain a statement that the plan is fully funded. This essentially indemnifies the PBGC. At this point, the company is free to physically distribute the plan assets to the insurance company or through some other instrument, if that alternative is chosen.
Distressed terminations are managed by the PBGC. This process involves notifying the employees and then turning over all the plan assets to the PBGC, who subsequently assumes the role of as plan administrator.
Reversion of Excess Plan Assets
Sometimes, in a standard termination, the plan assets will exceed the PBO. This means that either the company contributed too much into the plan or that the investments provided returns that exceeded the actuarial expectations. Either way, the company has a good problem!
The employer has two options to resolve this “problem.” The first option is to give each participant a proportional allocation of the excess assets. The second option is for the excess assets to revert to the employer. This second option is only available if the plan document specifically permits such an arrangement.
There is a taxation effect to reversion of the plan assets because the employer already received a tax deduction for any contributions in the year in which they were made. The IRS charges a 50 percent excise tax (code word for a nonviolation penalty) on any plan assets that revert to the employer. Wow, that seems a bit excessive! The IRS is really trying to encourage the plan to allocate at least a portion of the plan’s excess assets to the participants themselves. The excise tax is lowered to 20 percent if either 20 percent of the excess assets are allocated to the participant’s “accounts” or 25 percent of the excess assets are transferred to a qualified replacement plan. A qualified replacement plan is just what it sounds like ... an authorized secondary plan for the participants’ benefit. These plans are often under the care of an insurance company.
Termination Distribution Options
Depending on the stipulations of each plan, the employer may offer ultimate distributions in either the form of an annuity (which you will earn about in this section) or in a single lump sum. The employer can always elect at the time of termination to add a single lump sum payment option, but they cannot remove the lump sum option if the plan document formally establishes it. The participants usually choose the single lump sum option, if it is offered. They may withdraw all of the money at once and pay a huge tax liability, or they may roll the lump sum into an IRA (the most common choice).
The plan administrator will need to provide the participants with a benefit election form and notices of any spousal protections like a qualified joint and survivor annuity (QJSA). They also need to provide the participants with a notice of their right to roll their single lump sum into an IRA. This topic will be thoroughly discussed in another chapter.
When a plan does not offer a single lump sum, they are typically offering an annuity through an insurance company. Specifically, they will offer a single premium annuity contract (SPAC), which means that the employer will use the money in the retirement plan for each participant to purchase a group annuity contract. One stipulation is that the stream of annuity payments must be equal to the benefit promised to the participant by the plan.
This effectively shifts the risk from the employer to the insurance company. Great for the company ... risky for the insurance company, who now has the burden of making actuarial assumptions to determine exactly what to charge the employer for assuming the risk of making the promised benefit payments. The insurance company is well-compensated for taking this risk.
Even when the plan is shifted to an SPAC, the plan’s fiduciary still has risk exposure. The choice of the insurance carrier is considered a fiduciary responsibility with the full liability of any other fiduciary obligation. The biggest concern is: what happens if the insurance company goes out of business while they are still paying benefits to the plan’s retirees?
To handle this risk, the fiduciary must solicit several different bids for the insurance premiums to purchase an SPAC. They should then thoroughly review each insurance company’s ratings from several different ratings providers. The fiduciary should be careful to thoroughly document this search process. They should also not pick the lowest insurance quote because a lawsuit could follow an insurers collapse, especially if the fiduciary chose the cheapest option.
Terminations by the Operation of Law
There are a few different situations where the company may not have chosen to initiate a termination, but it is forced upon them by the operation of the law. One such circumstance is when the IRS with deem an event to be a partial termination. This rule is designed to protect the employees during a massive layoff. If at least 20 percent of the employees are subject to a layoff, then the company is deemed to be in partial termination, and all terminated employees must be 100 percent immediately vested. This can hurt a small business more than a larger business. If there are only four employees and one is fired, then technically they have crossed the threshold of 20 percent.
The company can rebut an IRS ruling of partial termination with facts and circumstances. If they can prove that this size of a layoff is a normal part of their business cycle, then typically, there will not be an issue for them. To avoid potentially being labeled as a “partial termination,” the employer could simply fully vest all the participants at the time of the layoff. This option may not prove very costly because the vesting schedules are already very advanced and the participant may not have much plan balance in which they were not vested at the time of the layoff. This option also is no different than what the IRS would impose, but it carries the benefit of having a less confrontational relationship with the IRS.
Profit-sharing type plan, like the 401(k), the stock bonus plan, the employee stock ownership plan (ESOP), and the profit-sharing retirement plan, have a different set of rules. The IRS will require full vesting if the plan makes discretionary contributions and then abruptly stops for whatever reason. This rule will apply if the discretionary profit-sharing contributions have been recurring and substantial. This last clause sounds a bit vague, but the IRS will explore the specifics because they routinely audit plans when they terminate.
The nasty side of plan terminations is when the PBGC needs to step in and take over a plan because they are so deeply underfunded that the PBGC’s risk is simply too high and not expected to be reversed. This scenario is known as an involuntary termination. The PBGC will confiscate all assets of the plan and then figure out what portion of the benefits can be paid to the participants. Sometimes, the PBGC will go after other assets of the company, if they are able. The logic behind this is that the company needed to fund the plan, but did not choose to do so. If there are other corporate assets that could be attached with a lien, then this may occur as the company is either struggling financially or in the process of filing for bankruptcy. Each situation is unique.
When someone abandons a pet, if they are lucky, the pet will find their way to the animal shelter and then be adopted into a new home where they are wanted and will be loved. What happens to a retirement plan that is abandoned? Yes, it is possible for this to happen. Sometimes, when companies merge or are acquired, the retirement plan just sort of gets “lost” in the process. The old owners are gone and the new owners don’t always know where everything is located. The basic question is: how can the financial institution that is holding the plan assets distribute them to the participants when the named fiduciary is gone? The only solution is for a court to appoint a qualified termination administrator who will then file reports with the Department of Labor (DOL) and distribute plan assets according the DOL rules for such occurrences.
Discussion Questions
What are the common reasons for initiating a plan termination?
What are common alternatives to a plan termination?
An employer with a DB plan approaches you about amending their plan into a 410(k). What would you advise them?
At your 10-year college reunion, an old friend tells you that he started a business five years ago and installed a 401(k) at the time. He has rethought of offering an employer-sponsored plan and has decided that it is too cumbersome and costly to retain the plan. He is planning on terminating the plan. What advice would you give him?
A client comes to you with information that they have discovered a major, yet accidental, compliance violation within their profit-sharing plan. They have decided to terminate the plan, rather than fix the problem with additional contributions. What advice would you give this client?
Is the only time that a voluntary ADL is recommended to be used at the installation of a plan?
What differences exist between the process of terminating a DC plan and a DB plan, assuming that the DB plan termination is a standard termination?
A large employer has been a very good steward of their DB plan. They have a PBO (plan liability) of $100 million dollars, but they have accumulated $125 million in the plan assets through contributions and market performance. They have decided to amend the DB plan into a cash-balance plan with frozen accruals, and then they plan to install a 401(k). The company is planning to take back the $25 million in excess plan assets. Is there a way to avoid paying $12.5 million as fines to the government?
A plan administrator is in the process of terminating their DB plan. They have chosen to use an SPAC for all participants. What issues does the plan administrator need to be aware of?
A small bicycle repair shop has established a 401(k). They have a total of four employees, including the business owner. One employee, who has a reasonable unvested balance, has been with the company for two years when their employment is terminated. From the perspective of regulatory oversight, what issues might this scenario present?
What is an involuntary termination? Why does it occur? What happens when this does occur?