In a recent blog we discussed concerns that defined benefit (DB) plan sponsors may have in the face of the COVID-19 outbreak. One of those concerns regards near-term contribution requirements that may be overly burdensome when coupled with severely reduced income and/or other pressing needs for available cash.
A separate blog, posted March 27, describes how the recently-enacted CARES Act partially addresses that concern by pushing back the due date for contributions that would otherwise be due during the 2020 calendar year. However, that legislation just delays the contribution requirement; it doesn’t reduce it. And even if future legislation does provide relief on required contribution amounts, in the long run those contributions will still come due at some point.
It’s useful to remember a basic underlying truth about long-term plan costs. Over the long-term, money that goes into the plan trust (including investment returns) must equal the money that comes out of the trust. In other words:
Contributions + Investment returns = Benefit payments + Administrative expenses
Doing a bit of algebra, we get:
Contributions = Benefit payments + Administrative expenses – Investment returns
Any legislation that may or may not be passed doesn’t change the amount that must ultimately be contributed; it can only delay those contributions. Over the long-term, contributions can only be reduced by one or more of the following:
- Reducing benefit payments
- Reducing administrative expenses
- Increasing investment returns
Administrative expenses are typically low enough that they don’t have much impact. And I wouldn’t hold out hope for increased investment returns any time soon (in fact, the opposite).
That leaves us with reducing benefit payments. The IRS does not allow for benefits that have already been earned to be taken away; the most that can be done is to prevent future benefits from being earned. And that brings us to the title of this blog, and to three terms that are often used interchangeably by non-practitioners but that mean very different things:
- A plan closure means that no new participants will be allowed to enter the plan after the closure date (this is sometimes referred to as a “soft freeze”, which can be confusing). It does not prevent existing participants from earning new benefits.
- A plan freeze means that no new participants will enter the plan, and that existing participants will not earn additional benefits. To prevent participants from earning a benefit in a year, the plan must be frozen prior to participants earning a year of service (typically, after 1,000 hours have been worked in the year). This means that most DB plans would need to have a freeze amendment in place by the end of May in order to prevent participants from earning additional benefits in 2020. Freezing the plan before a year of service is earned would significantly reduce, and perhaps even eliminate, contribution requirements for the year. Once a plan is frozen, the freeze remains in place until the plan is subsequently amended to restore accruals.
- A plan termination means that the plan has been frozen and that benefits are being distributed to all participants (either as lump sum payments or through annuity purchases). Once benefits are distributed, a plan termination cannot be undone, so only plan sponsors who don’t anticipate wanting to make contributions in the foreseeable future should terminate the plan.
If significantly reduced income and/or near-term cash needs have you concerned about contribution requirements for your DB plan, contact your IAI consultant today to discuss these and other options.