Speaking on a recent webinar, Dan Kravitz, president of Kravitz, Inc., and Chris Pitman, an expert plan termination consultant with the firm, offered an informative overview of the concept of strategic plan terminations.

As the pair explained, the question of “what actually is a strategic plan termination” is one they hear quite a lot from both plan sponsors and advisers. In the simplest terms, a strategic plan termination is a decision by the owners of a company to close their existing cash balance plan or a traditional defined benefit (DB) pension plan, in order to start a new plan that that is fundamentally different from the existing program.

Generally speaking, this process will entail a distribution of the assets in the form of annuity purchases and rollovers. And then, immediately thereafter, the employer adopts a brand new cash balance plan, usually with quite a different design and a different interest crediting rate. As Kravitz and Pitman noted, most often this is going to be done by a mature DB or cash balance plan that has a strong business need to make changes.

The pair stepped through the five most common reasons why employers consider this route, as follows. Importantly, none of these should be a sole factor in pushing an employer into a strategic plan termination, because in fact, some of these reasons in isolation could be construed by the Internal Revenue Service (IRS) or the Pension Benefit Guaranty Corporation (PGGC) as a breach of fair conduct:

• Owners or partners want to transfer current cash balance plan assets to the 401(k) profit sharing plan or to individual retirement accounts, most often to gain more discretion, to broaden investment options and to potentially increase returns. Kravitz consultants find that a lot of the partners and shareholders of companies, and the rank-and-file participants too, have a strong desire to self-direct assets. A strategic plan termination creates a distributable event for participants, so they can roll assets out to a 401(k) or an IRA, or they can accept annuitization. This reason, in particular, is one that could raise the ire of the IRS if taken in isolation.

• The employer is seeking to reduce the risk associated with guaranteeing an interest crediting rate on increasingly large balances. As a small employer finds success and grows quickly, a once diminutive cash balance plan can balloon in a hurry. The speakers pointed to cases where plans grew from $500,000 in assets to $5 million or even $50 million faster than the employer ever thought possible when creating the original plan design. Especially when an employer guarantees the safe harbor interest crediting rate, it creates an accounting liability that can grow beyond the perceived benefit of offering the cash balance plan as a recruiting/retention tool.

• The employer wants to replace a traditional DB plan with a new cash balance plan, rather than make the transition to cash balance through a more cumbersome plan conversion process. It is simply a market reality that many employers want to go from traditional DB to cash balance to limit their investment risk in the long-term, the speakers explained. And while an employer can conduct such a conversion directly, the road map for this can be difficult, and it often results in a very complex program on the other end during a wear-away period. According to the speakers, it is often much simpler from the administration perspective to terminate and then start a brand new plan.

• There is a desire among stakeholders to redesign a pension or cash balance plan following significant growth, a merger/acquisition, an ownership change, demographic shifts in the work force, late-discovered flaws in design, etc. Reducing normal retirement age, for example, from 65 to 62, and reworking the plan to allow for in-service withdrawal distributions (i.e., partial retirements) is a common motivation Kravitz consultants have seen.

• Finally, larger clients often want to change interest crediting rates from a safe harbor rate to something called the “actual rate of return.” This is another way to reduce risk for the employer, the speakers explained.

Regulatory requirements to consider

Speaking frankly to the matter, Kravitz and Pitman noted there are some misconceptions that this type of a strategic plan termination is outright illegal, but that’s just not true. If an employer has the right goals and follows the right process, they said, strategic plan terminations can be a win-win for the company and for employees.

Importantly, the IRS in particular has very specific rules and guidelines in this area. If these are perceived as being violated, the IRS can step in and disqualify the new cash balance plan or even forbid distributions from the old plan. The speakers observed that they have conducted hundreds of plan terminations and many that could be deemed strategic—but they have not once failed to receive an IRS approval letter for the new cash balance plan.

The speakers suggested it is more or less a general rule—though it is not set in stone—that the IRS outright will not question a plan termination if the plan being terminated has been around 10 or more years. If the plan hasn’t existed so long, strategic termination is still absolutely possible, so long as the process plays out correctly.

Probably most importantly, the new cash balance plan must look at least a little different from the old plan. For example, changing the crediting rate or altering the group of employees covered should do the trick, and there needs to be one or multiple clear business necessities that are cited for making the change. What’s an example of this? Change of ownership, merger/acquisition activity, or significant business challenges, to name just a few possibilities.

In the eyes of the IRS, the determination of whether a strategic plan termination of a plan that is less than 10 years old is going to be based on the real facts and circumstances of the case, not on general rules of thumb, the speakers concluded.