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How much will it cost to terminate your defined benefit plan?

You’d like to terminate your hard-frozen defined benefit (DB) plan sooner than later, but how soon will that be exactly? The answer depends on how long it takes to get the plan assets up to the point needed to cover the benefits promised to participants. Your actuary can help you calculate the potential amount of assets required, based on certain assumptions and variables.

The significant impact of interest rates

Some of the biggest variables impacting the cost of terminating your plan are the interest rates used to value plan liabilities. And since interest rates rise and fall over time, the amount of assets required to terminate can shift dramatically as well, as shown in the graph below.

Interest rate impact on termination liabilities

Higher interest rates result in lower costs for defined benefit plans.

A chart showing how higher interest rates result in lower liability costs for defined benefit plans.

As you can see, higher interest rates result in lower liabilities. But the reverse is also true—lower interest rates increases the liabilities. While the amount of increase or decrease can vary based on the ages of plan participants and the benefits being offered, generally a 1% change in interest rates can affect liabilities by 10 to 15%. That’s why it’s so important for your actuary to calculate the possible amount of plan assets required to terminate your DB plan using a variety of interest rate assumptions.

Covering a funding shortfall

In the graph shown above, the estimated amount of plan assets required to terminate the plan is higher if all plan participants get annuities (rather than non-retirees choosing a lump sum distribution). In addition, even assuming lump sum distributions are paid where allowable, the estimated amount required to terminate is more than what’s needed to fully fund the plan under the funding rules for an ongoing hard-frozen plan.

Based on the current interest rates (1st column), the estimated shortfall is $14.3 million on a termination basis (assuming lump sums are paid to non-retired plan participants)—the difference between the total liabilities of $60.1 million and assets of $45.8 million.

Knowing the spread between plan assets and liabilities on a termination basis will help you decide whether you can afford to fund the shortfall over one 1, 5 years or some other period. Depending on your risk tolerance and your organization’s access to capital, you may choose to fund the shortfall through contributions, investment earnings or a combination of the 2.

We can help

Our DB team at Principal has the experts that can help you meet your needs. Give us a call at 800-952-3343 ext. 22681 or contact your advisor to get started.

The subject matter in this communication is educational only and provided with the understanding that Principal® is not rendering legal, accounting, investment advice or tax advice. You should consult with appropriate counsel or other advisors on all matters pertaining to legal, tax, investment or accounting obligations and requirements.

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