Terminating a Defined Benefit Plan: 5 Things to Consider

Defined benefit plans are designed to provide stable, predictable benefits and lifetime income for retirees. These plans are complex to set up — and they can be equally challenging to end. 

Terminating a defined benefit plan has significant implications for both employers and employees. So, moving ahead with defined benefit plan termination requires organizations to carefully consider a range of factors to ensure a smooth and compliant process. 

From regulatory compliance to open communication with employees, our guide will outline essential considerations and steps employers must take to successfully navigate the defined benefit plan termination period. 

Key Takeaways

  • Terminating a defined benefit plan is a significant decision that requires strategic planning and extensive preparation to ensure regulatory compliance and a smooth process for all stakeholders.

  • There are several crucial considerations around open communication, a clear timeline, and a compliance review that can help guide plan sponsors through the process of plan termination.

  • October Three’s expertise in managing pension risk transfers, regulatory compliance, and distribution options like group annuity purchases can help streamline the termination process.

What Is a Defined Benefit Plan?

A defined benefit plan is an employer-sponsored retirement plan that promises employees a specific monthly retirement benefit based on a predetermined formula. Employers commit to providing a set retirement income determined by factors such as the employee's salary, age and years of service. Once a participant reaches retirement age, that benefit is paid monthly, based on the form of payment selected.

The employer serves as the guarantor for defined benefit plans, bearing the investment risks and maintaining the plan's financial health. Employers generally fund the entirety of defined benefit plans. As qualified plans that are regulated and protected under the Internal Revenue Code and the Employee Retirement Income Security Act (ERISA), defined benefit plans must adhere to strict regulations. Compliance is required to ensure fair and equitable benefits, adequate participant protection, and the financial and operational standards needed for tax benefits.

Since defined benefit plans aim to provide stable, predictable benefits and long-term security for retirees, they’re highly valued by the employees who participate in them. They also offer significant tax benefits for plan sponsors and beneficiaries. However, DB plans can involve high costs and complexities for the employers who sponsor them — requiring sponsors to meticulously manage funding and investment strategies to guarantee payments over time. 

What’s the Difference Between Terminating and Freezing a Defined Benefit Plan?

Plan sponsors may choose to freeze or terminate a defined benefit plan due to financial constraints, changes in company strategy, or the desire to reduce the administrative burden and risks associated with maintaining the plan. 

Here are some of the main differences between freezing and terminating a defined benefit plan.

Freezing defined benefit plans

A company may opt to freeze the plan, halting the accrual of benefits for participants. A plan freeze can be either "soft," where new employees can’t join but current employees continue to accrue benefits, or "hard," where all accruals stop for new and existing employees.

Freezing a DB plan is a reversible decision that allows employers to pause the plan's operations temporarily while leaving open the option to unfreeze should circumstances change. Participants in a frozen plan do not need to make immediate decisions about their benefits and can wait until retirement to access their accrued benefits as initially planned. Most often, the ultimate goal is to terminate a frozen plan and many steps should be taken on the road to plan termination to help reduce the burden and cost of the plan.

Terminating defined benefit plans

Terminating a defined benefit plan is a permanent decision to end the plan entirely. In this scenario, all plan assets must be distributed to participants, either as a lump sum or through annuities.

Employers may consider this definitive step if they are no longer able to fund the plan, face long-term financial downturns, or are undergoing significant organizational changes such as a business sale. They may also consider termination if they no longer need to fund the plan because it’s already fully funded or if they are considering better options. For instance, an employer may no longer want a defined benefit plan because they want to switch to a cash balance plan or a 401(k). 

Terminating a defined benefit plan involves final payouts and is beholden to regulatory requirements to ensure all participants receive the benefits they’re due.

5 Considerations Before Terminating a Defined Benefit Plan

The decision to terminate a defined benefit plan has serious implications. That’s why it’s crucial for employers to think through how they will create a smooth and compliant transition for all stakeholders. 

Here are five essential considerations to guide plan sponsors through the process of plan termination.

1. Ensure transparent communication 

Effective communication is crucial in mitigating concerns and misinformation during the termination of a defined benefit plan. Employers must proactively inform participants about the process, timelines and what they can expect regarding their benefits. 

In particular, employers should use various communication tools, including videos, newsletters and FAQs, to clarify the process and reassure participants that their funds are secure. Due to the substantial amount of information provided and the significant decisions participants must make regarding their pension benefits, it’s a good idea to organize a series of informational meetings about the termination process. Providing clear, accessible information as early as possible can help participants navigate the complexities of plan termination with greater ease and confidence.

2. Plan funding and financial implications

At the time of plan termination, all active participants must be fully vested. This means all participants are entitled to receive the full benefits they have earned, regardless of how long they have been with the company.

Plan sponsors are required to ensure the plan is completely funded and to disburse the full amount of accrued benefits to all participants. If there are funding shortfalls, plan sponsors must make additional contributions prior to termination. Employers need to understand the financial demands of termination, including the potential need to cover unfunded liabilities, which might involve complex financial strategies and negotiations.

3. Review compliance and legal considerations

Terminating a DB plan involves a thorough compliance check with federal rules and regulations. 

That includes the distribution of numerous mandatory notices to participants that detail their rights and outline the steps of the termination process. These documents must be meticulously prepared and distributed within specific legal timelines. 

To start, each participant must receive a Notice of Plan Benefits, which provides a comprehensive summary of their accrued benefits and the formulas used to calculate these benefits. This is especially critical for retirees who are already receiving benefits. The notice will confirm the details of the annuity they selected.

Additionally, plan sponsors must distribute other key documents, such as the Notice of Intent to Terminate, Notice to Interested Parties, Notice of Annuity Information, and Notice of Annuity Contract. These forms help provide transparency and keep all parties well-informed of their rights and available choices during the plan’s termination period.

As part of the process, plan sponsors must file PBGC Form 500, the standard termination notice, to notify the Pension Benefit Guaranty Corporation (PBGC) of the plan's intent to terminate. After benefit distributions are completed, PBGC Form 501 must be submitted to confirm the distribution of plan assets. The PBGC's review of Form 500 and approval of Form 501 directly influence the termination timeline because the process cannot be completed until the PBGC confirms compliance. Delays in filing or errors in documentation can extend the timeline significantly.

Compliance with these regulations ensures the lawful and ethical management of the termination process, safeguarding both the plan sponsors and the participants.

4. Create a timeline

Terminating a defined benefit plan involves many steps and numerous legal, regulatory and financial requirements. A clear, well-structured timeline is essential for coordinating this process. 

This timeline should outline all critical milestones, from the initial decision-making and communication to the final distribution of benefits, which may include: 

  • Decision to terminate

  • Actuarial valuation and funding assessment

  • Informing participants, beneficiaries and other stakeholders about the intent to terminate

  • Official filing of the notice of intent and submission of other forms with regulatory bodies, such as the IRS and the Pension Benefit Guaranty Corporation (PBGC)

  • Final benefit calculations and distribution of notices

  • Distribution of benefits and assets

  • Final regulatory filings

  • Final audits and closure of plan accounts

This timeline can vary significantly based on the size of the plan, the funding status, the number of participants and whether the plan is subject to PBGC oversight. Each step might take several weeks to months and the entire process could span from a few months to over a year.

5. Identify new options for participant benefits and distribution

Plan sponsors must also decide how benefits will be distributed. Benefits can be distributed through lump-sum payments or annuities. 

  • Lump Sum Payments: Lump-sum payments provide participants a one-time payout of their accrued benefits, allowing immediate access to funds that can be rolled over into another tax-advantaged retirement account such as a 401(k) or IRA. Given that participants take over the investment risk, they should carefully review their options to make sure their financial planning fits their lifestyle and retirement goals.

  • Group Annuity Purchase: Purchasing a group annuity offers guaranteed payments for a specified term or for life, appealing to those seeking steady income and financial stability post-retirement. 

Each distribution method must be carefully planned and coordinated with relevant parties, such as insurance companies for annuities or financial institutions for lump-sum distributions. Clearly communicating these options ensures participants can make informed choices suitable for their retirement needs.

How October Three Can Help

Terminating a defined benefit plan is a complex, nuanced process that demands specialized expertise. When considering distribution options like group annuity purchases, it's critical to partner with a firm that possesses deep knowledge in managing pension risk transfers and compliance with regulations. 

October Three offers comprehensive services to assist employers in navigating these challenges and ensuring a seamless transfer of pension liabilities. From strategic planning and compliance checks to communicating with participants and managing financial obligations, October Three's expertise ensures that plan terminations are conducted smoothly and in the best interest of all parties involved. 

Discover how October Three can help streamline your DB plan termination process with expertise, efficiency and ease.