Retirement Plan Terminations

Retirement plans can be expensive for the employer, so if business profitability declines significantly, then the business may have to terminate the plan. However, to protect retirement participants, the law requires specific procedures to shut down a retirement plan. In certain circumstances, the IRS and the Department of Labor may terminate the plan. The most common reasons for terminating a plan is because the employer can no longer afford the contributions or the administrative costs, but sometimes the employer wants to set up a different plan. Additionally, retirement plans often have to be terminated because the company was sold or merged with another company. The exact procedure for terminating or freezing a retirement plan will depend on whether it is a defined benefit (DB) plan or a defined contribution (DC) plan.

Instead of terminating a plan, the employer may freeze the plan, where no more benefits accrue to the plan. Terminating a retirement plan dissolves it completely, in contrast to freezing a plan that may be reinstated later. However, participants must be notified at least 15 days before the freezing date.

There are additional requirements for frozen DB plans. The participants must still receive any benefits earned based on the specified formula listed in the plan document. The employer must also make any contributions to fund accruals that are based on past service. A frozen DB plan will also incur continued administrative costs, including the payment of premiums to the Pension Benefit Guaranty Corporation (PBGC). A frozen DC plan will still require that the employer make any required contributions for services already rendered, but at least there is no premium payment to the PBGC.

Besides terminating a plan, the employer can also amend the plan to convert it to a different type. Generally, a DC plan can be converted into another type of DC plan and likewise for the DB plan. However, retirement plans cannot be amended to convert between DB and DC plans, so the employer must terminate the retirement plan 1st, then start the other retirement plan.

If a plan is terminated within 10 years of its installation, then the IRS may scrutinize the termination to determine if the plan was being used as a temporary tax shelter. If the IRS so rules, then the employer will be liable for all back taxes and penalties. Taxes and penalties may also be assessed if the IRS discovers that the plan is being terminated because of an infraction of the rules.

Employers rarely have problems funding DC plans since contributions can be reduced if net profits are lower. By contrast, DB plans require a minimum funding to provide the promised benefits to the participants, regardless of the profitability of the business. Consequently, DB plans are often terminated because the employer can no longer afford them.

Terminating a Direct Contribution Plan

To terminate a DC plan, the board of directors or the owners must pass a resolution to terminate the plan, which cannot be earlier than 15 days after the plan participants have received notice of the termination. At plan termination, benefit accruals will cease and participants will become 100% vested in their benefits.

The employer must make any contributions up until the plan termination. The assets contained in the retirement plan will be liquidated, with the proceeds distributed to the plan participants. If the employer is switching to a different plan, then an in-kind distribution may be used, where the assets are transferred to the new plan, either to another DB plan, another DC plan, or a direct rollover to an IRA.

When the DC plan is terminated, Form 5500, Annual Return/Report of Employee Benefit Plan must be filed and labeled as the final form. Additionally, the employer should get an advanced determination letter (ADL) so that the IRS has notice of the termination and can help ensure that the required steps are followed.

Terminating a Direct Benefits Plan

Terminating a DB plan is more involved. There are 2 types of plan terminations: the standard termination and the distressed termination. An employer can execute a standard termination only if the plan assets are at least equal to the projected benefit obligation (PBL), an estimate of the plans future liabilities. A distressed termination is undertaken by an employer who cannot sufficiently fund the plan to provide the defined-benefit. In such cases, the IRS will only permit the plan termination if the employer can show that continuing to fund the DB plan may undermine its continuance as a going concern.

The Board of Directors must pass a resolution to effect the standard termination, but all participants must be notified of the intent to terminate the plan 60 to 90 days before the proposed plan termination date. The participants must also be informed that the PBGC coverage for the retirement benefits will also cease when the plan is terminated.

If the plan assets are transferred to an insurance company in exchange for an annuity to the participants, then the participants must be given the name and contact information of the insurance company and the benefits should be explained. The employer must also notify the PBGC of the intent to terminate the DB plan. For a standard termination, the PBGC must be notified that the plan is fully funded. For distressed terminations, the retirement plan is taken over and administered by the PBGC. The employer must notify the employees about the distressed termination, and the plan assets must be transferred to the PBGC, who becomes the plan administrator.

Excess Plan Assets

Rarely, DB plan assets will exceed the PBL, either because the company contributed too much or investment returns exceeded expectations. There are 2 options available for the excess assets. One, each participant can be given a proportional allocation of the excess assets, or, if the plan document specifically permits, the excess assets can revert to the employer. Because the employer received a deduction for the tax years when the contributions were made, any excess assets that are distributed will be taxed. If the assets revert to the employer, then a 50% excise tax is assessed on the transference. A lower 20% excise tax will be assessed on the assets if 20% of the excess is allocated to the participants' accounts or 25% of the excess assets is transferred to a qualified replacement plan, which is often managed by an insurance company.

Termination Distribution Options

Depending on the retirement plan, distributions from a terminated plan can be in the form of an annuity or as a lump sum. An employer can always offer a lump sum payment, but the employer cannot refuse a lump sum payment if the plan document stipulates it. To avoid the large tax liability, most participants roll over the lump sum into a IRA.

Plan administrators must inform participants about any spousal protections, such as a qualified joint and survivor annuity, and they must also receive a benefit election form. They must also be informed of their right to transfer the lump sum payment into an IRA.

Most plans not offering lump-sum payments usually offer an annuity by an insurance company. The employer may purchase a single premium annuity contract to provide lifelong benefits to the participants, but the annuity payments must at least equal the benefit promised to each participant by the plan.

Choosing the insurance company is considered a fiduciary obligation, so if the insurance company goes bankrupt, then the fiduciary may incur significant risk. To lower the possibility of any findings of negligence, the fiduciary should seek bids from several insurance companies and check their credit ratings with credit reporting agencies. To better respond to any future litigation regarding a bankrupt insurer, the fiduciary should document the entire process of finding and selecting the annuity provider.

A plan can sometimes be terminated by operation of law, where the termination is enacted by the IRS or by the Department of Labor (DOL). The IRS may consider a plan to be partially terminated if at least 20% of the employees are laid off, in which case all terminated employees must become fully vested. A determination of a partial termination can be rebutted with certain facts, such as if the layoff is a normal part of their business cycle. An employer can prevent a determination of a partial termination by fully vesting the laid-off participants.

Different rules may apply to other types of retirement plans, such as profit-sharing plans, 401(k) plans, stock bonus plans, and employee stock ownership plans (ESOPs) and profit-sharing retirement plans, where discretionary contributions must become fully vested.

For underfunded DB plans, the PBGC normally takes over the plan in what is called an involuntary termination. To compensate for the risk that the PBGC is undertaking, it may attach assets or place liens on the company's property.

If the retirement plan fiduciary is no longer available, then the financial institution holding the plan's assets, will have the court appoint a qualified termination administrator to file reports with the DOL and distribute the plan assets according to the DOL rules for such circumstances.