What To Do About Those Underfunded Defined Benefit Plans?

June 2012Newsletters For Your Benefit

It is all too common that employers sponsor underfunded defined benefits plans that they cannot afford to terminate. Because interest rates bear an inverse relationship to the value of participant benefits, there is little chance of improvement in the near future. Unfortunately, far too many employers fail to act decisively to terminate the plan until their financial condition deteriorates beyond repair.

Most employers are aware that underfunded defined benefit plans may not be terminated without the permission of the Pension Benefit Guaranty Corporation (PBGC). Under ERISA, such permission may be granted only in the following four situations:

  1. Liquidation. The plan sponsor (and every member of its controlled group) is undergoing liquidation under Chapter 7 of the Bankruptcy Code, or equivalent state law proceeding.
  2. Reorganization. The plan sponsor has filed a petition under Chapter 11 of the Bankruptcy Code, or similar state law proceeding, and the court determines that, unless the plan is terminated, the sponsor is unable to pay all its debts and will be unable to continue in business outside the reorganization process unless the plan is terminated.
  3. Inability to continue in business. The plan sponsor demonstrates to PBGC’s satisfaction that, unless a distress termination occurs, the plan sponsor will not be able to pay its debts when due and to continue in business.
  4. Unreasonably burdensome pension costs. The plan sponsor demonstrates to PBGC’s satisfaction that the costs of providing pension coverage have become unreasonably burdensome solely as a result of declining covered employment under all of the sponsor’s single-employer plans.

As bankruptcy is not an option for many plan sponsors of underfunded plans for a variety of reasons, most plan sponsors are left to focus on the last two criteria, as neither requires that the plan sponsor declare bankruptcy. Nevertheless, in many cases, the cost of maintaining the plan has become unreasonable. This most often occurs when the plan sponsor is unable to make a required minimum funding contribution, which can often lead to substantial penalties. The IRS imposes an initial 10 percent excise tax on delinquent plan contributions and a 100 percent “second tier” excise tax if the contribution is not made after the 10 percent tax is assessed. Once the 10 percent excise tax is assessed, it is difficult, if not impossible, for many such employers to recover.

When the plan is unable to make a minimum funding contribution, or misses a quarterly contribution payment, it is imperative that the plan sponsor act quickly to prevent penalties, interest and excise taxes from snowballing out of control. In our experience, too many plan sponsors wait until it is too late to control these costs – to a point where bankruptcy is the only viable option. Once a plan sponsor is unable to meet minimum funding requirements, the only way to stop required contributions, interest and excise taxes from continuing to accumulate is termination of the plan.

Many plan sponsors (and pension professionals) incorrectly believe that the PBGC’s termination criteria are too narrow to permit plan termination outside of bankruptcy or believe that their financial situation is not dire enough so as to warrant termination. PBGC has the discretion to waive any requirement of the regulations to the extent it is in PBGC’s interest to do so. In this author’s experience, PBGC will accept a properly documented distress termination application that includes well-supported rationale for the termination.

Plan sponsors requesting PBGC approval of a distress termination must provide extensive information relating to the financial status of the both the plan and the plan sponsor. In requesting a distress termination, the plan sponsor must submit detailed and extensive information concerning the termination of the plan, including: (1) financial statements for five years; (2) minimum funding waivers approved by the IRS; (3) information concerning partial liquidation, of the plan sponsor; (4) complete footnote disclosures, for the financial statements; (5) business plans and projections, (6) recent financial analyses of the plan sponsor prepared by a third party; and (7) certification by the chief executive officer that the entity will not be able to continue in business unless the plan is terminated.

In many cases, the financial information does not tell the entire story. Sponsors seeking approval for a distress termination with PBGC need to supplement the financial and demographic information with an appropriate narrative that objectively marshals the facts that supports the distress termination, without “overselling” their dire financial condition. This is where the services of a pension professional with experience in this area is critical, as such professionals are experienced with working through this process with PBGC and can draw on their experience as to the type and substance of information that best positions the plan sponsor with PBGC.

One item of good news for plan sponsors in difficult financial straits is that while the decision to terminate a plan is a “settlor” function, and the professional advice in connection with that decision cannot be paid from the plan, the implementation of the decision to terminate is a cost of compliance which is generally payable from plan assets. Because the bulk of the costs, including the application to PBGC, will be incurred in the implementing the termination decision, such costs are generally payable from plan assets. Plan sponsors are well advised to seek the advice of experienced professionals early in the process.

For more information regarding this topic, please contact Harvey M. Katz or any member of the Fox Rothschild LLP Employee Benefits and Compensation Planning Practice Group.