Frozen DB Plan, AFTAP Restriction, and a Lump-Sum Window
Northstar Manufacturing sponsors a frozen defined benefit pension plan covering 1,100 participants, 60% retirees. The plan is 55% funded on a PBGC premium basis, with a $120 million funding deficit. The sponsor wants to reduce risk by offering a lump-sum window to terminated vested participants and purchasing a group annuity for remaining retirees. Interest rates have risen, but the plan's actuary warns the AFTAP is below 60%, and the next certification is due in three months. The plan has a $5 million minimum funding contribution due. The sponsor is also considering a new enhanced lump sum for retirees currently receiving annuities. The PBGC guarantees benefits but not all ancillary benefits. The HR team wants to announce the window in 30 days and complete it before year-end.
1. May the plan offer the lump-sum window given the 55% AFTAP? What steps must precede any announcement?
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Probably not yet. Under IRC section 436, a plan with an AFTAP below 60% is subject to benefit restrictions that generally prohibit lump-sum payments and other accelerated forms of benefit. The actuary's warning means the plan cannot safely announce a lump-sum window until it has a timely certification and confirms the AFTAP. The sponsor should ask the actuary to certify whether the AFTAP is below 60% and whether any 436 contribution or security could raise it. A $5 million minimum funding contribution may help, but it must be analyzed for its effect on the AFTAP and the funding target. Announcement before certification creates risk of promising a benefit the plan cannot legally pay. The plan also needs to amend the plan for the window, provide the required election materials and 204(h) notice if applicable, and give participants a meaningful election period. If the AFTAP remains below 60%, the sponsor should not launch the window; it should consider a later window after funding improves.
2. Evaluate the proposed annuity purchase and the sponsor's fiduciary process.
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An annuity purchase can be a sound de-risking step, but the sponsor must run a fiduciary process. It should select an insurer based on financial strength, claims-paying ability, expense, and administrative capability, and document the review. The sponsor should consider whether the annuity is the safest available annuity and whether state guaranty association coverage and PBGC protections are adequate. It should not steer participants based on the sponsor's cost alone. The plan should obtain an independent fiduciary or adviser if the sponsor has a conflict. Participants must receive clear notices explaining the transfer and any reduction in PBGC guarantees. If the plan purchases annuities for retirees, the plan may discharge liability only if the annuity is irrevocable and the insurer assumes the obligation. The sponsor should also review ancillary benefits, because PBGC does not guarantee all of them.
3. How should the sponsor address selection bias and participant communication?
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Selection bias is the central risk. A lump-sum window attracts participants who expect shorter lives or need cash, leaving the plan with a longer-lived population and making a subsequent annuity purchase more expensive. The sponsor should use objective, nondiscriminatory eligibility criteria, avoid designing the window to target only the sickest or healthiest, and have the actuary model take-up rates by age and health status. Communication should be balanced: it should explain the lump sum, the annuity option, the PBGC guarantee, and the consequences of each choice, without misleading projections. The sponsor should give participants time to decide and consider independent financial education. The board should document why the de-risking package is prudent for the plan as a whole, not just for the sponsor's financial statements.