De-Risking the Balance Sheet

New Financing Solution for Frozen Defined Benefit SERPs

With many corporate defined benefit (DB) plans now closed, frozen or terminated, many of those same plan sponsors may have leftover – i.e. “orphaned” – nonqualified defined benefit supplemental executive retirement plans (DB SERPs). These nonqualified DB SERPs, which were put in place for the company’s executives and typically mirror the benefits of the qualified DB pension plan, are now also likely closed and/or frozen. However, nonqualified DB SERPs are not easily terminated. Mesirow Financial’s Compensation and Executive Benefit Strategies (CEBS) group has developed a solution for sponsors of nonqualified DB SERPs – a solution that can help plan sponsors stabilize their balance sheets and solve the investment and mortality risk associated with these nonqualified plan liabilities.

Unmatched Liabilities for Company; Negative Tax Consequences for Executive
Plan sponsors who have closed or frozen their qualified DB plans likely took similar steps for their nonqualified DB SERP plans. Yet, many plan sponsors are finding that those nonqualified plans are not easily terminated under I.R.C. §409(A) without triggering negative tax consequences for its executives. Thus the plans tend to remain on the company’s balance sheet as an unfunded liability.

The problem with using traditional pension de-risking strategies, such as a buy-out annuity, is that, once the insurance carrier issues an annuity certificate to the executive and starts paying the executive directly, the executive becomes in constructive receipt of the full present value of the benefit stream. This would create negative tax consequences for the executive.

A Buy-In Annuity Solution
CEBS has designed a strategy which, similar to solutions used to solve qualified defined benefit risk, can also be used for nonqualified DB SERPs. The key component of the solution is a buy-in annuity contract, which is designed to be owned by the corporation or a rabbi trust to de-risk the DB SERP liability. Through a specially designed arrangement, the insurance company assumes the interest and longevity risk while still avoiding constructive receipt to the participants. The insurance company makes a bulk payment each month to the company or rabbi trust in the exact amount that is needed for the company to make the individual payments directly to the executives. This arrangement is key because, under Internal Revenue Code Section 72(u), a corporate-owned annuity is potentially taxable on the “income in the contract.” However, since retired DB SERP participants are already receiving annuity payments, the contract would be considered an immediate annuity, thus exempt from the Section 72(u) tax rule.

Effective De-Risking
Another advantage of the CEBS approach is that it allows the plan sponsor to match its pension assets and liabilities. This is critical because when many of today’s frozen DB plans were first set up, most of the participants were likely active employees, so the company was making very small or no monthly payments. Those executives are now older, and most have likely retired. Therefore, the monthly benefit payments are now much larger, resulting in a greater liquidity demand on the company than in the past.

The CEBS solution provides the exact liquidity needed for the monthly benefit payments. Thus the asset value of the annuity contract and the DB SERP liability on the plan sponsor’s balance sheet move in parallel for the retired participants in the DB SERP. In addition, the strategy effectively transfers the investment, longevity and other risks to a third party and also minimizes the volatility in shareholder equity on the balance sheet that can occur with an unfunded SERP as interest rates change.

Next Step for Plan Sponsors
SERP benefits play a key role in retirement planning for a company’s senior management team. Plan sponsors looking to de-risk their balance sheets should evaluate what they’ve done with their defined benefit supplemental plans and make sure they are aware of all the applicable rules. With proper planning and management, a frozen DB SERP doesn’t have to wreak havoc on your balance sheet.

Mesirow Financial Can Help

  • Assist in actuarial calculations
  • Model alternatives
  • Product placement
  • Ongoing monitoring
    • Reconciling bulk annuity payments against participant benefits
    • Facilitating death paperwork processing
    • Coordinating with auditors and other advisors
  • Ongoing SERP administration
    • Benefit statements
    • Actuarial valuation
    • Retirement benefit calculations