Frozen pension plans:
Is immunization or termination
the right choice?
Vanguard research
Executive summary. Is it more cost-effective to immunize or terminate
a frozen defined benefit pension plan? The answer depends on a number
of quantifiable variables, such as the cost of purchasing a group annuity
for plan participants, as well as on qualitative considerations such as the
plan’s demand on management’s time.
We identify the primary variables affecting the cost of immunization
and termination, and we analyze three hypothetical pension plans to
show how changes in these variables would affect the relative cost of
each strategy. We find that, in general, the costs of immunization and
termination are similar.
Given the similarity in costs, the qualitative aspects such as management
time spent on the frozen plan and administrative or legal hassles will likely
steer more plan sponsors toward termination. We recommend that plan
sponsors review each of the cost variables as well as the qualitative
considerations unique to their case when deciding whether to immunize
or terminate a frozen pension plan.
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November 2012
Authors
Nathan Zahm, FSA
R. Evan Inglis, FSA, CFA
It’s no secret that traditional defined benefit
(DB) pension plans have been on the decline
over the past two decades, with approximately
50% of private-sector plans now closed to new
entrants or frozen entirely as of 2010.1 For frozen
plans, a sponsor may wonder whether the plan
should be terminated or whether it is possible
to immunize the plan’s liabilities with matching
assets at a lower cost (see accompanying box
defining immunization and termination for
pension plans).
As a result of the federal Pension Protection Act
(PPA) of 2006, it is now less expensive to terminate
a plan. Prior to the PPA, plan sponsors used 30-year
U.S. Treasury bond rates to calculate the value of
lump-sum payments to participants. The 2006 law
allows sponsors to use the higher corporate bond
rates to calculate the value of these lump sums. The
use of these higher discount rates reduces the cost
of lump sums and, consequently, terminations.
This paper compares the cost of setting up a
portfolio of assets to fully (or almost fully) hedge a
plan’s liabilities with the cost of terminating the plan.
We conclude that the cost of the two approaches
is very similar, but that considerations that are hard
to quantify tend to favor plan termination. A variety
of factors, including asset performance, the size of
the plan, annuity costs, and the level of lump-sum
acceptances by participants affect the cost of each
approach. Plan sponsors with a frozen pension plan
may want to consider how the factors discussed in
this paper apply to their particular situation.
Factors affecting the decision
Plan demographics are a significant driver of cost
differences between immunization and termination.
To account for the influence of demographics,
we look at three hypothetical plans representing
different types of plan populations (see Figure 1).
• A typical plan: The total liability is split equally
among active, terminated-vested, and retired
participants.
• A mature plan: The majority of the liability
is associated with retirees “in-payment.”
• A young plan: The plan predominantly has
liability for active participants and only small
obligations for terminated-vested participants
and retirees. This situation often occurs in
plans that have offered a lump-sum option
for many years.
Because plan sponsors consider their pension
liability the way it’s defined in accounting or PPA
rules, we use that definition of liability as a reference
point in this paper. We refer to it as the “ongoing
plan liability.” This liability can be thought of as a
typical pension benefit obligation (PBO) accounting
measurement for a pension plan or a PPA Funding
Target (FT) measurement calculated according to
the yield curve parameters established in the law.
By using these common methods to determine a
market-consistent pension liability as a reference
point, we can better illuminate a concept critical to
the comparison—bond underperformance relative
to the liability.
Immunization versus termination
For purposes of this paper, we define immunization and termination as follows:
Immunization. The purchase of assets that secure the benefit payments. These assets typically include
long-duration, high-quality corporate bonds and U.S. Treasury securities whose cash flows match those of
the pension plan in timing and amount.
Termination. The complete wind-down of the pension plan and the distribution of all plan assets to
participants through lump-sum payments and/or the purchase of a group annuity contract that provides
annuity payments to plan participants. Termination eliminates all future obligations for the employer.
1 Source: Information from Pension Benefit Guaranty Corporation filings made available to Vanguard.
2
Figure 1.
Ongoing liability for three hypothetical frozen plans: Typical, mature, and young
(Liability in $ millions)
Plan type
TypicalMature Young
Active liability $166.7 $100 $400
Terminated-vested liability
166.7 100 50
Retiree liability
166.7 300 50
Total liability
500.0 500 500
Source: Vanguard.
In addition to the plan demographics, a variety of
quantitative and qualitative factors affect a cost
comparison of the two approaches. We identified
and tested the impact of seven critical variables,
three for immunization scenarios and four for
termination scenarios.
For immunization scenarios, we examined:
• Bond underperformance relative to the liability.
• Administrative expenses.
• The offering of lump sums.
For termination scenarios, we examined:
• The cost of a group annuity.
• Lump-sum acceptance rates.
• Enhanced early retirement benefits and other
plan designs.
• The offering of lump sums for retirees.
For each variable, we started with a baseline
estimate based on empirical values—historical
measures of bond underperformance, for example.
We then altered the variable to assess how changes
in its value would affect the cost of immunization or
termination. We also considered the size of a plan,
which affects the relative level of administrative and
other expenses. The costs for a large plan are smaller
as a percentage of liability than for smaller plans.
Other considerations
Some important aspects of the comparison
between immunization and termination are
difficult to quantify. These factors will generally
tilt the comparison favorably toward termination.
For example, we did not quantify the level of
demographic risk2 or reinvestment risk3 that would
remain with a plan in an immunized approach but
be transferred to participants and an insurance
company in a plan termination. Nor did we attempt
to quantify costs internal to the plan sponsor, such
as time spent managing the plan and making
decisions about it. We describe these factors and
others at the end of this paper.
Baseline results
When a pension plan terminates, active participants,
terminated-vested participants, and, occasionally,
retirees are offered the option to take a lump-sum
benefit rather than the annuity benefit. Typically,
active and terminated-vested participants are more
likely to choose a lump sum, and retirees are more
likely to keep their annuities. The liability is paid off
through these lump-sum payments and the purchase
of a group annuity from an insurance company to
provide the annuity benefits. It’s this combination
of methods for settling the pension obligation in a
termination that makes the comparison of costs for
immunization versus termination interesting.
2 Demographic risk is the risk that participants’ retirement behavior, benefit elections, longevity, and so forth, are different from the actuarial assumptions.
3 Reinvestment risk is the risk that the yield on a future investment will not be the same as the yield on a current investment that matures.
3
Figure 2.
Baseline costs of immunization versus termination for typical, mature, and young plans in 2012
(Liability in $ millions)
Plan type
TypicalMature Young
Baseline immunization liability
$537.6 Baseline termination liability
Termination/immunization ratio
Lower-cost alternative
$536.9 $540.0
$532.8 $537.4 $530.3
99.1%
100.1%
98.2%
Neutral
Neutral
Termination
Source: Vanguard.
In 2012 (and going forward), the cost of terminating
a plan is not significantly different from the cost of
keeping a plan with an immunized portfolio (Figure 2).
Although there are excess costs related to an
insurance company’s need to earn a profit and be
compensated for the risk of guaranteeing a group
annuity contract, the ability to settle a large portion
of the obligation with lump-sum payments offsets
this excess cost. Lump-sum payments represent
a savings relative to the cost of providing pension
annuity benefits, for various reasons. One reason
is that the corporate bond rates used to determine
lump-sum amounts undervalue the liability—this
is the result of the credit downgrade phenomenon
described in the upcoming section on bond
underperformance relative to the liability. Lump
sums also eliminate longevity risk and ongoing
plan expenses.
Figure 2 shows the “immunization liability” and
“termination liability” for the three different plans
described in Figure 1. Each plan is assumed to
have an ongoing liability of $500 million. An
“immunization liability” and a “termination liability”
are calculated by adjusting the ongoing liability.
The baseline liability from Figure 2 is identified for
each plan using estimates of typical values for the
seven quantitative variables that drive immunization
and termination costs. We provide more details on
these variables in Figure 3. (Appendix Figures A-1
and A-2, on page 16, include additional details about
the assumptions used for the liability calculations.)
4
To calculate the impact of changes in each variable on
cost, we modified the discount rate used to calculate
plan liabilities. If a plan’s ongoing administrative
expenses rose, for example, we reduced the discount
rate and thus raised the cost of plan immunization.
Insurance companies generally calculate premiums
for group annuity contracts this way.
We compared the costs of immunization and
termination on this present-value basis. We
calculated a “termination/immunization ratio” by
dividing the termination liability by the immunization
liability. When the liabilities were within 1 percent of
one another, we assumed the decision to immunize
or terminate the pension plan was cost-neutral.
Otherwise we identified the lower-cost alternative.
Figure 2 shows that for a plan with “young”
demographics, termination is likely to be the lowercost option, but for the “typical” and “mature”
plans, the cost comparisons are very close. This
makes sense because a plan with more active and
terminated-vested participants will generally have
more lump-sum acceptances when terminating, and
immunizing those participants would be relatively
more expensive because of the longer time horizon.
Figure 3 describes the variables that affect these
cost calculations and shows the baseline values
used to develop the comparisons in Figure 2.
Figure 3.
Descriptions and baseline values and assumptions for variables affecting immunization
and termination costs
Termination variables
Immunization variables
Variable
Baseline
value/assumption
Description
Plan sponsor considerations
Bond
underperformance
relative to the
liability
80-basis-point (bp)
reduction in discount
rate.
Neither corporate nor Treasury bonds
will have long-term returns as high
as the discount rates used to
measure ongoing pension liabilities.
Bond underperformance generally
occurs during waves of economic
and credit stress, followed by
longer periods of stability.
Plan expenses
10-bp reduction in
discount rate.
Administration, actuarial fees,
Pension Benefit Guaranty
Corporation (PBGC) premiums,
etc., are included. This factor
tends to vary by plan size.
Plan expenses are generally a
higher percentage of the liability
for smaller plans.
Lump sums
Offered to active and
terminated-vested
participants in both
immunization and
termination alternatives.
Lump sums are the least expensive
way to settle the pension obligation,
so they are assumed for both
termination and immunization.
Offering lump sums in plans that
aren’t terminating is a way to
reduce liability, headcount, and
expenses.
Annuity
purchase costs
110-bp reduction in
discount rate for retirees
and 150-bp reduction in
discount rate for active
and terminated-vested
participants.
Group annuity insurers capture
the cost of risk, administration,
and profit by adjusting the discount
rate. Retirees are less expensive
because the amount of payments
is more predictable.
The annuity purchase is the most
expensive part of terminating a
plan. Sponsors should receive
quotes for their plan, as pricing
can vary based on the insurance
company, economic environment,
and plan specifics.
Lump-sum
acceptance rates
(affect both
immunization
and termination)
75% of active and
terminated-vested
participants elect
lump sum.
Most participants choose a lumpsum option when it is offered.
Plan sponsors should use historical
or peer data to project potential
lump-sum acceptance rates for
their plan.
Enhanced
early retirement
benefits (affect
immunization
and termination)
No enhanced early
retirement benefits.
Enhanced early retirement benefits
increase the cost of annuities, but
they can be eliminated from lumpsum payments.
If early retirement benefits are not
included in the lump-sum value,
then lump-sum acceptance rates
may be lower.
Offering retiree
lump sums
No lump sums are
offered to retirees
at termination.
Retirees already in-payment can
be offered a lump-sum option at
termination.
Offering lump sums to retirees
may increase the cost of the group
annuity purchase.
Source: Vanguard.
5
Figure 4.
Ratio of termination cost to immunization cost and impact of key variables
Baseline comparison
Plan type
TypicalMature Young
99.1%
100.1%
98.2%
Immunization variable changes to baseline ratio
Annual bond underperformance relative to liability from
80 bps to 100 bps
(1.6%)
(1.6%)
(1.7%)
Ongoing plan expenses from 10 bps to 30 bps
(1.6)
(1.6)
(1.7)
Lump sums not offered during immunization
(2.9)
(1.8)
(4.0)
Termination variable changes to baseline ratio
Group annuity discount rate decreased by 35 bps
1.8% 2.2% 1.5%
Lump sum acceptances decrease from 75% to 25%
4.7
2.8
6.6
Plan contains enhanced early-retirement benefits
1.6
1.0
3.9
Retirees offered lump sum as part of termination
1.5
2.6
0.4
Source: Vanguard.
The rest of this paper examines the sensitivity
of these cost comparisons to changes in the value
of the variables. Figure 4 summarizes the results
from our tests of each variable. Negative changes
indicate a decrease in the cost of termination
relative to immunization. Positive changes indicate
an increase in the cost of termination relative to
immunization. Figures 7–9 focus on the variables
affecting the cost of immunization. Figures 10–13
focus on the variables primarily affecting the cost
of termination. We list additional factors that largely
resist quantitative analysis at the end of the paper.
Variables affecting the cost of immunization
Bond underperformance relative to liability
Bond underperformance relative to changes in the
value of the pension liability is a critical factor in
determining the cost of immunization for a frozen
pension plan. It is important that plan sponsors
realize that the true cost of their plan is higher than
the ongoing plan liability measured under PPA and
accounting rules, largely because of a mismatch
between the discount rates assumed in the
regulations and the real-world investment
opportunities in the bond market.
The assets available for an immunization strategy
are corporate bonds and Treasury securities.4
Corporate bonds can experience credit downgrades
and defaults, which raise their yields and decrease
their returns. The discount rate used to calculate
the plan’s liability is subject to no similar changes
in yield (see Figure 5, for an example). Treasury
securities have lower yields than the corporate
bond yields used to measure the ongoing liability.
In addition, there is a cost for managing the
immunized asset portfolio. For these reasons, a
portfolio of assets dedicated to immunizing the
pension liability will underperform the “return”
on—or changes in the value of—the liability. This
underperformance reflects the fact that plan liabilities
are calculated using the corporate bond discount rate
with no downgrades or costs. We define this effect
as “bond underperformance relative to the liability.”
(For additional information on bond performance and
allocation compared to liability return, see Bosse and
Inglis, forthcoming, 2012).
4 We don’t include other types of bonds, such as mortgage-backed securities (MBS), because their behavior in changing interest rate environments and other
characteristics do not make them a suitable asset for matching a pension liability.
6
Figure 5.
Impact of bond-rating downgrade on pension funding
Bonds A and B make up
liability universe
Market sees more
credit risk in Bond B
Bond B is downgraded
out of the liability universe
Bond
B
6.0%
Bond
B
Yield
Bond
A
5.0%
Bond
B
Discount rate = 5.0%
Bond
A
Yield
increases
Bond
A
Discount rate = 5.5%
Discount rate = 5.0%
Assets: Lose value
Liability: Decreases
Assets: No change in value
Liability: Increases
Source: Vanguard.
We estimated the average annual loss of an
immunization portfolio relative to a pension liability
to be roughly 65 basis points (bps) per year for a
typical plan. This estimate was based on the perfor­
mance of a hypothetical immunization portfolio for
the period March 1997–March 2012 (see Figure 6,
on page 8).5 The impact of defaults and downgrades
alone for a portfolio of 100% investment-grade
corporate bonds has been estimated at roughly
70 bps per year (Ransenberg and Hobbs, 2011).
We added investment fees (15 bps) to our 65 bps
estimate, resulting in assets underperforming
liabilities by a total of 80 bps annually.
The level of underperformance will vary over
time, and the cost of an immunized approach
will differ depending on the solution and asset
manager. We examined an alternative scenario
in which bond underperformance was 100 bps per
year instead of 80 bps. Figure 7, on page 8, shows
the change in the immunization liability with this
alternative assumption. Termination looks even
more favorable for the young plan and is also now
the lower-cost option for the typical and mature
plans, based on this new assumption for bond
underperformance.
Ongoing plan expenses
In addition to asset performance and investment
management expenses, an immunization approach
must also bear the costs of maintaining the pension
plan in the future. These expenses include items
such as actuarial fees, administration costs, and
Pension Benefit Guaranty Corporation (PBGC)
premiums. The pension benefit liability does not
typically recognize these items, but the assets
supporting the plan’s liabilities must be used to pay
these additional expenses. In the case of a group
annuity, an insurance company captures these costs
in the discount rate it uses to price these contracts.
For purposes of our comparison, we have translated
anticipated expenses for an immunized plan into a
discount rate factor.
The baseline assumption, a 0.10% decrease in
discount rate, is based on a plan with $500 million
in assets and 5,000 participants and equates to
annual operating costs of approximately $250,000.
Administrative costs may be higher for various
reasons, but as a percentage of the liability, the size
of the plan will be a major influence on the size of
these costs. In general, costs as a percentage of the
plan liability will be higher for a smaller plan (because
5 In Figure 6, the immunized portfolio loses approximately 9.15% of funding over 15 years, for an average yearly drop of 61 basis points (1 basis point =
1/100 of 1%).
7
Figure 6.
Bond downgrades and defaults have contributed to a decline in funded status for a
hypothetical immunized portfolio: March 1997–March 2012
Quarterly pension funded status based on immunization portfolio
120%
110
100
90
80
Mar. Dec. Sept. June Mar. Dec. Sept. June Mar. Dec. Sept. June Mar. Dec. Sept. June Mar. Dec. Sept. June
1997 1997 1998 1999 2000 2000 2001 2002 2003 2003 2004 2005 2006 2006 2007 2008 2009 2009 2010 2011
Mar.
2012
LDI Strategy
Note: The liability is represented by the Citigroup Pension Liability Index, and the asset portfolio is represented by 10% Barclays U.S. Aggregate Bond Index,
55% Barclays U.S. Long Credit Bond Index, and 35% Barclays U.S. 20–30 Year Treasury STRIPS Bond Index.
Source: Vanguard.
Figure 7.
As bond underperformance increases, termination becomes more attractive
(Annual bond underperformance increases from 0.8% to 1.0%)
(Liability in $ millions)
Baseline immunization liability
Change in immunization liability
TypicalMature Young
$537.6 $536.9 $540.0
$8.8 $8.6
$9.4
Adjusted immunization liability
$546.4 $545.5 $549.4
Baseline termination liability
$532.8 $537.4 $530.3
Termination/immunization ratio
Lower-cost alternative
Change in termination/immunization ratio
Source: Vanguard.
8
Plan type
97.5%98.5%96.5%
Termination Termination Termination
(1.6%)
(1.6%)
(1.7%)
Figure 8.
As a plan’s ongoing expenses increase, termination becomes more attractive
(Ongoing plan expenses increase from 0.1% to 0.3%)
(Liability in $ millions)
Baseline immunization liability
Change in immunization liability
Plan type
TypicalMature Young
$537.6 $536.9 $540.0
$8.8 $8.6
$9.4
Adjusted immunization liability
$546.4 $545.5 $549.4
Baseline termination liability
$532.8 $537.4 $530.3
Termination/immunization ratio
Lower-cost alternative
Change in termination/immunization ratio
97.5%98.5%96.5%
Termination Termination Termination
(1.6%)
(1.6%)
(1.7%)
Source: Vanguard.
relatively fixed costs such as actuarial fees and
administrative costs are borne by a smaller asset
base) and smaller for a bigger plan. Therefore,
immunization may be more cost-effective for larger
plans than for smaller plans. Note that a group
annuity contract will also recognize administrative
economies of scale, but the impact will be more
significant for ongoing plans.
Figure 8 examines the impact of roughly tripling the
plan expenses (as a percentage of plan liability) from
our baseline case, as might be the case for a smaller
plan. The cost of immunization rises and termination
becomes more cost-effective. The low-cost option
changes for both the typical and mature plan, while
termination becomes even more favorable for the
young plan.
Offering lump sums
Lump sums provide the most cost-effective way
of settling corporate pension liabilities. Typically
during a plan termination, lump sums are offered to
active and terminated-vested participants to reduce
the cost of termination (Inglis and Sparling, 2011).
Our baseline comparison assumed that the ongoing
immunization option would also offer lump-sum
payments to participants (paid at termination or
retirement), which gave the immunization option
some of the same cost benefit of offering lump
sums on termination. The cost benefit for the
ongoing plan is not the same, because participants
do not immediately elect lump sums as they would
in a plan termination.
9
Figure 9.
When lump-sum payouts are not offered in immunization, termination becomes a
more attractive option
(Liability in $ millions)
Baseline immunization liability
Plan type
TypicalMature Young
$537.6 $536.9 $540.0
$16.1
$9.7
$23.0
Adjusted immunization liability
$553.7 $546.6 $563.0
Baseline termination liability
$532.8 537.4 $530.3
Change in immunization liability
Termination/immunization ratio
Lower-cost alternative
Change in termination/immunization ratio
96.2%
98.3%
94.2%
Termination Termination Termination
(2.9%)
(1.8%)
(4.0%)
Source: Vanguard.
However, plan sponsors that do not terminate their
plan would not necessarily decide to offer lump
sums. The alternative results shown in Figure 9
illustrate how the cost of immunization changes
when lump sums are no longer offered at the point
of retirement or termination of employment. (We still
assumed that lump sums are offered in the plan
termination alternative.) The larger the number of
active participants, the bigger the impact of offering
lump sums during immunization. The cost of the
“young” plan increases by more than 4% if a lumpsum option is not offered.
Variations on lump-sum offerings exist. For example,
a plan sponsor can set limits on the amount of a
lump-sum payout or require that certain eligibility
criteria be met. The cost savings associated with
these in-between approaches will lie somewhere
between the baseline case and the results shown
in Figure 9 on a percentage basis.
10 Variables affecting the cost
of plan termination
Cost of a group annuity purchase
For reasons described previously, purchasing
annuities in a group annuity contract is relatively
expensive. The primary pricing lever used for
group annuity contracts is the discount rate. We
have used survey information from group annuity
brokers and compared their price quotes with data
from the Citigroup Pension Liability Index (a widely
used pension discount rate benchmark) and the IRS
non-averaged three-segment rates (used for lumpsum calculations) to estimate the typical difference
between the discount rate used by insurance
companies to price a group annuity contract and
the discount rate used to measure plan liabilities
in ongoing pension plans.
Figure 10.
As group annuity costs increase, the case for immunization improves
(Group annuity discount rate decreases by 35 basis points)
(Liability in $ millions)
Plan type
TypicalMature Young
Baseline termination liability
$532.8 $537.4 $530.3
$9.7 $11.8 $8.3
Adjusted termination liability
$542.5 $549.2 $538.6
Baseline immunization liability
$537.6 $536.9 $540.0
Change in termination liability
Termination/immunization ratio
100.9%
102.3%
99.7%
Lower-cost alternative
Neutral Immunization Neutral
1.8% 2.2% 1.5%
Change in termination/immunization ratio
Source: Vanguard.
We estimated the typical difference between the
discount rates for ongoing pension plans and those
used to price group annuities to be approximately
1.10% for a population of retirees and 1.50% for
a group of active or terminated-vested participants
(for details on group annuity costs, see appendix
Figure A-3).These were the levels used in the
baseline calculations. The larger reduction in the
discount rate for active participants represents the
additional risk associated with active participants,
such as uncertain benefit amounts, the timing of
retirements, and the reinvestment of assets in
different interest rate environments. Note that the
decrease in the discount rate affects the active,
terminated-vested and retiree liabilities differently
because of the different durations of the liabilities
associated with these populations.
Figure 10 reduces the discount rate by an additional
0.35% (that is, makes annuities more expensive) for
both the retiree and active/terminated-vested group
annuity purchase. We modeled this as a parallel shift
of 0.35% in the entire yield curve of rates used by
insurance providers to price their contracts. This
equated roughly to a 1.50%–2.50% increase in the
termination liability. (Note that only the non-lumpsum portion of the liability was affected.)
The lower the group annuity discount rate, the
more expensive the group annuity is, such that
immunization compares more favorably. The size of
a plan will have an impact on group annuity pricing,
sometimes in countervailing ways. For example, a
large plan may benefit from lower costs as a result
of economies of scale for administration. Insurance
providers may also be more aggressive about
winning group annuity business depending on their
circumstances (mix of desired business, available
capital, view on interest rates, and so on). On the
other hand, economies of scale can sometimes be
hard to realize because insurers may not have the
risk capacity to take on larger plans. Plan sponsors
can work with brokers or consultants to follow the
market and make good decisions about when to
solicit group annuity bids.
11
Figure 11.
As fewer participants take lump sums, immunization becomes more attractive
(Lump-sum acceptance rate decreases from 75% to 25%)
(Liability in $ millions)
Plan type
TypicalMature Young
Baseline termination liability
$532.8 $537.4 $36.2
$21.7
Change in termination liability
$530.3
$51.7
Adjusted termination liability
$569.0 $559.1 $582.0
Baseline immunization liability
$537.6 $536.9 $540.0
Change in immunization liability
Adjusted immunization liability
Termination/immunization ratio
Lower-cost alternative
Change in termination/immunization ratio
$10.7 $6.4
$15.3
$548.3 $543.3 $555.4
103.8%
102.9%
104.8%
Immunization Immunization Immunization
4.7% 2.8% 6.6%
Source: Vanguard.
Lump-sum acceptances
Another important factor in estimating the cost
of terminating a plan is how many participants
will elect a lump-sum payment, instead of an
annuity. As described earlier, lump sums are a
cost-effective way to settle a pension promise.
The more participants electing a lump sum, the
lower the cost of terminating a plan. While most
active and terminated-vested participants are
expected to take a lump sum, concerns about
longevity or investing the money themselves will
lead some participants to select the annuity.
In the baseline, 75% of active and terminatedvested participants are assumed to select a lump
sum. Figure 11 compares that to an acceptance rate
of 25%. We looked at this very low potential rate
of lump-sum acceptance in recognition of situations
where lump sums might be discouraged—some
union environments, for example. This assumption
was meant to represent the wide variability of
12 acceptance rates from sponsor to sponsor, not the
expectations for any particular sponsor. In general,
however, uncertainty about the rate of lump-sum
acceptance abounds. Our anecdotal experience
suggests that acceptance rates for any one plan
sponsor may vary by 20% or more from what is
expected.
Because the baseline assumes lump sums are paid
during immunization and termination, we changed
the acceptance rate for lump sums in both situations
to examine this factor. The lump-sum acceptance
rate has a bigger impact on the termination scenario
because in this situation the lump sum is elected
and paid immediately.
Figure 11’s results show that a low acceptance rate
significantly increases the cost of termination to the
point where immunization looks more cost-effective
for all three plans.
Figure 12.
When plans contain enhanced early-retirement benefits, immunization becomes more attractive
(Liability in $ millions)
Plan type
TypicalMature Young
Baseline termination liability
$532.8 Change in termination liability
$537.4 $530.3
($4.8)
($2.9)
($11.5)
Adjusted termination liability
$528.0 $534.5 $518.8
Baseline immunization liability
$537.6 $536.9 $540.0
($13.3)
($8.0)
Adjusted immunization liability
$524.3 $528.9 $508.1
Termination/immunization ratio
100.7%
101.1%
102.1%
Lower-cost alternative
Neutral Immunization Immunization
1.6% 1.0% 3.9%
Change in immunization liability
Change in termination/immunization ratio
($31.9)
Note: Terminated-vested participants are assumed to have forfeited their right to early-retirement benefits by quitting, and retirees are already in payment; thus no
adjustment is required.
Source: Vanguard.
Enhanced early retirement
Many pension plans provide incentives to retire
at certain ages through enhanced early-retirement
benefits. These may be in the form of reduced
benefits that start before normal retirement or
supplements intended to help the retiree bridge
the period until Social Security benefits can be paid.
An enhanced early-retirement benefit will change
the termination versus immunization comparison.
First, plan sponsors are not obligated to include the
value of enhanced early-retirement benefits in lumpsum payments, so the cost of a plan termination
may be reduced by excluding these benefits from
lump-sum payments. On the other hand, a group
annuity provider will charge for the extra risk
associated with the uncertainty of participants’
retirement date and benefit amount.
In our baseline case, we assumed the plans had
no enhanced early-retirement benefits. Figure 12
examined the impact if:
• Ten percent of the active liability was due to
enhanced early-retirement benefits.
• Participants electing the lump sum forgo the 10%
of their liability associated with their enhanced
early-retirement benefit.
• The group annuity for active participants has
a 15% load added for the additional risk to the
insurance company.
Note that because lump sums are also assumed
to be paid for the ongoing immunized plan, the
presence of early-retirement benefits affects the
cost of immunization as well. The immunized liability
is not loaded for the risk associated with early-
13
Figure 13.
When retirees are offered a lump sum at termination, the financial impact is sensitive to the
number of participants accepting the lump sum
(Liability in $ millions)
Plan type
TypicalMature Young
Baseline termination liability
$532.8 Change in termination liability
$7.7
$537.4 $530.3
$13.9 $2.3
Adjusted termination liability
$540.5 $551.3 $532.6
Baseline immunization liability
$537.6 $536.9 $540.0
Termination/immunization ratio
100.6%
102.7%
98.6%
Lower-cost alternative
Neutral Immunization Termination
1.5% 2.6% 0.4%
Change in termination/immunization ratio
Source: Vanguard.
retirement benefits, because we have assumed the
actuarial assumptions are realized, but plan sponsors
should be aware of the risk that more participants
than expected will take the early-retirement benefits
and thus increase the cost of immunization.
As shown in Figure 12, immunization looks more
favorable for both the young and mature plans if
the plan includes enhanced early-retirement benefits.
Note that if a plan sponsor chooses to include the
value of enhanced early-retirement benefits in lumpsum payments, the group annuity would be more
expensive without an offsetting decrease in the
value of lump sums, and the cost of immunization
would look even more favorable.
Retiree lump sums
Typically, once a retiree elects a form of payment,
the payment form cannot be changed to a lump
sum.6 However, during a plan termination, a plan
sponsor has the opportunity to allow retirees who
have already elected an annuity to change their
minds and elect lump sums.
The appeal of offering a lump sum to retirees
already receiving an annuity is to avoid the expense
of purchasing an annuity for as many participants as
possible. However, a group annuity provider is also
likely to increase the annuity premium for adverse
selection (more healthy people choose the annuity)
if a lump-sum offer is made or has been made in
the recent past. These conflicting forces—reduced
costs for paying lump sums and increased costs for
adverse selection—leave the ultimate level of cost
reduction uncertain. Based on the assumptions we
used for retiree lump-sum acceptances and adverse
selection costs, total termination costs actually
increase, but this will vary based on actual plan
experience.
Figure 13 takes into account the impact of offering
lump sums to retirees during a plan termination. We
assumed that 50% of retirees would elect to take
the lump sum. If the election percentage differs from
50%, then the cost of termination may look more or
less favorable.
6 In an exception to this generalization, Ford Motor Company announced in April 2012 that it would offer lump sums to retirees already in payment, even
though the company was not terminating its pension plan.
14 Other factors
Conclusion
Figures 7–13 quantified the costs of immunization
and termination in order to compare them on a
numerical basis. Plan sponsors will also want to
consider factors that are harder to quantify. In most
situations, the costs of termination and immunization
are very close, so the factors listed here will be a
significant part of the decision.
Generally the cost of immunizing a portfolio and
the cost of terminating a pension plan will be about
the same, but the comparison does vary based on a
variety of factors. Factors for which costs are difficult
to quantify may also be significant and will affect the
decision. Plan sponsors should be aware of the cost
impact for each of these factors on their frozen
pension plan when deciding whether to immunize
or terminate.
Factors that may sway a plan sponsor toward
immunization:
• The plan sponsor desires that employees receive
an annuity benefit and a lifetime source of income
from the company.
• The frozen pension benefit is still used as part of
the larger retirement benefit for the sponsoring
organization.
• The plan sponsor feels a fiduciary responsibility
to execute the plan.
Factors that may sway a plan sponsor toward
termination:
• The administrative burden of the pension plan.
• Management decisions related to the plan distract
from the core business.
• The frozen pension plan is confusing and
misunderstood by employees.
• Employees want access to the value of their
frozen pension benefit.
References
Bosse, Paul M. and R. Evan Inglis, forthcoming,
2012. For Better Pension Liability Matching,
Add Treasuries to the Mix. Valley Forge, Pa.:
The Vanguard Group.
Brentwood Asset Advisors. December 2010–
October 2011. Annuity rates; available at
brentwooodllc.com.
Dietrich and Associates. December 2009–
October 2011. Monthly interest rate updates;
available at www.dietrichassociates.com.
Inglis, Evan R., and Jeff Sparling, 2011. Pension
Plan Terminations: Minimizing Cost and Risk.
Valley Forge, Pa.: The Vanguard Group.
Ransenberg, Daniel, and Jonathan Hobbs, 2011.
Overcoming Credit Downgrades: Four Ways to
Improve Your Liability Hedge. New York: BlackRock.
• An immunization approach does not eliminate
all risk, including demographic risks related to
participants’ life expectancy and other factors
that cannot be hedged effectively.
15
Appendix. Ongoing liability assumptions
Figure A-1.
Hypothetical liability durations
Figure A-2.
Hypothetical liability discount rates
prior to variable adjustment
Liability duration (years)
Active liability
15
Ongoing liability discount rates
Terminated-vested liability
13
Active rate
Retiree liability
Figure A-3.
8
5.00%
Terminated-vested rate
4.50%
Retiree rate
4.00%
Comparing discount rates of a group annuity provider and a typical pension
Liability
discount rates
RetireeActive/terminatedannuity discount vested annuity
rate costs
discount rate costs
Active/RetireeRetiree Active Active
Annuity purchase rates
Retiree terminated-insuranceinsuranceinsuranceinsurance
discount vested
Dietrich Dietrich
Brentwood
Brentwoodcosts—costs—costs—costs—
Date
rate*
rate**
retiree
active immediate deferred
DietrichBrentwood
DietrichBrentwood
December 31, 2009
5.32%
6.13%
4.50%
5.13%
0.82%
1.01%
January 31, 2010
5.31
6.14
4.00
4.38
1.31
1.76
February 28, 2010
5.42
6.29
4.25
4.75
1.17
1.54
March 31, 2010
5.31
6.21
4.25
4.63
1.06
1.58
April 30, 2010
5.27
6.12
4.00
4.63
1.27
1.50
May 31, 2010
5.11
5.92
3.50
4.13
1.61
1.80
June 30, 2010
5.05
5.91
3.50
4.13
1.55
1.79
July 31, 2010
4.80
5.71
3.50
4.00
1.30
1.71
August 31, 2010
4.51
5.45
3.13
3.88
1.39
1.58
September 30, 2010
4.45
5.52
3.13
3.88
1.32
1.64
October 31, 2010
4.41
5.62
3.13
3.88
1.29
1.75
November 30, 2010
4.58
5.88
3.38
4.38
1.21
1.50
December 31, 2010
4.91
6.00
3.63
4.38
4.30%
4.60%
1.28
0.61%
1.63
1.40%
January 31, 2011
4.92
5.95
3.63
4.38
4.25
4.60
1.29
0.67
1.58
1.35
February 28, 2011
5.01
6.06
3.63
4.38
4.25
4.60
1.38
0.76
1.69
1.46
March 31, 2011
4.90
5.97
3.88
4.38
4.25
4.60
1.02
0.65
1.59
1.37
April 30, 2011
4.90
5.96
3.63
4.38
4.10
4.60
1.28
0.80
1.58
1.36
May 31, 2011
4.67
5.73
3.63
4.38
4.00
4.60
1.05
0.67
1.35
1.13
June 30, 2011
4.66
5.79
3.63
4.38
4.10
4.85
1.04
0.56
1.42
0.94
July 31, 2011
4.65
5.76
3.13
3.88
3.80
4.35
1.52
0.85
1.88
1.41
August 31, 2011
4.34
5.46
3.13
3.88
3.35
4.10
1.22
0.99
1.59
1.36
September 30, 2011
4.24
5.28
3.38
3.88
3.50
3.85
0.86
0.74
1.40
1.43
October 31, 2011
4.31
5.12
3.13
3.63
3.60
4.10
1.19
0.71
1.50
1.02
November 30, 2011
4.22
4.94
3.13
3.88
N/A
N/A
1.10
N/A
1.07
N/A
December 31, 2011
4.21
4.92
3.13
3.63
3.35
3.85
1.09
0.86
1.30
1.07
Average—Average—
retiree 1.07% active
Notes: The IRS publishes, on a monthly basis, three segment rates for plan sponsors to determine minimum lump-sum benefits. The first segment rate discounts
payments due in the first five years; the second segment rate discounts payments due for the next 15 years; and the third segment rate discounts payments due
for 20 years and beyond.
*Retiree discount rate is 10% of the first segment rate and 90% of the second segment rate as published by the IRS for each month.
**Active/terminated-vested discount rate is 40% of the second segment rate and 60% of the third segment rate as published by the IRS for each month.
Sources: Vanguard, using data from the U.S. Internal Revenue Service, Dietrich and Associates, and Brentwood Asset Advisors, as indicated in this table.
16 1.46%
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