When you set up a defined benefit plan, you always have the ability to freeze it at some point in the future. Why would you want to do this and how does it work? We will address this in this post.
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Why would you freeze a plan?
The company has the option to voluntarily change plan provisions at any point. This is done by amending the plan. In some cases, the sponsor would like to improve benefits. In other situations, the company may want to reduce future benefits that are not yet earned.
It generally is not possible to reduce benefits that have been accrued due to the IRC anti-cutback rules. It is, however, well within the plan sponsor’s rights to decrease future accruals on a prospective basis.
For example, if your plan accrued a $5,000 pay credit for anyone who works over 1,000 in a given year you cannot in December of the year decide to freeze the plan in order to eliminate this accrual. Presumably, your employees have earned this benefit so you cannot take it away from them retroactively. But you could in December decide to freeze the plan for future years. It is possible to reduce future benefit accruals to zero as long as the employer gives notice to the participants ahead of time.
How do you freeze a defined benefit plan?
As stated previously, the freeze is completed by completing a plan amendment. Your third-party administrator can take care of this for you. This part is usually pretty simple.Are you looking to get over $100,000 into retirement? Get a FREE Illustration showing your contribution and tax savings today. See for yourself why our plans are one of the best tax deferrals!
What is the difference between a hard freeze and a soft freeze?
The first step is deciding what type of freeze you would like. There are two types of freezes: a hard freeze or a soft freeze.
A hard freeze is when the employer freezes the accrued benefit as of a certain date. The benefits accrued up until that date are finalized based on salary and service history to date using the benefit formula on the day of the freeze.
After that date, no further accruals occur. Even if a participant works for the employer for many more years and receives regular salary increases, it will not change the benefit payable to the participant beyond the date the plan was frozen.
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Usually, when a plan is frozen in this manner, no new participants are allowed to enter the plan as of the date of the freeze. If no new participants are allowed to enter the plan, new hires do not need any information about the plan.
A soft freeze occurs when a certain aspect of the plan is frozen. For example, participation might be frozen, but benefits for the currently active participants continue to accrue going forward. In this manner, liabilities are limited to the current group. After a certain date, no new participants can join the plan, and eventually, there is no one left in the plan. This is referred to as a closed group.
Another type of soft freeze occurs when pay or service is frozen (but not both). (A hard freeze occurs if both pay and service are frozen, resulting in a frozen benefit.) The plan sponsor can freeze pay and allow service to continue. In this manner, benefit determinations are made up of salary history to the date of freeze while using all service to exit date. Alternatively, the plan sponsor could freeze service and let pay continue. In this case, no additional years of benefit service are credited in the benefit calculation. Still, historical pay is used through termination of employment, which gives the participant a form of wage inflation adjustment.
A freeze acts to limit the employer’s ultimate liability and reduce the cost of employee benefits. The most extreme case is a hard freeze. Soft freezes can be any one of three basic styles: frozen pay, frozen service or frozen participation.