Over the years, the retirement plan industry has introduced new features for defined contribution (DC) plans to mimic the advantages participants received from defined benefit (DB) plans. It seems that although DB plan sponsors have been eliminating or offloading their obligations, the industry has recognized the benefits of a plan design in which employees automatically participate and receive guaranteed payments for life.
Richard Hudson, a consulting actuary with First Actuarial Consulting Inc. (FACT), says the real problems for DB plan sponsors, and the reasons many are offloading their plans, are risk and unknown costs. “If DB plan sponsors knew consistently what their costs would be, they would be more inclined to stick with it,” he says.
Hudson explains that with a traditional DB plan, an employer might decide to target a replacement of 60% of employees’ income. An actuary would figure out the benefit formula to get to that target and calculate the cost to the employer at, for example, 6% of payroll. That might have been the cost when the employer started the plan, but as interest rates have been falling, the cost of providing that benefit has increased. It now could be 15% of pay, Hudson says. “Instead of changing the benefit formula, the escalating cost moves them instead to eliminate the plan altogether,” he says.
Syed Nishat, a partner at Wall Street Alliance Group, says the main concern for DB plan sponsors is risk; their costs are sensitive to interest rates. “If interest rates go up, it helps funded status and the plan sponsor doesn’t have to put in more money. If rates go down, liabilities and funded status deficit decrease, and the plan sponsor may have to come up with more money,” he explains. “For plan sponsors, it is difficult to predict what rates will do.”
Nishat says this is one of the reasons many plan sponsors got rid of their plans. Another reason is the huge expense of Pension Benefit Guaranty Corporation (PBGC) premiums.
Nonetheless, DB plans offer important benefits to employees.
“Data shows people are worried about being able to retire and they want to know they won’t outlive their savings. There’s comfort in being paid forever no matter how long you live,” John Lowell, an actuary and partner with October Three Consulting, says. “More people are saying they need guaranteed lifetime income in order to feel comfortable about retirement. Their DC plan balances may be big, but looking at the rates of returns they can get—1% on a good day in a money market fund—those balances are limited in what income they can provide.”
Nontraditional DB Plan Designs
Hudson sees some plan sponsors starting new DB plans. He notes that he helped one client move from putting contributions into a DC plan to offering a DB plan. The client kept the DC plan open for employee deferrals.
He says most plan sponsors that are taking this approach are interested in new DB plan designs that seek to eliminate the problems with traditional pensions. He explains that the traditional final pay plans have a lot of variability and volatility, as they are sensitive to plan liabilities. “If employers are looking for stability, traditional plans are not the answer,” he says.
According to Hudson, a new DB plan design gaining traction among plan sponsors is a variable/adjustable plan. With this plan design, the employer decides what it can afford to put into the plan and the actuary calculates the level of benefits this can provide. For example, an employer cost of 6% of pay might provide a benefit level of 1% of pay.
The advantage to the variable/adjustable plan is that when interest rates and mortality tables change, the benefit accrual changes, not the employer contribution. “So, next year, if interest rates move, with 6% of pay, the plan may only provide a benefit of 0.9% of pay, for example,” Hudson explains. “With this plan design, employers have cost security and participants get retirement security with lifetime income. The plan sponsor pays out benefits via an annuity.”
Hudson notes that actuarial costs are about the same as with a traditional DB plan, but computer models allow for actuarial calculations to be done much more quickly than before. However, variable/adjustable plans can cut plan sponsors’ PBGC premium expenses. “Variable plans usually target being slightly overfunded, 110% or so. The ones I’ve worked on have never paid a variable rate premium [VRP],” he says.
Cash balance plans have become more popular since the passage of the Pension Protection Act of 2006 (PPA). “Now, about 30% to 40% of DB plans are cash balance plans,” Nishat says. Cash balance plans are easier for employees to understand and appreciate because they look like a DC plan in that they receive a statement of their account balance each year, he explains.
With a cash balance plan, the balances participants see on their statements are guaranteed benefits. The account balance is the accumulated value of employer contribution credits (defined in the plan as a percentage of pay or a flat amount) and a guaranteed investment return, or interest crediting rate. When they retire or leave their job, participants can take their balance as a lump sum or choose to annuitize it. “Although sponsors of cash balance plans have to offer employees the opportunity to take their benefit in the form of an annuity, usually benefits are paid as a lump sum, which mitigates mortality risk,” Hudson notes.
“Because the participants’ account balances are not subject to the interest rate fluctuations, a cash balance plan is easier to manage from a fiduciary point of view when compared to a traditional DB plan,” Nishat says.
He adds that participants in a cash balance plan can accumulate nearly double the benefits they would in a 401(k).
One reason an employer would want to offer a cash balance plan is that it is easier to manage the funding. If the plan sponsor wants to decrease or increase its contribution, it can change the plan’s contribution formula, Nishat says. Changing the contribution in a traditional DB plan is much more complicated since it depends on the legislated actuarial assumptions to determine plan liabilities. Cash balance plans can be amended before employees accrue 1,000 hours—typically by May of that year—so the plan sponsor contributes less, Nishat says. He notes that changes must be communicated to participants.
There is also more flexibility for employers if they want to control their costs. When designing the plan, highly compensated employees or certain job classifications (e.g., nurse practitioners, physician assistants, etc.) can be excluded if the plan sponsor thinks the contributions for them would be too high, Nishat says. He notes that these exclusions need to be stated in the plan document.
The Setting Every Community Up for Retirement Enhancement (SECURE) Act also made it easier for employers to adopt a cash balance plan, Nishat notes. Previously, employers had to adopt one and fund it by the end of December. “This caused great concern because employers didn’t know how their businesses would fare in the following year,” he says. “Now, employers can decide whether to adopt a cash balance plan and fund it by their tax filing deadline. This is better because they know their business’ budget for the current year.”
Plan sponsors can mitigate cost volatility in cash balance plans by using certain interest crediting rates. However, Hudson says approximately two-thirds use an interest crediting rate tied to the Treasury rate, which makes it more difficult to provide a reasonable benefit due to today’s low interest rate environment. Hudson suggests that plan sponsors combine the concept of a cash balance plan with a variable plan to adjust each year the amount of pay credit it gives participants. “If plan investments don’t earn enough to cover the interest credit, the plan sponsor would lower the pay credit so the amount of funding it has to put into the plan remains solid,” he explains.
Lowell says if plan sponsors have a market-return cash balance plan, or, to a lesser extent, a variable annuity plan, they can create a scenario where they can use investments to create a liability hedge and see very little volatility. “Whatever the contribution and interest credit formula is, that is your cost, plus you’ll have administrative costs,” Lowell says.
Employees are attracted to retirement plan designs that include the ability to get guaranteed lifetime income, Lowell says. “Plans in which employees are paying fair prices for guaranteed lifetime income rather than going into the market and purchasing an annuity are going to be from employers of choice,” he says.
Lowell acknowledges that it’s hard to go against the grain. “It’s hard for a CFO [chief financial officer] or human resources [HR] officer to say, ‘We’re going to be different,’ and I think that’s what stopping things right now,” he says.
Benefits of Offering a DB Plan for Employers
Hudson says a problem with offering employees a DC plan rather than a DB plan is that participants may defer retirement if they are not comfortable retiring with a plan that doesn’t offer lifetime income.
“An aging workforce precludes a company from the natural movement of employees through the ranks, and employers may see increased medical and disability costs,” he says. “When deciding to move from a DB plan to a DC plan, sponsors typically only look at costs and not the whole effect on their workforce.” Hudson says a DB plan is valuable because it provides a subsidy to Social Security so employees will have guaranteed income for life.
Lowell says now that the majority of employers offer DC plans, they’re missing out on the ability to create a retention mechanism. “Going back 30 years, a company offered a pension and its design would incentivize employees to stick around. If they stay until age 55, for example, they got better benefits,” he says. “With a 401(k), there’s nothing to keep people around. It’s both a beauty and a curse they are portable, and because many employers want a safe harbor plan design, employees are vested immediately.”
There are also no longer features in DC plans to help organizations differentiate themselves, Lowell contends. “If someone is looking for a job and gets multiple offers, they may ask whether there’s a 401(k) plan and some might even know enough to ask whether there is a match, but they almost never ask how good the match is,” he says. “I think if an employer can tell a candidate, ‘We have a retirement plan that gives you guaranteed lifetime income,’ that has a huge amount of pizzazz right now.”