In the best of times, sponsors of defined benefit (DB) plans enjoy what is essentially a free ride in terms of funding their pension plans. That was the case from 1982 through 1999 when strong stock market returns made it virtually cost-free to provide retirement benefits. With the volatility of the economy in the last decade, pension plans again require funding and have experienced similar volatility. DB plan sponsors are asking what their options are to stabilize pension costs and expenses.
Demise of DB plans is exaggerated
As a result, many organizations have considered alternatives to providing retirement benefits through a defined benefit pension plan. It is believed that many plan sponsors have frozen their DB plans and switched to defined contribution (DC) plans as their primary retirement benefits. Significantly, this trend is not as widespread as popularly believed. Among Fortune 1000 companies, there were 417 active DB plans and 190 frozen ones in 2009. In 2010, those numbers changed only slightly—to 378 active plans and 208 frozen ones. Most of the decrease in defined benefit pension plans has come from small plan sponsors whose economies of scale are not as significant (e.g., small doctor offices or sole proprietor plans).
In addition, the trend toward freezing DB plans is much less prevalent in the public sector than it is in private industry. In the private sector, 22% of participants are in frozen plans, compared with only 9% in government employer programs. And even within the private sector, only 11% of union workers participate in frozen plans, compared with 28% of non-union workers.
Alternatives to pension freeze
Significantly, the DB market has evolved in the past few years to create new DB strategies and modify existing ones in ways that make them compelling alternatives for many organizations. For example, Bureau of Labor Statistics data show that after freezing existing DB plans, 11% of private companies turn around and create a new DB plan. This isn’t as mysterious as it sounds. In most cases, these are new cash balance plans, which grew in number from just over 1,000 nationwide in 2001, to nearly 5,000 by 2007. In the remainder of this paper, we will focus on the rationale for cash balance plans—as well as five other strategies that employers are considering if they currently offer DB plans. The six strategies are:
- Liability-driven investing
- Funding relief
- Modifications to current DB plan
- DC conversion
- Cash balance plan
- Cash balance plan plus DC
We’ll examine each approach in terms of out-of-pocket costs to the plan sponsor and the expected volatility of those costs. At the end of this survey, we’ll offer some general guidelines on how employers can tackle the decision of which strategy or strategies to incorporate in their programs.
Liability-driven investing (LDI) represents a shift of strategic focus for sponsors of DB plans who had previously depended on the equity portions of their portfolios to drive the funding of their pension plans. LDI strategies do not focus on total asset return. Instead, they seek to generate a return at or above the market-based growth of the liabilities, thus controlling the volatility of pension expense.
Although LDI represents a major change on the policy level, it is actually relatively simple to implement. At opportune times, the plan sponsor changes the asset allocation to reduce exposure to the volatile assets in the portfolio, investing instead in assets that act like the liabilities. Typically these are corporate bonds with a duration that matches that of the index used to value the liabilities.
Switching to LDI has minimal impact on participants, and requires the same amount of the plan sponsor’s time as any change of managers would entail. LDI will significantly reduce the volatility of funding the plan. But the cost may be high, assuming there is an opportunity cost from foregone equity returns. (In down markets, LDI represents a cost savings as well.)
On June 24, 2010, Congress passed the Preservation of Access to Care for Medicare Beneficiaries and Pension Relief Act. This legislation was in response to the financial crisis, designed to give plan sponsors some extra breathing room to fund their pension obligations. Plans that choose to adopt this strategy are allowed extra time to amortize big losses they were exposed to during any two plan years between 2008 and 2011. Relief is still available for the 2011 plan year.
Currently, the Pension Protection Act requires that any gain or loss be amortized over seven years. Under the provisions of the Pension Relief Act passed last year, plans have two options to extend the amortization period. They can choose a nine-year schedule, where the first two years are interest-only; both interest and principle must be accounted for in Years 3 through 9. The second option allows a 15-year amortization period without triggering the benefit restrictions that normally apply.
Plans that employ either of these funding relief strategies would be subject to a matching contributions requirement for any employee’s compensation in excess of $1 million; the same rule applies to any extraordinary dividends or redemptions. The benefit of these strategies is the potential to reduce costs. By spreading the plan’s cash requirements over more years, there is potentially more time for market returns to make up for recently experienced losses. However, in terms of volatility, the pension plan’s position would probably remain the same.
Modifications to current DB plan
Every employer has its own particular philosophy about benefits. The traditional defined benefit plan provides a great incentive to attract and retain long-term employees. In today’s environment, many employers choose to retain the traditional DB plan, but modify the plan design to control costs. One option is to reduce the existing benefit formula. For example, instead of providing 1.5% of final average pay, the sponsor could reduce its obligation to 1%—applied either to all employees or to future hires only. Alternatively, the sponsor could adopt a different, less costly funding formula such as a career average benefit formula or similar types of formulas.
Other options include the reduction of ancillary benefits, such as disability benefits or early retirement subsidies. Such reductions are clearly takeaways relative to the status quo. Nonetheless they would still allow the plan sponsor to provide a larger benefit to employees when they retire and a richer benefit than a DC plan—at a lower cost than a typical DC plan.
Freezing the DB plan and replacing it with a DC plan is the first option that many employers think about when looking to reduce pension expense and volatility. Of course, the cost of the DC plan will vary depending on plan design. The employer can elect to contribute a flat percentage of pay—with or without a match for participant contributions. Or the employer contribution can be tiered, based on age, service, or points, which is a combination of age and service.
In a DC conversion, the volatility of contributions will clearly decrease, as all of the market risk is transferred to participants. The employer experiences a small amount of volatility related to fluctuations in payroll and the number and amount of employee contributions that need to be matched each year.
However, the cost savings may be ephemeral, at least over the short term. Even a frozen DB plan must be funded in order to pay for benefits for employees who are still owed a pension at retirement.
While a DC plan can reduce the cost to the plan sponsor, the cost savings comes at the expense of the employees. A much reduced retirement benefit is usually provided when plan sponsors switch to a DC plan. A point also worth noting is that providing a similar level of retirement benefit through a DC plan actually costs the plan sponsor more money, which is mostly due to the loss of economies of scale and the loss of positive investment experience.
Cash balance plans
Cash balance plans are often referred to as “hybrid plans” because they provide participants with the feel of a DC plan even though they are, in fact, DB plans. The plan sponsor remains responsible for investing assets and paying a benefit upon retirement. But the formula is based on a set contribution rate for current employees, plus a fixed rate of return, which is always positive—no matter what the market returns.
The cash balance plan can be a good deal for employees, who get a guaranteed rate of return without having to shoulder as much market risk. Their statements read more like a savings passbook than an investment account, which means the benefit is easy to understand and appreciate. Cash balance plans also benefit employers, who can choose exactly how much risk they want to take. They can decide to employ an LDI strategy that matches the promised benefit with an investment of similar duration—typically corporate bonds. Or they can choose a more aggressive investment strategy that seeks returns in excess of the rate of return promised to employees.
To take an example, in a DC plan all of a promised 6% annual contribution would come from the organization’s operating account. With a cash balance plan, sponsors could enjoy a discount of 1% or more derived from the plan’s investment program exceeding the guaranteed rate of return. Most plans sponsors promise a conservative rate of return in cash balance plans. However, volatility is less than in a DC plan, because no investment returns are guaranteed. Figure 1 illustrates the cost comparison of a defined contribution plan with a cash balance pension plan.
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Given the assumptions listed, providing a 6% cash balance plan would cost the plan sponsor less than 5% of payroll. The 6% defined contribution plan would cost the plan sponsor 6% of payroll. This is a 17.8% savings to the plan sponsor over the working career of an employee hired at age 25.
Cash balance plan plus DC
The last option explored here is a cash balance plan supplemented by a DC plan. We can look at this as an alternative for an employer that was thinking about instituting a DC plan with an 8% annual contribution. Instead, the organization could contribute 4% of salary to a cash balance plan, plus 4% to a defined contribution plan. The advantage to employees is significant enhancement of retirement security through diversification.
As with the pure cash balance approach, the employee still receives a guaranteed return from the DB component of the program. This corresponds to the fixed income allocation in a diversified approach. The amount committed to the DC plan can then be invested more aggressively, including a significant percentage of equities with their higher expected return.
In many respects, this option represents the best of both worlds. Employees get a well-structured investment program that’s easily understood, provides employees with the opportunity to have control over their investments, and is portable. Similarly, employers have the opportunity to satisfy employees’ interest in earning high returns, yet still have the ability to pay for part of the benefit out of investment returns. Not surprisingly, the cost and volatility of this option lands right between those of the pure DC and cash balance options.
Choosing the right option
Two of the main concerns for plan sponsors are the potential volatility and cost of their defined benefit pension plans. Figure 2 illustrates how each of the six options detailed above may affect the volatility and cost of the pension plan. The actual extent of the cost savings or reduction in volatility will depend on the level of the changes made and the specifics of each plan.
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Which of these options is right for a particular organization’s retirement program? The decision-making process is best begun by systematically posing a series of questions. It also helps to have appropriate tools to collect the data—and expert guidance in evaluating it. Typical questions include:
- What are the key objectives for each group of employees covered by the retirement programs?
- How do the objectives for the benefits policy align with overall corporate objectives?
- What is the desired level of funding?
- What level of volatility is acceptable?
- How much flexibility is needed to make plan changes?
- Is a change in employee behavior sought as a result of plan changes? If so, how are responses to be measured?
- How will the plan work under different economic conditions, in terms of both investment performance and employee response?
Of course, the strategic questions about plan objectives can be answered by a policy review conducted by members of the retirement committee. The remaining topics require some degree of data collection and analysis. These don’t necessarily have to be complex. In many cases, questionnaires and surveys are helpful in quickly spotlighting key priorities.
Further insight can be gained by graphing survey results in a scatter diagram, similar to the one reproduced above. Instead of labeling the axes “cost” and “volatility,” we could use “employee reaction” and “competitiveness,” to get a better understanding of how effective each strategy would be in achieving growth and retention goals.
Another effective tool shows each participant on a plot with age as one axis and the DC contribution percentage needed to replace the existing DB benefit on the other. Other tools generate information such as the demographic impact of the plan changes, the effectiveness of different options in terms of employees’ income replacement ratios,1 cost projections, and Monte Carlo simulations of the probable outcomes of asset liability management (ALM) strategies.
To freeze or not to freeze
There’s no doubt that the past decade has been a difficult one for sponsors of traditional DB plans. Regardless of the market environment, it is simply prudent for plan sponsors to review the alternatives to see if a new approach would better serve the retirement needs of beneficiaries. However, prudent decision-making requires a thorough evaluation of trade-offs. Recent trends to terminate or freeze DB plans and replace them with a “3% DC solution” appear to be motivated solely by cost concerns.
Examining a full range of options based on objective criteria is a more thoughtful approach. Logically, a more thorough vetting process makes it more likely that the new solution will stand up over the long term, so the retirement committee will not find itself readdressing the same issues—and investing in big changes—every three to four years.
Controlling pension expense and volatility is a complex problem, so it’s important to identify a program that will adapt to market conditions and remain aligned with corporate objectives. When the economy eventually turns around, the new program needs to be attractive to employees and competitive as a retention tool for key personnel. That way, whether it’s the best of times or the worst of times, the organization can retain its focus on its core business.