The challenge: Lowering retirement plan costs
A not-for-profit organization sponsored a traditional defined benefit plan for its employees. The organization wanted to continue offering competitive retirement benefits but was concerned about the plan's contribution amounts, which were both volatile and steadily rising. The organization did not want to change benefits for current employees. Based on the results of a multi-year cost projection prepared by Milliman, the plan sponsor considered closing the defined benefit plan to new entrants. The retirement committee asked Milliman for recommendations of plan design alternatives that would allow the employer to continue to offer meaningful retirement benefits to new entrants but at a lower and more predictable cost.
The Milliman strategy: Controlling volatility through a cash balance design
Milliman consultants started by analyzing the specific sources of cost increases and volatility of the employer's current defined benefit plan. The plan was integrated (split-level benefit depending on pay relative to Social Security covered compensation) based on a five-year final average earnings formula. The plan used a total pay definition that could result in a pensionable pay amount that could swing considerably due to year-end bonuses. Milliman noted that the plan's final average pay design along with senior-level participants with long service contributed to volatility and rises in plan costs. The Milliman team proposed account-based design options that would provide career average benefits instead of final average benefits to directly address cost and volatility issues.
Milliman's plan design strategy involved two key decision points:
1. Three variations of a benefit formula applicable for new entrants
- Flat percentage of pay credit design – A simple formula that would be easy for participants to comprehend. The formula would offer the same benefit for all new entrants.
- Integrated design – A slightly more complicated design where a higher level of pay credits are provided for pay above the Social Security taxable wage base, but similar to the current defined benefit plan's formula. This formula could be used to provide higher accruals for higher-compensated employees.
- Age/service weighted design – This formula would be the most sophisticated of the three and would allow the organization to reward older and/or longer-serviced participants. This formula could also be used to most closely replicate the level of retirement benefits currently offered by the defined benefit plan to current participants.
2. The vehicle to provide benefits for new entrants
- Profit-sharing design – This design would require the plan sponsor to set up a new defined contribution plan. Investment risk would be shifted from the employer to the plan participant. Longevity risk would also be borne by the participant since the plan would not be required to offer annuity-type benefits upon retirement. A safe harbor formula could be constructed within this plan, eliminating the need for annual nondiscrimination testing. Investment earnings on a participant’s profit-sharing account would be based on the actual returns associated with an individual participant’s asset allocation. Participants would have the opportunity to invest their retirement assets aggressively or conservatively depending upon their appetite for risk.
- Cash balance design – This design could be incorporated within the organization’s current defined benefit plan. Investment risk would remain with the employer; participants would be credited with a risk-free rate of return. The participant would be also protected from longevity risk since the plan would provide annuity options at retirement. The plan would be required to perform annual nondiscrimination testing under this design given the different benefit structures offered to current and new participants. However, this plan design would offer an additional cost savings opportunity when compared to the profit-sharing design. Interest credited to the cash balance accounts could be based on U.S. Treasury yields, and plan assets could be invested in conservative investment vehicles that would allow for returns above Treasuries with less investment volatility, thus minimizing the investment risk to the employer. Another volatile unknown that could be controlled with this design is the annual pay credit for each participant. The use of a design that credits the hypothetical accounts of plan participants at a single percent of pay, or one that varies the percent of pay within the constraints imposed to avoid discriminating in favor of highly compensated participants may be utilized. The combination of the proposed interest crediting rate and pay credit would not increase the cost to the plan sponsor as participants approach retirement and the sponsor’s cost would be more predictable from one year to the next.
After further discussion with the plan sponsor, Milliman recommended the cash balance design with flat percentage of pay credits for new entrants. With an account-based design where each year's benefit accrual is based on a participant's pay in that year, the employer could avoid the cost-leveraging effects of funding additional layers of benefits due to prior service accumulation each year. Although this design change would generally lower benefits for new entrants compared to participants in the current plan, it would allow the plan to remain competitive and reduce contribution and cost volatility.
The outcome: Redesigned plan offers more predictable contributions
The plan sponsor agreed with the Milliman strategy of providing an account-based design for new entrants. It also favored the flat percentage of pay credits formula via a cash balance plan given its simplicity and cost savings opportunity. The client felt that this design gave it the best alternative for future savings and still provided its employees with meaningful benefits and retirement options. The plan redesign would make plan contribution requirements more predictable and stable for new entrants, and it equipped the employer with the cost-control measure it was looking for, thereby allowing it to provide ongoing retirement benefits through a single plan.