Case study: Milliman gives federally funded DB plan options for the future

Milliman's client had a crisis with its pension plan.

This nonprofit organization was unusual, in that its defined benefit pension plan was funded by the federal Medicare program. The plan provided a modest formula of 1% of final earnings, multiplied by credited service.

Funding was fixed several years ago at a very low percentage of total compensation. The amount was sufficient to cover the cost for the annual accrual; until recently, the assets and liabilities were approximately equal.

Then the recession hit, and in 2008 the plan lost around 28% of its assets.

Taking into account the new requirements under the Pension Protection Act of 2006 (PPA), Milliman came up with a preliminary ten-year funding projection: the plan sponsor was required to make up the asset losses over a seven-year period.

Projections showed that the fixed contribution amount would not be sufficient to cover both the benefits accruing during the year (the Target Normal Cost) and the shortfall amount. For 2009, the IRS provided some flexibility in selecting the interest rate to use for funding purposes. Therefore, the organization probably could meet its funding obligation for the 2009 and 2010 plan years by using a substantial portion of the existing carryover balance. However, for the 2011-2016 plan years, the plan sponsor would very likely be required to make contributions over and above the fixed contribution amount.

The client explained these projections to the relevant federal agency, and asked for added contributions to make up the 2008 asset loss. The agency answered that no additional funds were allocated for this case. The nonprofit organization would have to find another way to meet its estimated future funding requirements.

Unfortunately, the organization was unusual in another way: unlike many other nonprofits, it had no endowments or other sources of income to get the extra cash needed to fund this plan.

The client asked Milliman to explore different ways for the organization to mitigate the large projected contribution increase. Milliman analyzed the following plan design alternatives, including 10-year funding projections under each scenario.

Alternative Plan Design I (Freeze Scenario)

In this scenario, the plan would be temporarily frozen for several years. Doing so would eliminate the Target Normal Cost each year; however, the organization would still contribute the fixed contribution amount. These actions, coupled with positive investment returns, would allow the client to make up the shortfall before the seven-year period. The goal of the organization, under this approach, was to restart the benefits that stopped accruing once the plan was fully funded.

The client also explored the possibility of creating an enhanced 403(b) plan, with a minimal company contribution amount, while the plan was frozen. They would decide this amount at the end of the year, when Milliman determined the contribution requirement for the current plan year.

The Freeze Scenario concerned the Pension Committee. What would it do to employee morale? Participants would not receive any pension accruals for several years, so employees were likely to worry that once the plan was frozen, the organization would not restart the accruals after the plan made up the 2008 investment losses.

Alternative Plan Design II (Career Average Plan)

Milliman designed a plan that would provide a minimal accrual under a Career Average Formula. This way, the organization would have the flexibility to increase the Career Average Percentage when the plan became fully funded. Although this approach would take longer than Design I (the Freeze Scenario) to make up the 2008 investment losses, it would ease employee’s concerns.

Milliman presented the alternatives to the full Board of Trustees (which was ultimately responsible for making all decisions with regard to the pension plan), along with exhibits, graphs, and sensitivity analysis. Milliman's experts explained that, with the flexibility provided by the IRS for the 2009 plan year, the initial deficit was unlikely to occur before the 2011 plan year.

The organization's decision

Armed with this information, the board chose the Career Average Plan, to take effect January 1, 2010. Milliman will help with the communications, employee meetings, and individual participant statements to educate the active participants in the plan.