Case study: Plan redesign meets not-for-profit organization's goals for an affordable alternative to its traditional defined benefit plan

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By Marcella Giorgou | 27 May 2011

The challenge:

Increasing plan costs in recent years, coupled with significant asset losses in 2008 and 2009, led the not-for-profit organization (Organization) to reevaluate its traditional defined benefit plan (Plan).

The Plan was a multiple employer plan made up of 40 employers (some with less than 100 participants in the plan). As part of a multiple employer plan, the Organization and its affiliated agencies contributed to the Plan, which benefits their union and nonunion employees. These agencies were experiencing an increasing financial burden due to required contributions that were reaching historical levels of 8% of payroll or more due to the significant asset losses in 2008 and 2009.

The Organization's goals for the Plan redesign included:

  • Reducing costs
  • Avoiding large swings in the Plan's funded status
  • Limiting any negative effects on older longer-serviced participants

The solution:

Milliman prepared a plan design study to be presented to the board of trustees, which included:

  • Utilizing FutureCost, a deterministic asset-liability modeling tool to project pension plan financials (e.g. contribution requirements, funded status, expense, etc…).
  • A comparison of the different types of plan designs.
  • A comparison of benefits under the current and proposed plans for a set of hypothetical participants.

The Organization understood that in order to meet its goals, an alternative plan design for new entrants coupled with a reduction in future benefit accruals for current plan participants was necessary.

Based on the Organization's goals, Milliman identified two alternative plan designs for new entrants:

  • Profit sharing plan (defined contribution plan)
  • Cash balance plan

If structured the same way, a profit sharing and cash balance plan design can offer similar retirement benefits to the plan participant. However, each plan type holds different risks for the employee, including investment risk. Because contributions are invested by the plan participant in a profit sharing plan, the employee would bear the investment risk. Because a cash balance plan is a defined benefit plan in which the plan sponsor makes contributions and allocates assets, the plan sponsor would bear the investment risk.

In the case of the cash balance design, the Organization would be able to limit investment risk by employing an asset-liability matching strategy that would invest in assets matched to the corporate bond yield curve used to value plan liabilities under the Pension Protection Act of 2006. Because the cash balance plan would be structured to earn an interest credit based on lower risk US treasury securities, the Organization's assets could earn a spread above the interest crediting rate, reducing costs for the plan sponsor, as well as avoiding large changes in funded status.

In order to fully meet the Organization's goal of cutting costs, a 10% reduction in benefits under the current plan was also necessary. Although the cash balance plan design would allow for lower costs to the Organization for any new entrants, the Plan still had a large unfunded liability for current participants. A reduction in future benefit accruals would allow the Organization to allocate its funding policy contributions towards paying off the Plan's unfunded liability quicker.

However, reductions in future benefit accruals would burden older longer-serviced participants that the Organization wanted to protect. Therefore, Milliman proposed the Organization protect participants' benefits so that they were no less than benefits based on (1) service accrued to the date of the plan change and (2) compensation at termination. This would limit the full impact of the reduction in benefits for older longer-serviced participants for the first few years after the plan change, since the benefit still allowed for future pay increases.

Many active participants were subject to the protected benefit and therefore, earned only a pay-related accrual for the year. Their reduced benefit, based on service and compensation accrued to date, was less than their protected benefit. This benefit change also had the added advantage of reducing plan contribution requirements in the year of the plan amendment due to a reduction in benefit accruals.

The outcome:

In keeping with its goals for the plan design study, the Organization opted for a cash balance design for new entrants and decided to reduce current benefits by 10% for current participants, subject to the protected benefit formula discussed above. These changes will reduce future cost. Volatility can be reduced if the Organization employs asset-liability matching to protect the funded status of the plan.