Our client, a small insurance company with a final average pay defined benefit (DB) plan, changed their retirement program in 2000 to a cash balance formula for newly hired employees. Fast forward to 2016: company leadership has now seen employees retire without significant retirement income under the cash balance benefit. The company-sponsored defined contribution (DC) plan provides additional retirement income, but does not offer adequate monthly benefits at retirement to properly supplement monthly income.
In addition, the company is concerned that the retirement options available do not provide sufficient flexibility for retirement income. The plan allows lifetime annuity options or a lump sum option. This “all or nothing” approach does not provide longevity protection for those who choose a lump sum nor does it allow those who choose a monthly payment to reduce debt or leave money in their estate to divide among multiple heirs if they choose.
The client was concerned about the smaller level of benefits provided by the cash balance formula than the original final average pay formula, and they thought it could be affecting employee morale to have the two groups with significantly different levels of retirement benefits. To address this concern, we reviewed several design options to improve the cash balance formula for future and past service to increase income for those with this formula. We compared replacement ratios to the final average pay formula as well as the improvement in replacement ratio for each of the proposed designs. We determined the impact on the employer’s ERISA funding requirements and accounting results. The company has historically contributed to the DB plan in excess of minimum required contributions, resulting in a well-funded plan. Because the plan is 160% funded on an ERISA basis, the minimum required contribution is zero and continues to be under the all design options proposed. Similarly, the plan is well over 100% funded on the PBGC variable rate premium basis, so they only pay the per-participant fixed PBGC premiums. Therefore, they are able to make benefit improvements without incurring increases in PBGC premiums or minimum required contributions.
The well-funded status of the plan allows them to provide higher benefits without incurring costs in the short term, and is a reason to make improvements in the DB plan rather than provide higher DC contribution to the cash balance group, which would have had an immediate cash cost as well as complicate the testing for the DC plan. The DC plan is a profit sharing plan for which they determine a discretionary contribution each year based on the company’s performance. The combination of the defined benefit that provides a target replacement and the DC, which supplements it, gives the company flexibility in the cash they contribute to the retirement program. For the employees, having both plans gives them a sufficient guaranteed benefit from the defined benefit plan plus an additional benefit based on the shared enterprise of the company’s success.
We also suggested they consider allowing employees to roll their DC accounts into the defined benefit plan in order to increase total retirement income and provide longevity protection. Participants who want monthly income could avoid having to purchase an annuity on the individual market and obtain longevity protection at below insurance market cost. The potential increase in longevity and volatility risk in the DB plan was not a concern for the plan sponsor due to the well-funded status of the plan and the long-term investment strategy of the plan assets.
In addition, we proposed adding a new optional form that would allow participants to take part of their retirement benefit as a lump sum and part as a monthly benefit. This option would allow an employee to use the partial lump sum to pay off debt, such as a mortgage, and still have the insurance of a guaranteed lifetime income, or it would allow them to roll over the partial lump sum to an IRA and receive a monthly payment to cover current expenses.
To address the sufficiency of the post-2000 DB plan, the company chose to increase the cash balance formula from 4.25% to 6% of pay for the first five years, and from 6% to 8% of pay for the next five years. The pay credits after 10 years were kept the same at 8% of pay. This increase applied retroactively and resulted in, on average, 30%, increase to the current cash balance benefits. In terms of dollars, the increases in balances ranged from $1,300 to $25,675, with an average increase of $9,370. The projected balances at Normal Retirement Date increase 11%.
In addition, to improve income for those who choose to take monthly benefits, they are allowing rollovers from the DC plan. A 65-year-old participant with a DC balance of $50,000 can increase the annuity benefit by roughly $300 per month by rolling the balance into the DB plan.
To allow more flexibility in retirement planning, they added an option to bifurcate the benefit and allow the following combinations of lump sums and annuities at retirement:
- 25% lump sum and 75% monthly payment
- 50% lump sum and 50% monthly payment
- 75% lump sum and 25% monthly payment
To mitigate the administrative costs (including PBGC premiums) of small monthly benefits, the plan does not allow for this option if the present value of a resulting annuity payment is less than $25,000.
This will allow significant flexibility with their retirement income planning. Spousal protection of qualified joint and survivor options continues to be offered, and PBGC guarantee protection continues to cover the monthly payments, but the employee can choose the combination based on their unique circumstances.
We provided a communication announcement for the company to distribute with the 2017 benefit statements that describes all the plan changes. In addition, for the cash balance participants, we provided two statements for the company so individuals could compare their current and projected balances before and after the plan change to see the impact on their own benefits. According to the company, the cash balance improvements generated positive reactions (“discussions around the water cooler”). Participants close to retirement age are interested in the partial annuity options, with a participant who plans to retire at the end of this year already indicating he plans to elect the 50% lump sum and 50% annuity option. In addition, they plan to have a Milliman consultant present at employee meetings to promote these changes as well as to increase employee understanding and appreciation of the benefit program.
The plan sponsor is happy to have achieved their goal of improving the amount of retirement benefits they are providing to their employees as well as giving them the ability to receive income in retirement on a flexible basis for their own individual needs.