Providing adequate retirement income for employees through cash balance plans

Challenge

A regional financial services employer recently approached Milliman to help redesign their retirement program. They felt that their current retirement program did not provide adequate retirement income for the majority of their employees, and they wanted to design a retirement program that would better meet their future needs.

Working with Milliman, five specific participant-centric goals were developed:

• Provide broad coverage
• Offer meaningful benefits
• Attract and retain talented employees
• Be innovative
• Differentiate the employer from their peers

There were also several business considerations. To the extent possible, the new retirement program should:

• Be cost and expense neutral
• Be competitive and cost effective
• Manage benefit volatility and investment risk

The employer was willing to consider all options, including those that ran counter to current trends, provided that the redesigned retirement program met their primary objectives.

Solution

Assessing the current retirement program

The employer had a long history of offering retirement benefits to their employees. Initially, their retirement program offered benefits only through a defined benefit (DB) plan. However, like most other employers, they added a 401(k) plan in the mid-1980s. This approach of offering two qualified retirement plans, a DB plan with guaranteed benefits and a 401(k) plan with a combination of employee deferrals and employer matching contributions, worked well for a number of years. But in the mid-2000s, they (like many DB plan sponsors) became concerned about volatility and excessive risk, and reassessed their retirement program. As a result, at the end of 2007, they decided to close the DB plan to new participants.

Recently, coverage in the DB plan had dropped to just under 40% of their active employees. While the 401(k) plan had a high participation rate (92%), employee deferrals were lower than the amount required to receive the full employer matching contribution (6.0% deferral required to receive 4.5% employer matching contribution) and the average 401(k) participant (age 44) had accumulated an account balance of only $54,000.

In order to assess the adequacy of the current retirement program in meeting their goals, Milliman looked at each employee’s replacement ratio (RR). A RR is a person’s gross income after retirement divided by gross pre-retirement income. Historically, a 70% to 80% target RR (including Social Security) is cited as the minimum required RR for an individual to maintain his or her standard of living in retirement.

The average RR under the current retirement program was projected to be approximately 38% (24% from the DB plan and 14% from the 401(k) plan).

Shortfalls of current retirement program

Based on our initial assessment, the current retirement program fell short of meeting employer goals. While the DB plan offered a guaranteed retirement income for some employees, it did not offer broad coverage. Alternatively, the 401(k) plan offered broad coverage for those choosing to participate, but did not provide meaningful benefits due to low deferral rates. The current bifurcated retirement program also did not differentiate the employer from other financial service employers, which were offering similar programs. The current program was not meeting the needs of current employees, and it failed to provide an incentive that could be used to attract and retain talented employees.

Outcome

Redesigned retirement program

After reviewing a broad range of alternative plan designs, the employer decided that a cash balance plan would best meet their objectives and offer the best opportunity for attracting and retaining key employees. The new unconditional fixed cash balance benefit would replace the conditional matching contribution offered under the 401(k) plan. Under the redesigned program, the average projected RR increased to 55% from 38%.

Employees hired after 2007

Under the redesigned retirement program, all employees hired after 2007 are eligible to participate in the new cash balance plan. Instead of a matching employer contribution to the 401(k) plan (maximum 4.5%), all employees in this group will now receive an annual 5% pay credit to their cash balance account, which will grow with a guaranteed annual interest credit of 4%. Even though the 401(k) employer matching contribution was eliminated, employees will be encouraged to continue to defer into the 401(k) plan.

Employees hired before 2007

Current DB participants (hired prior to 2007) will retain the traditional DB plan; however, future benefit accruals will be at a higher accrual rate.

By eliminating the 401(k) match and establishing the new cash balance plan, the employer has:

• Broadened coverage-100% of employees are now covered by the retirement program
• Provided meaningful benefits–The new retirement program provides a guaranteed benefit for all employees
• Made their retirement plan competitive and cost effective–The redesigned program is cost neutral
• Become an innovator and a differentiator–The new retirement program offers a retirement benefit that is generally not offered by other financial institutions
• Eliminated participant investment risk and benefit volatility for a portion of their retirement income

John B. Wukitsch, ASA, EA, MAAA, is a principal and consulting actuary with Milliman’s Albany office. Contact him at [email protected].

Neil A. Hagin, EA, MAAA, is a consulting actuary with Milliman’s Albany office. Contact him at [email protected].