Case study: Is it time to unfreeze your company’s defined benefit plan?

Once considered the gold standard for employee benefits, defined benefit (DB) plans offer employees the financial security of a guaranteed monthly income in retirement. Unlike 401(k) plans, the risks associated with investment and interest rate fluctuations in DB plans are borne by the employer. These risks, along with the cost of funding DB plans, have led to the decline of DB plans in the private sector.

From the year 2000 until recently, the low-interest-rate environment and market volatility, coupled with longer-than-average life spans, resulted in lower DB funding ratios and increased plan liabilities. To mitigate these financial consequences, many corporations froze their DB plans by closing them to new hires and stopping future benefit accruals for current plan participants. Some plan sponsors created an enhanced 401(k) plan. However, typically these plans fell short of the amount of money needed for a comfortable retirement nest egg as compared to a DB plan.

This was the case with a regional nonprofit dedicated to helping people with intellectual disabilities. The organization froze its DB plan in 2010 due to escalating pension costs, poor asset returns, and low interest rates.

Another factor was the Pension Protection Act of 2006 (PPA), effective for the plan year beginning in 2008. PPA is a federal law that holds companies accountable for underfunded pension plans over a relatively short time horizon as compared to the prior regulations (seven years), using the current low-interest-rate environment.

The decision to freeze the plan was extremely difficult for the nonprofit’s board of directors. The organization employs approximately 1,000 people, about 300 of whom work in the business office and 700 who work directly with the intellectually disabled, including people who need 24-hour supervision. The nonprofit’s team provides this care in an environment of rapidly growing need yet shrinking support due to state and federal budget cuts. Because of the organization’s own budget constraints, it was challenging to maintain the DB plan and also provide other benefits to employees, such as competitive health insurance. Many of the organization’s employees work there due to its mission statement of helping people with intellectual disabilities, sometimes forgoing competitive salaries to help others. The DB plan was intended to provide a valuable lifetime income to employees to help offset these lower wages.

After freezing its plan, the organization’s board was concerned about both employee retention and retirement security. The board intended to reopen the plan when the funded percentage improved and the shortfall between assets and liabilities decreased. In the meantime, employees only had the option to save for retirement in a non-ERISA 403(b) plan, a tax-advantaged retirement savings plan available to some nonprofit employers. This option offered employee deferrals only, with no employer match.

The path to reopening the DB plan

From 2011 through 2019, the low-interest-rate environment left the organization’s DB plan with a shortfall of approximately $5 million. The board’s objective was to close this gap and achieve 100% funding as quickly as possible, and in consultation with Milliman it proposed to keep funding the plan based on the ongoing level (prior to the freeze date) to eliminate the shortfall as quickly as possible. This funding strategy enabled the plan to build up a prefunding amount that would eventually enable the board to consider reopening the plan.

Prefunding allows DB plan sponsors to contribute more than the minimum required each year, so that excess contributions can assist with funding future benefit accruals. The nonprofit implemented this strategy by continuing to fund the frozen DB plan based on its pre-2008 funding policy, which was 2.75% of pay for all employees annually. This strategy built up a large prefunding balance. Plan sponsors can use a prefunding balance to meet a plan’s funding obligations if the actual cash contributions are not sufficient to cover the actuarially determined cost, with some restrictions. This also reflected some years during which the organization made additional contributions, if possible, above the agreed-upon funded policy.

Eventually the prefunding strategy paid off. In mid-2021, the asset returns for that fiscal year left the plan with a funding surplus, even amid low interest rates. At that point, the organization’s CEO and CFO began discussion with the board to consider unfreezing the DB plan and created a retirement task force to explore their options.

Making the best retirement plan choice for employees

After carefully considering the volatility associated with defined contribution plans, the need for retirement security among the organization’s employees, and the lack of participants in its non-ERISA 403(b) plan, the nonprofit’s task force decided that all future accruals for active employees would be based on a hybrid retirement plan structure. Newer hybrid plan designs such as variable annuity plans and cash balance plans feature a more balanced cost-sharing relationship between the employee and the employer while allowing plans to maintain full funding moving forward. The task force also mandated that the organization meet its financial objectives based on the funding policy for the new cost of benefits.

With these objectives in mind, the task force worked with Milliman to evaluate two types of hybrid retirement plans:

• Cash balance pension plans are DB pension plans that offer the option of a lifetime annuity. They appear to look similar to a 401(k) arrangement. Plan participants receive an annual pay credit equal to a set percentage of their compensation plus interest, which may be tied to the employee’s length of service. The benefit and interest rate are determined based on the formulas in the plan document. The Pension Benefit Guaranty Corporation insures cash balance plans.
  With cash balance plans, the plan sponsor takes ownership of the portfolio’s profits and losses, and portfolio changes do not impact the benefits received by the plan participant. The benefit is typically paid out as a lump sum at termination of employment, although employees may choose a monthly annuity payment. Plan participants must be 100% vested in their benefits after completing three years of vesting service, which is an accelerated vesting schedule compared to traditional DB plans. A cash balance pension is portable, so employees can take the vested portion with them if they resign.
• Variable annuity pension plans are designed to provide plan participants with a lifelong income like a traditional pension while providing contribution stability in all market conditions and remaining fully funded by changing pension benefit amounts in response to the plan’s actual asset returns. For employers, a variable annuity plan offers stable, predictable contributions since asset performance does not cause underfunding. For participants, it provides steady retirement income regardless of longevity, along with expected protection for inflation.
  Milliman’s Sustainable Income Plan® (SIP) is a type of variable annuity pension plan that contains an innovative feature called a “stabilization reserve” which differentiates it from other variable annuity plans. It mitigates participants’ exposure to market risk and dramatically reduces the possibility of benefit declines. During years of high returns, plan assets exceeding a predetermined cap flow into the stabilization reserve, which is then used to shore up benefits in bear markets. Plan participants can rest assured that they will receive a lifelong income stream without any personal investment decisions and that they will not outlive their retirement income or be expected to watch it plummet during a financial downturn. Plan sponsors benefit from predictable contributions and a stable balance sheet.

The nonprofit’s task force worked with Milliman over several months to completely understand these options and how other clients, particularly similar nonprofits, made retirement plan decisions. At first, the task force was more in favor of the cash balance plan because it is relatively easy to understand, and they felt it would be straightforward to communicate the benefits and details of the plan’s structure to employees. However, after careful consideration, the task force chose the Milliman SIP plan, for the following reasons:

• SIP benefits can increase each year based on asset performance, offering inflation-protected benefits to retirees.
• Future accruals are designed to remain fully funded and therefore protect the plan sponsor, which was a pivotable point for this organization.
• Over time, as more legacy employees retire and new hires participate in the SIP, the plan is fully protected against all market conditions.

Expanding retirement benefits to all 1,000 employees

The nonprofit’s board was delighted to provide a valuable lifetime income benefit to its employees:

• About 350 employees were legacy active participants in the DB plan whose benefits were frozen. They will receive an A + B benefit, where A is their frozen legacy benefit and B is the new accruals under the Milliman SIP plan.
• The remaining 650 employees will start accruing benefits under the new Milliman SIP structure.

Through diligent planning and analysis, the nonprofit’s board was able to offer inclusive, generous retirement benefits to the entire organization, including new hires moving forward. Board members gain the satisfaction in knowing they have done their best to support their employees and acknowledge their contribution, while offering a differentiation that boosts morale and goes a long way toward improving employee engagement, satisfaction, and retention.

Why the time is right to consider unfreezing your DB plan

Due to regulatory and economic changes, the environment has come full circle to the point where unfreezing DB plans makes sense in many cases. Sharp rises in discount rates have led to funded status gains and pushed many plans into surplus funding territory. In addition, robust investment strategies that match pension assets with plan liabilities can be applied to preserve surplus funding levels. Finally, regulatory relief significantly reduced the minimum cash funding requirements of DB plans, provided future funding relief for plan sponsors, and extended interest rate smoothing provisions. These regulations make it much more likely for plans to meet minimum funding requirements to maintain their funded status or increase it to a surplus position—without taking risky investment positions.

Considerations for sponsors of frozen DB plans

There are several options to consider when it comes to pension plan changes. Organizations with frozen DB plans that are nearing full funding or are in a surplus position might begin investigating how to take advantage of today’s opportune economic conditions to unfreeze their plans and offer increased retirement benefits to their employees. Considerations include:

• The funded status of the DB plan: In some cases, the upswing in interest rates has significantly improved the funded status of DB plans and lowered DB plan liabilities to the point where it is prudent for senior management to start evaluating pension plan options.
• Competition around employee recruitment and retention: In today’s competitive labor market, offering an attractive pension plan might be a cost-neutral or cost-effective way to reduce turnover and differentiate the organization among quality candidates.
• The organization’s tax status: A detailed analysis will determine if changes to the pension plan would be advantageous to the company’s bottom line, even for nonprofits with unrestricted net assets that affect their balance sheet and loan covenants.

For additional examples of how companies have reopened their defined benefit plans, see the Milliman article Case studies: Considerations for unfreezing defined benefit plans to drive business value.