The administrative impact of changing to a variable annuity formula

Plan overview

Over the last five years, Milliman has worked closely with a pension administration client to transition its 30,000-participant defined benefit (DB) plan to a novel solution that continued to offer ongoing benefit accruals to participants, while maintaining cost-efficiency and contribution stability.

The plan, established in 1987, offers a cash balance formula as its primary benefit. When the client chose Milliman, it wanted to modify the cash balance formula to achieve both plan health and cost-efficiency. During a subsequent consulting session, it was determined that the plan’s goals could be better met by moving to a variable annuity benefit formula. As a result, Milliman worked with the client over the last two years to create a pension administration software solution to efficiently calculate and integrate the new benefit with the existing cash balance formula. The solution will administer the required annual adjustments to the variable annuity benefits and effectively communicate these changes to participants through the Milliman website.

Like other defined benefit formulas, a variable annuity formula uses a participant’s salary and length of service to calculate a benefit. What makes the administration unique among DB plans is that the variable annuity’s annual accrual is expressed in terms of unit values instead of dollars because the benefits themselves are directly affected by the return on a diversified investment portfolio.

As market returns on these investments fluctuate, so does a participant’s benefit, both before and after retirement. Therefore, a participant’s benefit depends not only on salary and years of service, but also on market returns. Unit values are set annually by the plan actuary based on a separate formula using average asset values, plan liabilities, and a minimum rate-of-return. The unit values are then used to update the benefits for all participants, including active and deferred participants, as well as those participants already receiving benefits from the plan.

Administrative challenges

Updating the plan to a variable annuity formula came with administrative challenges. While the cash balance has no age requirement for commencement, the variable annuity established an earliest retirement age of 55 for non-disabled participants. Depending on a participant’s age at a requested benefit commencement date, the cash balance might be available for payment while the variable annuity might not be.

Another challenge is that the variable annuity benefit is only payable as an annuity. This differs from the lump sum option that participants were used to under the cash balance formula. The client wanted to ensure that participants were not only aware of these changes, but could model benefits under both formulas in the same calculation. The client also wanted to encourage participants to commence under both formulas on the same retirement date when available.

Additionally, variable annuity formulas have the unique challenge of administering the annual changes in the unit value, which fluctuate with market returns on the underlying plan assets. With this plan, the underlying rate of return and final unit value would not be determined by the plan actuary until early March—well after the December 31 plan year-end. This creates a gap at the beginning of each plan year, where benefit accruals and retiree payments would still be based on the prior year’s unit value. Milliman worked with the client to determine how best to calculate and communicate to participants the effect of the annual unit value change and the true-up adjustments to in-payment benefits.

Client and participant solutions

Milliman began programming the system before the client decided when the variable annuity formula would take effect. Thus, we programmed a variable effective date to ensure that the system would be ready for both client review and participant use in advance of the actual change in formula. The variable date allowed the configuration team to begin coding all calculation, distribution form, and web experience changes based on an unknown future effective date.

This was helpful because the client delayed the plan amendment date several times along the way. The variable date also triggered whether a participant would see modeled benefits under the cash balance formula, the variable annuity formula, or a combination of the two, as well as which distribution forms were available.

Because the two formulas could have different retirement dates and distribution forms, the client ultimately decided to simplify both participant communication and administration by displaying the two formulas as separate elections. Additionally, if a participant was under age 55 as of a requested benefit commencement date, it meant that they were eligible to receive the cash balance formula, but not the variable annuity formula. In this case, Milliman programmed the calculator to display electable optional forms for the cash balance benefit and display optional forms as of normal retirement date for the variable annuity benefit. This clearly delineates for the participant which benefits are payable now and which are payable at a future eligible date all in the same calculation.

The client was unsure how best to model the fluctuating future annuity unit values for active employees continuing to work. Should participants be able to model the underlying assumptions and factors built into determining the unit values, including the predicted return on assets in future years?

The Milliman team suggested a conservative approach of assuming that future unit values would be the same as the current unit value. This allowed for not only consistent modeling across participants, but also sidestepped the challenge that the complex formula and inputs of the unit value would be complicated for most plan participants.

One of the biggest administrative challenges Milliman needed to address was the timing and calculation of the annual payment updates for retirees who receive a portion of their payment under the variable annuity formula. Under the plan provisions, as the unit value is adjusted each January 1, the accumulated units of a participant’s account are multiplied by the new unit value to determine the impact on the new year’s payment amount.

Example: Unit values at each year of retirement

* Accumulated Units x Unit Value ÷ 12

The unit value calculation cannot be completed until returns on the underlying investments have been finalized. The plan actuary would not have the new unit value until early March each year. As such, the monthly payments during the first three months of each year will be based on the last known unit value until the updated unit value is provided by the actuary and the annual retiree maintenance process can be completed.

Milliman’s process determines the change (either increase or decrease) in the payment amount for the new year, beginning with the April payment cycle. It will also include a one-time adjustment for any over- or under-payment during the first three months of the year. Additionally, the standard administration process includes a letter to each retiree, informing them of the adjustment to their monthly benefit amount based on the updated unit values for both ongoing payments and the one-time adjustment.

Outcome

The client appreciated Milliman’s effort to adjust the pension administration system before the plan formula change took effect so that it could conduct appropriate communication and training with employees. While the plan participants did not have a choice regarding the formula change, one of the key benefits of the Milliman solution was the ability for participants to model their benefits with formula changes before they happened. Milliman’s redesign of the participant communications and website helped ensure a stable transition to the new formula, and the client was confident that its goals were met.