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Retirement Readiness and Defined Benefit Pension Plan Design

Grant Verhaeghe
CAPTRUST Senior Director | Asset Liability Practice Leader

In recent years, corporations have materially shifted the burden of retirement savings toward participants. The U.S. Department of Labor (DOL) reported a 57 percent decline in the number of defined benefit plans from 1975 to 2011 (the most recent data available from the DOL) while reporting a 182 percent increase in the number of defined contribution plans during the same period.1

Additionally, the Pension Benefit Guarantee Corporation (PBGC) reported that more than 41 percent of private sector defined benefit plans have partially or entirely frozen benefit accruals or participation.2 This article explores the evolving state of the defined benefit marketplace and potential options we see plan sponsors considering when addressing participant retirement readiness.

A confluence of regulatory and accounting changes and the market environment led to an increase in the cost of maintaining defined benefit plans. These same factors also introduced volatility in contributions and financial statements over shorter time horizons. The Pension Protection Act of 2006 introduced an economic measure of liabilities for determining minimum required contributions.3 Also in 2006, the Financial Accounting Standards Board forced more transparency in funding for accounting purposes and, at the same time, adopted market-based measures of liabilities.4 More recently, Congress increased PBGC premiums, the required governmental insurance coverage on pension plans, twice since 2012.5,6 As a result, plan sponsors are less willing to bear the burden of increased transparency of pension liabilities, higher pension costs, and volatility in the cash flow required to maintain plans.

But is the shift to defined contribution plans good or bad for employees? In June 2013, the EBRI conducted a study to address this question. In short, the answer depends on participant income level, plan design, savings rate, investing behaviors, and a few other factors. EBRI’s work indicated that the median outcome was a 15 to 44 percent higher income replacement rate for younger workers with a 401(k) than a traditional pension plan, depending on income level. The numbers were even more compelling for 401(k)s relative to the traditional cash balance plan used in the evaluation. The study showed that reducing the return assumption for participants by 2 percent in a 401(k) still generated higher income replacement rates for higher-wage workers. However, lower-wage workers would likely have fared better with a traditional final average pay plan. The 401(k) also led to better outcomes over a traditional cash balance plan for all income levels in the lower-return-assumption scenario.7

The data suggest that, on average, savings in a 401(k) will lead to higher income replacement levels over traditional final average pay and traditional cash balance plan designs studied. However, since a participant’s investment returns are path-dependent in a 401(k), the amount and timing of contributions can have a material impact on the outcome. Variations in participant investment behaviors, savings rates, and plan design may lead to disparate outcomes. 

Defined benefit pension plan advocates claim that the shift toward defined contribution plans disaggregates risk at the participant level, bringing this “outcomes of one” problem to the foreground. They argue that pension plans address the path-dependency issue by managing for the collective time horizon and risk tolerance of a group of participants, rather than an individual beneficiary. This claim certainly has merit; however, to state the obvious, individuals care more about their own specific retirement income than the average retirement income in their neighborhood. Their livelihood depends on it.

So is there a plan design that addresses plan sponsors’ concerns about traditional pension plans while also addressing the “outcomes of one” criticisms of 401(k) plans? Perhaps. In 2010, the Internal Revenue Service (IRS) released proposed and final regulations regarding new market-rate cash balance plan types.8 In its 2013 National Cash Balance Research Report, actuarial consulting firm Kravitz predicted that the number of cash balance pension plans would grow by over 15 percent in 2012, with the new market-rate rules likely a large contributing factor to that growth.9

These new rules include several notable developments. Among them, they allow cash balance plan sponsors to credit an investment rate of return tied to market proxies such as mutual funds or the pension trust’s rate of return. This materially diminishes one of the primary pain points for plan sponsors — the need to develop an allocation strategy that matches assets with liabilities — and allows for more focus on risk tolerance. The rules also prescribe a capital preservation rule, which limits downside risk for individual participants, thus addressing another key pain point. While market-rate cash balance plans may not alleviate all plan sponsor concerns over offering defined benefit pension plans, they do address several of the most pressing ones.

It is widely accepted that the IRS will finalize certain aspects of these regulations in the next six to twelve months. However, since 2010 it has already issued favorable determination letters for many plan sponsors based on this proposed regulation. For more on market-rate cash balance plans, please see “Plan Design and Investment Strategies for Market-Rate Cash Balance Plans” from the second quarter 2013 issue of CAPTRUST’s Strategic Research Report.

Rather than simply shifting them between employers and employees, the market-rate cash balance regulations discussed above, for the first time, provide plan sponsors with framework for rationally sharing and allocating retirement-related risks. Used in conjunction with employee 401(k) deferrals, hybrid pension plans — such as market-rate cash balance plans — are one potential avenue to balance risks 

between plan sponsors and participants while addressing participant retirement readiness. Combining features from both defined contribution and defined benefit plan designs provides a wide spectrum of possible solutions. The right answer for an individual plan sponsor and plan’s participants will vary based on the plan sponsor’s willingness and ability to bear the risk of guaranteeing lifetime income — which regulations have amplified over recent years — versus shifting that risk to individual participants. As always, CAPTRUST stands ready to assist you in managing and allocating these risks as you strike the right balance for your organization. 

Sources:

1 “Private Pension Plan Bulletin Historical Tables and Graphs,” U.S. Department of Labor Employee Benefits Security Administration, June 2013, 2011 Data Release Version 1.0
2 “Table S-36 PBGC-Insured Plans by Status of Benefit Accruals and Participation Freeze (2008-2011) Single-Employer Program,” Pension Benefit Guaranty Corporation, 2012 Pension Insurance Data Tables
3 Pension Protection Act of 2006, accessed June 23, 2014, http://www.gpo.gov/fdsys/pkg/PLAW-109publ280/pdf/PLAW-109publ280.pdf
4 Financial Accounting Standards Board, Statement No. 158, accessed June 23, 2014, http://www.fasb.org/summary/stsum158.shtm
5 Moving Ahead for Progress in the 21st Century Act, accessed June 23, 2014, http://www.gpo.gov/fdsys/pkg/BILLS-112hr4348enr/pdf/BILLS-112hr4348enr.pdf
6 Bipartisan Budget Act of 2013, accessed June 23, 2014, http://www.gpo.gov/fdsys/pkg/BILLS-113hjres59enr/pdf/BILLS-113hjres59enr.pdf

7 Jack VanDerhei, Ph.D., “Reality Checks: A Comparative Analysis of Future Benefits from Private-Sector, Voluntary-Enrollment 401(k) Plans vs. Stylized, Final-Average-Pay Defined Benefit and Cash Balance Plans,” Employee Benefit Research Institute, Issue Brief No.387
8 Internal Revenue Service, “Employee Plan News – November 5, 2010 – Hybrid Defined Benefit Plans – Final and Proposed Regulations,” accessed June 23, 2014, http://www.irs.gov/pub/irs-tege/epn_2010_10.pdf
9 Kravitz, “2013 National Cash Balance Research Report,” accessed June 23, 2014, http://cashbalancedesign.com/articles/documents/NationalCashBalanceResearchReport2013.pdf