by Richard Berger, Cammack LaRhette Consulting
It seems as if everybody is freezing their pension plans. If your defined benefit (DB) plan is desirable, how can you make it manageable for the long haul and avoid a freeze?
What Has Driven Employers to Freeze?
Employers have been freezing their pension plans for two main reasons, (1) rising plan costs and (2) volatility/unpredictably of plan costs. “Cost” may mean the actual cash required under Internal Revenue Code minimum funding requirements, or the annual accounting expense under Financial Accounting Standards Board financial rules.
During the 1990s, extravagant returns on pension plan assets allowed many employers to reduce or eliminate contributions. Two major market declines, in 2000-2002 and in 2008, coupled with more stringent funding rules under the Pension Protection Act (PPA), reversed that trend. Many employers saw plan funding requirements and accounting expense and liabilities rise sharply. Furthermore, with expense and cash determinations now linked to bond market rates, gyrations in the credit markets can cause pain and confusion for pension plan sponsors.
Does Your DB Plan Still Make Sense?
Under PPA rules, if plan assets fall below 60 percent of the plan’s funding liability, an employer is forced to freeze the pension plan. Ignoring such involuntary freezes, how can an employer who wants to continue its plan cope with higher, unpredictable costs?
Employers commonly provide retirement plans, such as a 401k or 403b plan that gives employees the advantage of a tax-deferred buildup of a nest-egg. Employers may supplement employee contributions with matching or base contributions. Clearly, employees appreciate employer-sponsored retirement plans.
The real question is whether a DB plan is appropriate. Defined contribution plans have overtaken DB plans in popularity because they are portable and easier to understand.
On the other hand, many employees, who are not comfortable with making their own investments, have been unnerved when their accounts nosedived twice in the past decade. They might be attracted to a plan with guaranteed returns and professional investment, such as a cash balance plan, which is a DB plan. Even if you can find a plan that appeals to employees, the cost/volatility problem still remains.
Defusing Volatility
Volatility in contributions and expense arises from fluctuations in the investment returns of plan assets and fluctuations in plan liabilities. Plan liabilities vary due to the nature of the plan design and changes in employee demographics. The value of plan liabilities is based (among other things) on assumptions about future employee pay, length of service, or longevity and will change if the future is different than assumed.
For example, if your plan uses a traditional final average pay formula, deviations in actual salary increases from those assumed can drive your liabilities up and down. With the move to market-based liability measurements, changes in credit markets subject your plan to even greater variation. One method for handling the volatility arising from this source is by so-called liability driven investing (LDI).
Traditional pension plan investments have aimed at the greatest return for a given level of risk (read volatility) or the lowest volatility for a given return. Plan assets were in a race with liabilities, in which assets could suddenly surge ahead, as in the late 1990s, or unexpectedly fall behind, as has happened more recently.
Under LDI, assets and liabilities are considered together. Managers select assets that behave in coordination with liabilities, so that mismatches are reduced. In many cases, LDI leads to more investments in fixed income securities similar to those used to set discount rates for liabilities. The downside of this approach is that fixed income investments typically produce lower returns than equities over the long haul, so a plan may be more costly.
Adjust Your PlanFor Sustainable Costs
If you adopt an effective LDI strategy and reduce volatility, you can tackle the level of cost. Assume, for example, you have moved to more fixed income investments. If the cost of your plan is now higher than you can afford, you can reduce it by altering your plan’s formula. For instance, you might increase the averaging period for final average plans, or change the basic accrual rates under the plan. A more radical approach is to change the final average plan to a cash balance plan. That mimics a defined contribution plan, with annual additions to the account based on compensation, and an “investment” return tied to an index. The cost of a cash balance plan can be adjusted to an acceptable level by changing either of these features.
There is no reason for an employer to freeze a DB plan that it is inclined to continue. The key to long-term viability lies in a mixture of plan design and an appropriate investment strategy.
Richard Berger, FSA, EA, is the managing actuary for Cammack LaRhette Consulting, a full-service employee benefits and human resources consulting firm offering large and mid-sized businesses and organizations value-added consulting services for their retirement, health and welfare, human resources and HR technology services needs.