Traditional pension plans have been going the way of the
Dodo for a few years, but many employers are switching to hybrid plans to
minimize their risk while continuing to offer a lifelong benefit to employees.
Hybrid pension plans pull some of the best features from
defined contribution and defined benefit plans, making them very attractive to
large public and private sector employers who have struggled with massive
unfunded liabilities in their traditional pension plans.
Many companies have frozen their pensions to new hires.
Others have abandoned their pensions in favor of a 401(k) or other defined
contribution plan. But not everyone is happy with defined contribution plans
because they often leave participants to fend for themselves when most have
never had to make investment decisions.
Hybrid plans share the risk between employers and employees.
In 2013, 30 of the Fortune 100 companies were still offering pension plans to
their employees: seven of those were traditional pensions and 23 were hybrid
plans, according to research by Towers Watson. The rest of the Fortune 100 were
offering only defined contribution plans.
The hybrids getting the most play in the past 15 years have
been cash balance plans, which are defined benefit plans where the “benefit is
defined as an account balance, rather than an annuity,” explains Towers Watson.
Other hybrids that are just starting to take off include variable annuity and
adjustable pension plans.
“I think we are going to see more hybrid arrangements and
fewer defined contribution and traditional defined benefit plans [in the
future],” says Mark Olleman, principal and consulting actuary at Milliman, Inc.
in Seattle. “I think we really need more plans to provide people with a
lifelong income, without providing employers unpredictable contributions.”
Employers who sponsor cash balance plans have a stated
contribution amount, like in a defined contribution plan, but also promise a
certain level of benefits, like a defined benefit plan. In a typical cash
balance plan, a participant’s account is credited each year with a certain
amount of money, say 5% of compensation from his or her employer, and an
interest credit, which is either a fixed rate or a variable rate that is linked
to an index such as the one-year treasury bill rate.
Also see: Cash balance plans, anyone?
Changes in the value of the plan’s investments don’t affect
the participants’ benefits, so the investment risk is borne solely by the
employer, according to the U.S. Department of Labor. But, when it comes time to
retire or change jobs, the participant has the right to turn his account
balance into an annuity or take it as a lump sum distribution.
Wisconsin, Rhode Island, Nebraska and Utah have all switched
their pensions to hybrid plans. Most have chosen the cash balance option, but
some are considering newer plan designs.
Wisconsin’s plan looks more like a variable annuity pension
plan. Its goal is a 5% return. If the plan returns better than 5% over the long
term, retirees get dividends. If it returns below 5%, the dividends will be
taken away, Olleman says. Retirees receive a minimum amount regardless of how
the market performs.
The big difference between public sector and private sector
plans is that public sector plans need to get permission from the legislature
to make changes, he said. Both sectors have shown an interest in hybrid
options.
Kelly Coffing, a principal and consulting actuary for
Milliman who works more closely with private sector employers, says that
variable annuity pension plans have been around for a while but have not been
popular with retirees. The reason? They don’t like it when their benefits go
down, she said. In a VAPP, the monthly benefits move up and down based on the
performance of the plan. If the assets go up, the benefits go up. If the assets
go down, the benefits go down.
Despite the volatility, these types of plans always stay
funded and have very predictable, rational employer costs, Coffing says. They
also offer longevity pooling and inflation protection, which is something
participants don’t get in a defined contribution plan.
“While they are volatile, they do go up over time. With all
that going on, you would think they would be more popular,” she says.
Milliman has attempted to smooth out some of that volatility
for retirees in its latest version of the VAPP.
“In years where returns are high, we don’t give the whole
upside to participants. We tap the increases. Any excess above 8% builds a
reserve. When the market goes down, we can shore up the benefit to the high
water mark,” she says. This way, participants don’t see a rollercoaster of ups
and downs in their retirement accounts.
She added that with a variable annuity pension plan, the
investment risk is borne by the participants and the longevity risk is borne by
the plan.
VAPPs minimize the risk regardless of the maturity of the
plan, Coffing adds, because they take some of the money from up years and use that
money as a hedge against down years.
Milliman’s experts say they hope the variable annuity
pension plan will gain in popularity now that the Internal Revenue Service has
given its approval to the New York Times’ adjustable pension plan, which is
another type of hybrid pension plan.
The IRS approved the New York Times’ plan in June. The
Newspaper Guild of New York, which represents news employees at the Times,
worked with a team from Cheiron, Inc., an actuarial and financial consultancy,
to develop the adjustable pension plan that went into effect in July 2013. They
had until July 31 of this year to get IRS approval of the plan model. If the
IRS had not given its blessing, the plan would have automatically become a
401(k) plan.
“It is very welcome news and very happy news for our members
at the New York Times,” says Bill O’Meara, president of the Newspaper Guild of
New York.
The IRS’ approval means that, like a traditional defined
benefit plan, participants will receive a check every month for life. It also
means the plan is covered by the Pension Benefit Guaranty Corporation, unlike a
401(k) plan, he says.
The adjustable plan was devised as a replacement for the
company’s traditional defined benefit plan and “was really a key to getting our
contract settled,” O’Meara explains. “[Employees] were reluctant to give up the
defined benefit plan. They understand the value of it.” The adjustable plan was
a compromise that addressed the concerns of the company and the employees.
It combines the flexibility of a 401(k) plan with the
guaranteed income stream of a defined benefit plan.
Like the VAPP, the adjustable pension sets more conservative
goals with its investments. From the employer’s perspective, the plan operates
in the same way as a 401(k). Each year, the trustees for the fund look at
earnings on investments to determine the level of contributions that are needed
to pay benefits. Once that amount is set, it is set. There is no changing it.
“It insulates them from a big drop in the stock market,
something that would cause them to put in a lot more money than expected into
the pension plan,” O’Meara says. “That doesn’t happen. Whatever the company
agrees to put in each year is the benefit.”
In an adjustable plan, employers and employees share the
risk. Participants know they will receive a check of some kind every year from
their plan. It will either be the minimum amount set when the plan was started
or the adjustable amount, whichever is more.
“More employees want a defined benefit plan. They are willing
to give up salary for more retirement security,” says Richard Hudson, principal
consulting actuary at Cheiron Inc. and one of the developers of the adjustable
pension plan. “This gives employees what they want: a defined benefit plan. The
reason employers don’t want to offer a traditional defined benefit plan is cost
volatility.”
Under the adjustable pension plan, “the benefit accrual rate
will adjust to meet the minimum funding requirement. It won’t be subjected to a
doubling or tripling of the contribution. It gives [employers] contribution
stability. It gives employees what they want: retirement security and a
lifelong benefit,” Hudson said.
O’Meara likes the plan to a plate of pancakes. One year, a
participant’s pancake may be small and the next year, big. But no matter what,
when they retire, participants know they will have a plate of pancakes waiting
for them.
“The average 401(k) balance is nowhere near enough for
people to retire on,” O’Meara says. “Because this plan offers payment every
month for life, I think it could be a solution to the retirement crisis. I hope
other unions and companies look at this to provide economic benefit to
employees in a way that doesn’t expose the company to risk and volatility.”
The Newspaper Guild of New York and Cheiron devised a
similar retirement plan for Consumer Reports.
The IRS has until March 2015 to make a decision about that plan, O’Meara
said. He is confident the IRS will rule favorably in that case since the
Consumer Reports adjustable pension plan is nearly identical to the one the IRS
just approved at the New York Times.
Cheiron has also worked with some large public sector plans,
including Maine Public Employees Retirement System, to implement an adjustable
pension plan. Maine is still waiting for
the state legislature to make a decision about its proposed plan.
Milliman has a couple of clients implementing variable
annuity pension plans in the near future, but “they are not as far along. We
don’t have a determination letter from the IRS. Any tweaks to the variable
annuity design may require a determination letter,” Coffing adds. “That’s what
has caused many plan sponsors to be hesitant [about this plan design], but I
think we are seeing movement on it anyway. Since the IRS approved one such plan
design, people will be more willing to jump in.”
Source: Employee
Benefit News
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