a win-win for employers and employees. The authors call this type of plan the. Low Volatility Pension Plan (LVP). CREATI
4 | 2012 The Magazine of WorldatWork©
CRE ATING A
D HYB R ICD RETIREMENT PL AN
Combining old and new creates the framework for a plan whose basic design is a cash balance plan.
T
here has been a shift in employment-based retirement benefits away from traditional defined benefits (DB) pension plans to defined contribution (DC) plans. This has disrupted employees’ retirement patterns and impaired employers’ ability to manage their workforce. The move has been driven by several factors, including the cost volatility of pension plans and the lack of employee understanding/ appreciation of them. However, 401(k) plans have their own set of concerns,
most notably the amount of responsibility they place on plan participants to save enough and save consistently, to invest effectively, to avoid withdrawing funds for nonretirement purposes and to manage market and longevity risks. The authors believe that recently issued retirement benefit regulations have given employers an option that captures the best of DB and DC plans and represents a win-win for employers and employees. The authors call this type of plan the Low Volatility Pension Plan (LVP).
By Lee James and Jeff Passmore, Buck Consultants © 2012 WorldatWork. All Rights Reserved. For information about reprints/re-use, email
[email protected]
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The basic design of LVP is a cash balance plan. Cash balance plans are DB plans that look a lot like DC plans to participants. In fact, cash balance plans are often called hybrid plans because they combine characteristics of DB and DC.
the employee’s behalf. Historically, cash balance plans have had two drawbacks: First, there was legal uncertainty regarding some of their design features and second as a pension plan, the risk of investment losses fall on the employer. Recent benefits regulations have addressed both drawbacks. First, they have made clear what cash balance design features are acceptable. Second, they have described several permissible approaches to linking cash balance benefits to market returns so that employers do not bear the investment risk. The LVP takes advantage of this new clarity to combine the best of the old DB and DC designs and provides a win-win for employers and their employees. LVP Advantages for the Employer
Defined Benefits vs. Defined Contribution DB plans have several positive attributes; in particular they provide a benefit for the life of the participant (or the joint lifetime of the participant and her spouse) and they do not depend on participant discipline in saving or participant expertise in investing. However, traditional DB plans have some key shortcomings. First, they have significant cost volatility for the employer. Second, employees often don’t understand how the benefit is determined or appreciate the value of a lifetime benefit. DC plans effectively address these shortcomings. The cost for the employer is either known in advance or reasonably predictable and limited. Furthermore, the benefit is expressed in an intuitive way, namely as a total account balance that grows with contributions and earnings. But DC plans have their own shortcomings. In particular, for the employee, they require significantly more responsibility, especially in a matched savings DC plan where
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the participant chooses from several investment options. For the employer, if employees are not able to retire with financial security, the plan has failed. This failure is manifest as misspent benefit dollars, reputational risk and most importantly the risk that employees retire in place — so called “warm seat attrition.”
An Innovative Approach The basic design of LVP is a cash balance plan. Cash balance plans are DB plans that look a lot like DC plans to participants. In fact, cash balance plans are often called hybrid plans because they combine characteristics of DB and DC. In particular, cash balance plans are expressed in the same intuitive way that DC plans are described: as a total account balance that grows with contributions and earnings. However, unlike a matched savings DC plan, the contributions are made by the employer on a consistent basis over the working career of the participant and invested on
❙❙ Predictable contributions, even in volatile market conditions. ❙❙ Meaningful retirement benefits for participants that do not depend on participant savings discipline or investment success. ❙❙ As a result of more reliable benefits for employees, smooth and predictable retirement patterns, enhancing workforce management. ❙❙ An alternative to freezing or terminating an existing DB plan that does not require the plan sponsor to bear the investment risk. LVP Advantages for the Employee
❙❙ A benefit that is intuitive to understand. ❙❙ A stable and predictable benefit growth pattern. ❙❙ A retirement benefit that requires no savings discipline or investment expertise. ❙❙ A benefit that is either available as a lump sum payment (for portability) or as a monthly annuity (to protect against longevity risk).
How Does The Low Volatility Pension Plan Work? There are three primary design elements of LVP plans: the benefit
For corporate and not-for-profit plan sponsors, if the plan is intended to replace part or all of an existing DC or DB plan, then you would modify those plans accordingly (e.g., by freezing or reducing them) and add the LVP.
| A ccumulation of Value Comparison
Figure 1
300,000
Lump Sum Value
DB
DC
LVP
200,000
100,000
0 45 46 47 48 49 50 51 52 53 54 55 56 57 58 59 60 61 62 63 64 Age
Figure 2
| Minimum Required Employer Contribution by Year
10%
DB
9%
DC
LVP
8% 7% 6% 5% 4% 3% 2% 1% 0% 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010
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credit, the interest credit and the investment strategy. The benefit credit and the interest credit determine how the LVP benefits grow over time. In the LVP, these are linked together with the investment strategy: ❙❙ The benefit credit is the annual “contribution” to the employee account, generally a percentage of pay. ❙❙ The interest credit is the “earnings” on the employee account. There are several options within the regulations for ensuring the earnings credited to the employee accounts are closely related to the actual earnings in the trust. The most straightforward option is to simply define the interest credit to be equal to the trust return. ❙❙ The investment strategy is key to ensuring that the LVP helps both employers and employees manage
investment risk, rather than shifting between them. There are three vital considerations when developing an investment strategy. First, assets must be invested in a way that contributions will accumulate to meaningful retirement benefits. Second, the assets should be an appropriate part of any well-diversified retirement portfolio as they will have to serve younger and older workers equally. Finally, the risk/ return should be conservative relative to the discount rate used in the actuarial calculations of plan cost.
Employees’ Perspective DC, DB and LVP
Consider Figure 1, which compares three plans with similar level of cost — these three plans each cost about 5 percent of pay. The hypothetical employee shown was hired at age 45, on Jan. 1, 1991.
The authors have made conservative assumptions about pay growth and used actual stock and bond returns over the period 1991-2010 in these calculations. The DB plan smoothly increases from date of hire until age 62, the early retirement age for this plan. The DC plan is assumed to have been invested 60 percent in stocks and 40 percent in medium-term bonds. It does generally well but is impacted by downturns in the market, especially the recent liquidity crisis in late 2008 — imagine the impact if this participant had planned to retire at age 63. The LVP is shown as though it was implemented before the employee was hired. The LVP assets are assumed to be invested in mediumterm bonds and its interest credit is assumed equal to the trust return. The LVP benefit line shows a smooth
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progression which enables the employee to plan for a financially secure retirement.
Employer’s Perspective DC, DB and LVP
Figure 2 on page 47 shows the cost pattern of the same three plans illustrated in Figure 1 over the same period. Note that the DC cost is a steady 5 percent of pay each year. The DB cost reflects the minimum required funding each year; these contributions vary based on the funded status of the plan. The authors have assumed that the DB plan is invested in the same 60/40 equity/bond mix assumed for the DC plan in Figure 1. The erratic nature of the cost illustrates how DB funding can be volatile due to the mismatch between assets and liabilities. There are two things to note regarding the LVP. First, the cost pattern is similar to the DC in terms of steadiness and predictability. Second is the level of cost. Although the LVP benefit includes a 5 percent of pay benefit credit, the cost line is just above 4 percent for the duration of the period. The actuarial calculations for the LVP require that the accounting and funding calculations defer recognition of some of the plan cost. Of course this does not alter the ultimate benefit payout but as long as the plan continues to have new entrants this pattern will persist.
Implementing an LVP The steps to implement an LVP depend on the type of plan you currently have, your intentions for the LVP (i.e., is it intended to replace part of your defined contribution or defined benefits plan) and whether your organization is a corporate plan, notfor-profit or public sector plan sponsor. For corporate and not-for-profit plan sponsors, if the plan is intended to replace part or all of an existing DC or DB plan, then you would modify those plans accordingly (e.g., by freezing or reducing them) and add the LVP. Total benefits at retirement will be the sum of the reduced/frozen benefit plus the LVP. Best practice for the plan design process would include a team with representatives from the organization’s human resources and finance functions as well as outside support from legal and retirement benefit (actuarial) experts. This team would work together to develop the three design elements, and would consider things like competitive benefit levels, targeted levels of benefits at retirement for affected participants and desired levels of cost, among other things. For public plan sponsors, step one is to establish the constraints that would apply to the introduction
of LVP coverage. For example, determining whether state law would allow for a change to an LVP-type formula for current active participants, or would a change to LVP be permissible only for new employees? This question usually requires the help of legal counsel to answer. Once the constraints are established, the design process described previously can begin. When an LVP is replacing a pension benefit, then there would be a separate investment strategy for the legacy portion of the plan vs. the LVP portion. For the legacy portion, the authors recommend establishing an investment strategy that would limit volatility based on the nature of the liabilities. For the LVP portion, the considerations are those described in the prior section. The authors also recommend modeling the results as part of this process to demonstrate the low-volatility property of the new design relative to the “legacy” plan under various economic scenarios. Once a design is agreed on, there are additional steps, such as the crafting of appropriate plan amendments, employee communication and implementation of the needed administrative support for the LVP plan.
LVP A Win-Win for Employers and Employees?
LVP plans provide a way for employers to offer their employees a secure benefit while maintaining financial stability and flexibility. While there is no magic solution for retirement planning, LVPs provide a fresh, compelling alternative for employers to consider. Author’s note LVP is a registered trademark of Buck Consultants. Lee James is an actuary at Buck Consultants in Houston. He can be reached at
[email protected]. Jeff Passmore is a principal in Buck Consultants’ Investment Consulting Practice in Dallas. He can be reached at
[email protected].
resources plus For more information, books and education related to this topic, log on to www.worldatwork.org and use any or all of these keywords: ❙❙ Defined benefits plan ❙❙ Defined contribution plan ❙❙ Low volatility + pension plan.
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