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Suddenly funded DB plans – What should a plan sponsor do?

Suddenly funded DB plans – What should a plan sponsor do?

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Only 27% of retirement plan participants surveyed are confident in their ability to save enough to cover their expenses in retirement, according to Buck’s new survey “Saving for retirement: Employee and employer attitudes towards retirement savings.” 

To help improve this outlook, employees and employers both agree that increasing the employers’ matching contribution to the employees’ defined contribution plan could help. But the next most popular option, supported by 36% of plan participants and 35% of employers, is to improve and/or offer a traditional defined benefit pension plan. While it is surprising to see employers still consider the defined benefit system as an avenue to provide improved retirement outcomes given the general trend for plan sponsors to move away from them over time, they do generally result in less risk and better retirement security for employees than defined contribution plans. 

Dizzying twists and turns

Company defined benefit or pension plans have gone through many ups and downs in recent decades. 

For an extended period, low interest rates coupled with the global financial crisis of 2008, resulted in trying times for plan sponsors of defined benefit plans struggling with large funding deficits. Reduced discounting driven by lower returns, increased liabilities. Plans needed a higher level of assets in their portfolio to meet the fixed promises to retirees in the future. However, turmoil in the housing market and its repercussions had depressed assets, leaving many plans without the means to make up for this growing funding deficit with cash over the short term. 

Then, the situation reversed in recent years. 

Following a strong recovery from the market losses at the onset of COVID-19, interest rates rose quickly over a matter of months in 2022 with the FTSE Pension Liability Index discount rising more than 250 basis points from the beginning of the year through October , lowering liabilities. Assets also declined at the same time, but for many sponsors this impact was offset by the decrease in liabilities, leading to increased funding ratios for many plans. This bump, combined with the cash that had been contributed over the years where funding levels were depressed, pushed their funding ratios over 100%. 

The case for the DB plan

The trend in the last decade has been to freeze, close, and dismantle defined benefit (DB) plans but there are several benefits to DB plans that can’t be ignored.

First and foremost, DB plans offer longevity risk pooling that provides lifetime income, usually at a markedly lower cost that would be available by using defined contribution (DC) funds in the private annuity market. DB plans generally employ professional asset management that, on average, shows greater returns than are achieved in DC plans. 

The flexibility of DB plans allows risk to be borne by either the sponsor or employee, as best aligns with the goals of the organization and the preferences of the participants. These plans can range from a final average pay plan with an automatic cost of living adjustment where the participant is insulated from investment, inflation and longevity risk, to a market-based cash balance plan where these risks are borne by the participant to a great extent.

For plan sponsors, having a fully funded plan, or to take it a step further, one with a significant surplus, opens up a number of additional options. 

Without the need to outpace the interest rates incorporated in the calculation of liabilities, the plan may move to an investment strategy that trades higher returns for lower risk. Risk may also be transferred out of the plan through a lump sum offer to participants, an annuity purchase from an insurer, or a complete termination, which may involve both. 

Resurrecting the DB plan

DB plans have many attractive attributes so, despite current trends, it is not a foregone conclusion that a prudent sponsor needs to take this opportunity to withdraw from the DB system. Here are other options that should be considered:

  • The plan could be maintained and even expanded or enhanced
  • The plan surplus could be employed to pay future accruals and plan administrative expenses
  • Ad hoc cost of living increases could be provided to retirees who have had their purchasing power eroded by the recent spike in inflation

If the DB plan has been closed, the plan could reopen to new participants. IBM recently took this step in reopening their plan which had been closed for 15 years. The move will allow IBM to replace their 401(k) match with a DC-like cash balance accrual in their DB plan, using surplus assets already in the plan rather than cash.

Designing DB plans for the 21st century  

Looking back at the last couple of decades it’s apparent that taking on most of the risk of the plan over an extended period of challenging market conditions was beyond the risk-tolerance of many plan sponsors. As a result, many plan sponsors moved to a DC-only approach, putting nearly all of the risk inherent in saving for retirement squarely in the court of participants. 

There are certain DB plan designs, which are growing in popularity, that also move a significant amount of the plan’s risk over to participants, though they stop short of the level of risk transfer brought on by a shift to a DC plan. For example, variable annuity plans are designed to adjust participant benefits based on investment experience, which can reduce or eliminate the asset-liability mismatch risk as liabilities move in concert with assets. The plan still retains the longevity risk and other demographic risks. 

Similarly, market-based cash balance plans base the crediting rate applied to the participants’ notional account balances on the actual return of the assets in the trust (subject to the preservation-of-capital rule that prevents cumulative returns from going below 0%.)  SECURE 2.0 introduced an update to accrual rules that eliminated the need to establish a floor crediting rate in excess of zero. That floor makes the liability much more difficult to hedge, so the change is welcome to sponsors looking to offer a plan with minimal investment risk. 

These plans look and feel much like DC plans but bring with them certain advantages from the DB system.

Striking a balance

The rise in interest rates and funded status opens up many opportunities including the opportunity to consider whether participants and sponsors would be better served by some flavor of DB plan rather than a pure DC approach. 

With the benefit of the lessons learned during the last few years and a fresh look at the risk tolerance of sponsors and employees alike, a balance can be struck and a plan can be put in place that provides for the retirement security of the participants without overly burdening the sponsor or employee.