The Future of Retirement Plans?

Lee Barney of Plan Sponsor reports, A Pension Plan That Makes No Promises (h/t, Suzanne Bishopric):

Variable benefit plans are a type of defined benefit (DB) plan that have been around for decades, according to Matt Klein, a principal and leader of the actuarial services practice at employee benefits consulting firm Findley Davies in Cleveland.

However, few sponsors and retirement plan advisers know about them, he says, estimating that there are fewer than 100 of these types of plans in the United States. Nonetheless, he believes that sponsors and retirement plan advisers might be interested in them since they shift the investment risk off of the sponsor’s shoulders onto the participant’s—while moving the longevity risk over to the sponsor.

Employers continue to shut down their pension plans, redeploying their employees into defined contribution (DC) plans, Klein notes. But unless participants are automatically enrolled into their DC plan at meaningful deferral rates into an appropriate qualified default investment alternative (QDIA), most DC participants fail to make appropriate investment and deferral decisions, he says. The DC system fails to properly prepare most people for retirement, he maintains.

A variable benefit plan is a type of pension plan that, unlike a traditional DB plan that promises a set return every year, fluctuates with the market, he explains. Hence the name variable benefit.

“Sponsors interested in a comprehensive benefits package that will be able to provide employees with a comfortable retirement might want to consider a variable benefits plan, which eliminates the traditional risks associated with defined benefit plans and provides a stable cost and contribution policy that fits better with companies’ goals and objective in the 21st century,” Klein says.

NEXT: Comparison to traditional DB plans

In a traditional DB plan, the employer takes on the investment risk, he explains. But when a pension plan faces a market correction, such as the 2008 financial crises, assets decrease significantly while participants’ promised benefits remain intact, requiring the sponsor to make additional contributions to fund the plan at the precise time when they are typically facing a recession, Klein notes.

Like a traditional DB plans, a variable benefit plan uses an accrual rate whereby the sponsor contributes a percentage of each participant’s salary to the plan each year and ensures that the assets are professionally managed. Unlike a traditional DB plan, however, a variable benefit plan establishes a hurdle rate, which is the percentage return goal for each year, Klein says. If the returns are actually higher than the hurdle rate, the sponsor can increase the participants’ benefits—but if it is lower, they can reduce the benefits, Klein says.

“You would invest the assets in a variable benefit plan very differently than a traditional DB plan,” he adds. “A lot of traditional DB plans are doing some sort of asset/liability matching or glide path strategy, matching bonds to expected cash flows coming out of the plan. With a variable benefit plan, you don’t have the downside risk keeping employers up at night. One way to approach investing in a variable benefit plan is to treat it like an endowment while still being cognizant of the downside risk.”

NEXT: Advantages for participants and sponsors

From the participants’ perspective, the key advantage of a variable benefit plan is that, like a traditional DB plan, when they retire, they receive an annuity that pays them a set monthly income, as opposed to a lump sum they would receive from a DC plan or even a cash balance plan, Klein notes.

He believes that because DC plans are so prevalent today, sponsors and participants are now accustomed to variable returns—and the fact that their balances could decrease—and that they might be more receptive to variable benefit plans.

“Part of my passion here is to try and educate employers and advisers that these plans do exist,” he says. “They meet all of the legal hurdles and requirements of the IRS, DOL and ERISA. They are a win/win for both plan sponsors and plan participants while splitting the investment and longevity risks between the employer and the participant.”

An additional reason an employer might consider a variable benefit plan is that, unlike traditional pension plans that are typically underfunded and that require DB plan sponsors to pay 3% of their underfunding each year to the Pension Benefit Guaranty Corporation (PBGC), variable benefit plans remain 100% or very close to 100% funded. The reason for this is that the benefits rise or decrease as the plan’s returns exceed, meet or fall below the hurdle rate, Klein says. Therefore, variable benefit plan sponsors do not have to pay the annual 3% to the PBGC, only the minimal per-head cost.

Findley Davies has created a white paper comparing the benefits of variable benefit, DB, DC and cash balance plans, titled, “The Future of Retirement Plans: Variable Benefit Plans.” The paper makes the case that variable benefit plans strike the right balance between investment, interest or inflation, and mortality risk. It is available here.

I went through the white paper, “The Future of Retirement Plans: Variable Benefit Plans,” and found it was well written.

The paper begins with the three most significant risks to any retirement plan (click on image):

Of these, the most significant risk is the direction of interest rates, especially when rates are at historic lows. The the lower they go, the higher the liabilities shoot up relative to assets.

Why? Because the duration of liabilities is much bigger than the duration of assets, so for any given decline in interest rates, the increase in liabilities will dwarf and increase in assets.

This is especially true in a low rate environment which is why I've always warned my readers a prolonged bout of deflation will decimate many pensions which are already in deeply underfunded territory.

So how does it work? There is an example given in the white paper (click on image):

And for the active participant using the same example (click on image):

What are my thoughts? Obviously variable benefit plans are better than defined-contribution plans because they offer a monthly income for life and from an employer's perspective, they offer the added advantage they remain off the hook if the plan is underfunded as employees will bear cuts (or increases) to their benefits depending on where annual returns lie relative to the hurdle rate.

But let's not kid ourselves, while variable benefit plans offer some benefits relative to DC plans, they are still far and away inferior to a large well-governed defined-benefit plan which has adopted a shared-risk model among its stakeholders (Ontario Teachers, HOOPP, OPTrust, CAAT for example).

Basically, without going into too much detail, variable pensions suffer from the same deficiencies as DC plans, namely, they only invest in public markets and are subject to the vagaries of the stock market. Only difference is if the plan has a bad year, benefits are automatically adjusted down, which is no skin off the employer's back. There is zero risk-sharing going on here (employees assume all the risk in bad years).

Go back to read my last comment on Canada's new masters of the universe where I stated the following:

The brutal truth on defined-contribution plans is they are leaving millions at risk of pension poverty which is why unlike the Andrew Coynes of this world, I kept harping on enhancing the CPP knowing full well Canadians are getting a great bang for their CPP buck.

And when I read about what is happening to Nortel's pensioners, it infuriates me and reminds me that there is still a lot of work left to do in terms of pension policy in this country, like creating a new large, well-governed public pension here in Montreal in charge of managing the assets of all Canadian DB and DC corporate pensions (Montreal is home to the country's best corporate DB pensions like CN's Investment Division and Air Canada Pensions).

When it comes to pensions, nothing, and I mean nothing, compares to a large, well-governed DB pension which has adopted risk-sharing, typically in the form of adjusting inflation protection if the plan is underfunded, not cutting benefits every year depending on how stocks and bonds are doing.

And I would prefer if these were large well-governed public DB pensions like we have in Canada. Smaller DB pensions are struggling and I think it's high time we consolidate a lot of local and city pensions into the big ones.

Below, Milliman consultants Kelly Coffing and Grant Camp discuss some of the benefits that VAPPs offer sponsors and participants in this Milliman Hangout. Keep my comments above in mind as you listen to this discussion. VAPPs may be the future of pension plans but they are not the best solution.