Why plan sponsors are taking a fresh look at hybrid defined benefit plan designs[1]
By Milliman consultants Sarah Murray, FSA, EA, MAAA, Principal & Consulting Actuary, and Mary Markham, Director of DB Client Relations
Two types of hybrid defined benefit plan designs have been in the spotlight recently: cash balance pension plans and Variable Annuity Pension Plans (VAPPs). Neither plan design is new, but legislation in recent years has made them more viable options for employers. In this article we explore these two options for plan sponsors contemplating a potential change in retirement plan design.
What are cash balance pension plans?
Cash balance plans have been around since the 1980s, and they are a popular option for small business owners. In the large plan space, IBM made headlines in late 2023 with the announcement that it was reopening its frozen traditional pension plan and replacing its previous 401(k) retirement benefit with a cash balance benefit in the reopened plan. IBM’s decision has prompted a lot of discussion in the retirement industry about the possibility of other corporate plan sponsors reopening their own frozen pension plans.
A cash balance plan is a defined benefit (DB) plan that has several characteristics of a defined contribution (DC) plan. It’s often referred to as a hybrid plan, blending the traits of both DB and DC plans. Cash balance benefits are earned in the form of a pay credit and an interest credit. The pay credit can be a dollar amount per year or a percentage of the participant’s annual salary. The interest credit can be a fixed rate or a variable rate linked to an index. The specific details of a plan’s interest credit and pay credit are laid out in the plan document and must meet various legal requirements, such as not discriminating in favor of highly compensated employees.
The funding or assets for the cash balance plan are held in a pooled account. Each participant’s benefit is communicated in terms of a hypothetical account balance that grows with the pay credits and interest credits.
Why a plan sponsor might consider a cash balance plan
A cash balance plan design can be easier to understand than other pension plans, a feature that benefits both the plan sponsor and its employees. A cash balance plan can look and feel like a 401(k) plan design, which is already familiar to a lot of people. The simplicity in design makes
communicating the value of the benefit easy to understand and easy for participants to track the cash balance account growth.
Cash balance plans can serve as a strategic instrument for employee retention. Employers can leverage comprehensive retirement benefits, including cash balance plans, to not only attract but also retain seasoned talent within their workforce. By providing an appealing avenue for retirement savings, these plans encourage prolonged tenure among employees. With cash balance accruals credited annually, employees find motivation in witnessing the growth of their accounts, fostering a commitment to their current employment.
Employers may be able to achieve certain objectives and administrative advantages with the cash balance design. Take pay credits as an example. A flat pay credit (either flat dollar amount or flat percentage of pay) can be used for simplicity in communication and to make satisfying nondiscrimination testing requirements easier. Tiered pay credits can be used to give greater contributions to certain participants, such as those who have more service with the company. Benefit formulas must meet regulatory requirements like the aforementioned nondiscrimination testing, but there are options to suit a variety of employer goals.
Administratively, there tends to be fewer manual calculations due to the straightforward nature of the plan, which can also reduce the burden of monthly maintenance tasks. The features of these plans increase efficiency of plan administration, ensuring accurate and timely processing of participant transactions. Additionally, the simplicity of cash balance plans makes them more conducive to administering qualified domestic relations orders (QDROs), further simplifying the process for participants and plan administrators alike.
The contribution limits for a cash balance plan are higher than those for a 401(k) plan, so greater tax-deferred contributions can be made. If an employer offers both a cash balance plan and a 401(k) plan, the contribution limits are separate for the two plans, resulting in even greater tax deferral.
There are also options for the employer in terms of who bears the investment risk in a cash balance plan. If the interest crediting rate is set up as a fixed rate, the participant is protected from investment risk because their account is guaranteed to grow at the fixed rate each year. An alternative is a market-based cash balance plan where the interest crediting rate is linked to the plan’s asset return; in this case, much of the investment risk is transferred to the participant.
Plan assets are combined and professionally managed, so the participant isn’t responsible for making investment choices. Whether this is an advantage depends on who you ask. Some participants may see this as a negative if they prefer to manage their own investments and believe they could achieve higher investment returns in a 401(k) plan. Other participants may appreciate a guaranteed return (if the interest crediting rate is fixed) and not having to make investment decisions themselves.
Cash balance benefits are typically covered by the Pension Benefit Guaranty Corporation (PBGC), unlike 401(k) plans. This federal insurance protects participants’ benefits up to certain limits. Note that annual premiums must be paid by plans that are covered by the PBGC insurance.
Plan sponsors should also be aware that cash balance plans are subject to annual minimum funding requirements that are calculated under IRS rules, so employers don’t always get to choose how much to contribute to the plan in any given year.
How do participants benefit from cash balance plans?
Cash balance plans offer several benefits to participants, making them an attractive option for retirement planning. One of the key advantages is the transparency they provide. Unlike traditional defined benefit plans, where benefits are calculated based on complex formulas tied to years of service and salary history, cash balance plans offer individual account balances. This allows participants to easily track the growth of the balance over time and understand the factors influencing their benefits. This is something most participants can easily translate in their minds due to the similarities to DC plans.
Furthermore, cash balance plans typically provide detailed statements that break down contributions, interest credits, and account balances. This makes it easier for participants to understand how their savings are accumulating, providing a clear picture of their retirement income. This increased transparency can enhance financial literacy and empower employees to make more informed decisions about their retirement savings.
Cash balance plans offer flexibility in payment options to participants, accommodating diverse preferences and enhancing participants' ability to tailor their retirement benefits to best suit their individual needs and circumstances, ultimately promoting financial well-being in retirement. Plans are required to offer the option of receiving lifetime income through an annuity and typically allow participants to opt for a lump sum payout instead. This combination of mandatory and optional payment methods empowers participants to make decisions based on their unique circumstances and financial goals. For some, the stability and longevity of annuity payments may be preferable, offering a steady income stream throughout retirement. Others may prefer the liquidity and immediate access to funds provided by a lump sum payout, enabling them to pursue specific financial objectives or investments. An advantage to the lump sum option at termination of employment is the portability of the benefit. If the participant terminates prior to retirement, they can roll over the lump sum to an account of their choosing.
Although they are similar, perhaps the biggest difference between a cash balance plan and a 401(k) plan is a benefit to the participant; a cash balance plan typically doesn’t require employees to contribute part of their salary to participate. Participants must be vested in their cash balance benefits no later than after three years of service, which is a faster vesting schedule than the requirements for traditional DB plans.
What are Variable Annuity Pension Plans?
VAPPs have been around since the 1950s but interest has increased in recent years due to additional regulatory guidance.
In a basic VAPP, the participant earns benefits for each year of service with the employer. The benefit formula is typically a flat dollar or career average accrual. The benefits earned can move up or down each year based on the plan’s actual asset return, even after retirement. A target return rate is established in the plan and, if the actual return equals the target, then benefits do not change. Benefits increase if the actual asset return is greater than the target rate. Inversely, benefits decrease if the actual asset return is less than the target rate. The result is that plan assets and liabilities move up and down together and thus the plan stays fully funded regardless of current market conditions.
A disadvantage to the basic VAPP is that benefits decrease in years where asset return is less than the target. The Milliman Sustainable Income Plan (SIP) is a variation on the VAPP design that tackles this benefit volatility. In addition to having the regular VAPP features, including contribution and funded status stability, the SIP also includes downside protection for participants in retirement. The SIP does this by using a stabilization reserve that builds up excess assets in years of good asset return, to help cover participants’ benefits in future years when returns are less than the target. Thus, the SIP significantly reduces the chance that benefits would decline in down markets.
Why a plan sponsor might choose a VAPP
One of the most attractive features of a VAPP is that it stays fully funded in all market conditions. This removes the balance sheet volatility that is associated with many traditional DB plans. The contributions are more stable and predictable as the employer funds the benefits earned plus plan expenses. This eliminates the need for additional employer contribution amounts to make up for a funding shortfall.
Participants have PBGC protection for their benefits and the plan pays lower PBGC premiums due to being fully funded. One part of the PBGC insurance premium is a flat rate, based on participant head count, while another part is a variable rate based on the underfunded amount of the plan’s liabilities compared to its assets. A fully funded plan does not have to pay the variable rate portion.
To help meet their objectives, plan sponsors have design options when setting up a VAPP, such as using the stabilization reserve mentioned above to protect participants’ benefits from decreasing in retirement. A VAPP can have a floor and/or ceiling on the amount of asset return to consider when adjusting benefits, to provide more benefit stability.
Plan sponsors who implement a VAPP should note that participants may need initial education about the plan, as well as ongoing communication about benefit adjustments. A robust communication campaign in the beginning stages can help facilitate a successful transition to a VAPP.
How do participants benefit from a VAPP?
VAPPs offer several benefits to participants. Like plan sponsors, participants benefit from a VAPP’s feature of staying fully funded in all market conditions. This design provides participants with a reliable source of retirement income and removes the uncertainty that can be associated with other types of retirement plans. By sharing in the investment returns, it is more likely that the benefit will be available for the lifetime of the participants.
VAPPs also provide a lifetime benefit for participants in retirement and can include inflation protection. This ensures that participants' benefits will keep pace with the cost of living, providing them with a stable and secure income throughout their retirement based on actual economic conditions. Benefits can increase even in retirement. In addition, participants in VAPPs benefit from the professional management of investments in the plan. They don’t have to make individual investment decisions themselves, which can be a relief for those who prefer not to navigate the complexities of investment management.
Participant benefits have layers of protection. They are protected by the PBGC, and VAPPs with a stabilization reserve (as described above) offer protection against participants’ benefits decreasing in retirement, providing additional security.
Participants may find it easier to relate to VAPPs due to their familiarity with volatility in the market. The alignment of VAPPs with market dynamics can resonate with participants, as they may already be accustomed to navigating fluctuations in their personal investment portfolios or witnessing the impacts of market volatility on broader financial landscapes. By mirroring the ups and downs of the market, VAPPs provide participants with a tangible connection to the performance of their retirement savings, fostering a sense of engagement and understanding. Communicating the relationship between VAPPs and market volatility to plan participants is crucial. Fostering transparency and trust between plan sponsors and participants ensures that participants are fully aware of how their retirement benefits are structured and the factors that may influence their future payouts.
Which pension plan design to choose?
Both cash balance plans and VAPPs offer unique benefits to participants, making them attractive options for retirement planning.
When contemplating a new plan design, plan sponsors should first focus on the objectives they are trying to achieve as an organization. Particular goals may include increasing retirement income security for participants, reducing balance sheet volatility, attracting and retaining employees, or achieving more stable contribution patterns, just to name a few. Cash balance plans and VAPPs have both advantages and disadvantages, like any retirement plan, but one of these plans could be the design that fits the needs and goals of your company. The choice between the two will depend on individual circumstances, preferences, and the specific features of the plans you offer.
For more information on cash balance pension plans or Variable Annuity Pension Plans (VAPPs), or for assistance with finding the right retirement plan design for your organization, please contact your Milliman consultant.
[1] This article is an update of the May 2024 Milliman article, Two designs worth a look for corporate plan sponsors: Cash balance pension plans and Variable Annuity Pension Plans, available at https://www.milliman.com/en/insight/two-designs-corporate-plan-sponsors-cash-balance-variable-annuity-pension.
