There’s been a lot of talk in industry circles about the DB-ification of defined contribution plans, but some in the industry believe plan sponsors should instead change their defined benefit plans to be more like DC plans.
In the past decade, the stock market has dramatically shifted up and down a few times and interest rates have remained artificially low since the Great Recession, forcing many companies that offer pensions to underfund their plan liabilities. Many have started de-risking their plans by either closing them to new hires or by eliminating them all together by offering a lump-sum buyout or turning the plan’s assets into an annuity.
Larry Sher, partner with October Three Consulting, calls the shift to DC plans from DB plans “risk shifting” rather than de-risking. “Risk is being shifted from the employer in the DB plan,” he says. “The employer was taking on the investment rate risk and the longevity risk.”
Another option is a hybrid plan that adds some of the properties of DC plans – like being subject to market ups and downs – to a DB plan model. Cash balance plans have been around since the 1980s and more and more large companies are adopting them.
A cash balance pension plan is one in which an employer credits a plan participant’s account with a set percentage of his yearly compensation, plus interest. So the plan sponsor decides how much of a pay credit to deposit in a participant’s account, such as 5% of pay, and an interest credit, which is either a fixed or variable rate that is linked to an index such as the one-year Treasury bill rate. Ups and downs in the value of a plan’s investments don’t directly affect the benefit amounts promised to participants, thus, the investment risks are borne solely by the employer, according to the Department of Labor.
Sher advocates for what he calls “market-return” cash balance plans – plans in which the interest credits are based on real market rates of return, rather than bond yields.
Like defined contribution plans, market-return cash balance plans credit actual rates of return so they are going to go up and down with the market, but “legally, these plans have to provide a minimum return of 0%,” Sher says. If an employer credits a person’s account with $10,000, that balance can go up to $15,000 or down to $8,000, but the employer is still required to pay the minimum of $10,000 that was initially promised, no matter what happens with the market.
“It is something that behaves like a DC plan but has guarantees.”
“What is interesting is that once it is a DB plan, there are all kinds of design features that can be introduced,” he says. There is a minimum the law requires but after that, the plan is flexible. Employers can increase the minimum or share upside returns with their employees in some way. For instance, if assets earn 20% in a given year, employers could give employees 90% of that return.
“It is something that behaves like a DC plan but has guarantees,” Sher says.
These types of plans are more predictable for employers. They know how much they are giving into the plan and the costs to the employer are quite stable compared to a traditional defined benefit plan because “a lot of the investment ups and downs are absorbed and shared by employees,” Sher says.
These plans operate in tandem with 401(k) plans, Sher said. Some employees want the option of setting money aside for their own retirement savings. Unfortunately, plan participants can take money out of defined contribution plans to pay for things other than retirement, which Sher believes is a problem. Plan leakage doesn’t help anyone and does a very good job of reducing the retirement savings pot that many employees expect will last them throughout their retirement.
In a cash balance plan, the money stays in until the person retires and is paid out in the form of an annuity.
“DC plans are great for what they are really good at, but can we succeed if we do try to make them into something they were never intended to be and are not really very capable of becoming without a lot of disruption?” he asks. “The better approach is to allow them to do what they are really good at. Don’t force them to be what they aren’t. Go down the path of much less resistance and take the DB plan and convert it over to a market-return cash balance plan. You end up having something that looks very much like a DC plan and they complement each other.”
