Planning for retirement presents a host of risks for employees. Are they saving enough? Are their investments appropriate and efficient? Will they be able to retire when they want and in a manner they desire? Will their retirement assets last for the rest of their lives?
What, if anything, can an employer do to help?
Historically, many employers shouldered most of these kinds of risks by sponsoring traditional defined benefit (DB) pension plans, under which employers are responsible for making required contributions, investing assets, bearing investment risk, and paying annuity benefits to retirees.
In the 1980s, employers began to move away from such traditional pension plans in favor of defined contribution (DC) programs such as 401(k) plans. The movement has greatly accelerated since 2000, as weak stock market performance and all-time low interest rates have driven up costs. At least as problematic has been increased volatility of costs, due to jittery financial markets exacerbated by “mark-to-market” oriented changes in pension funding and accounting rules. Today, there is a widespread view that employers should no longer be in the business of underwriting retirement-related risks.
“Freeze, de-risk, DC” is not a panacea
The emerging consensus among retirement professionals today goes like this: “freeze, de-risk, DC.” The idea is that freezing the pension plan and implementing a DC plan avoids ongoing company risk; and the legacy risk can be mitigated by shifting asset allocation from stocks to bonds and, where not previously available, offering lump sum distribution options.
We understand why employers have pursued this strategy. The traditional DB approach is, for many of them, no longer viable in a global economy seeking more transparency and focused on volatility and risk. But we think that the “freeze, de-risk, DC” strategy may be a mistake and a missed opportunity, for several reasons.
First, freezing pension obligations does nothing in and of itself to address “legacy” benefits earned prior to the freeze – the assets and liabilities with respect to those benefits are still on the company’s books.
Second, “de-risking,” to the extent that it involves investing assets in a matching bond portfolio, forecloses entire asset classes and investment strategies. The likely result is weaker investment performance and increased (cash and accounting) costs.
Third, with interest rates at lower levels than any of us have seen in our lifetimes, any “de-risking” that involves either a significant commitment to bonds (as an asset-liability matching strategy) or adding a lump sum option (typically to deferred vesteds) may, in retrospect, be seen as very poor timing.
Thus, strictly from the point of view of the employer, we believe the “freeze, de-risk, DC” strategy is problematic. But when you take a broader view, the picture gets even worse.
Moving from a DB to a DC plan will ultimately move risks off company books. Where do those risks go? To employees. And there is mounting evidence that employees are not able to effectively manage those risks themselves – in some cases, the same risks the company can no longer tolerate. In fact, employees are probably worse at managing many retirement-related risks – and are more affected by them – than the company is.
And if you think of financing retirement as a company challenge – where the company is understood to include both the employer and its employees – making things better for the employer by making them worse for employees is not really a “win.”
Redefining retirement benefits
Cash balance plans have long been touted as “hybrid,” middle-ground designs. These plans feel like DC plans to employees, by expressing benefits as account balances. However, their growth was stifled by legal uncertainties beginning in the late 1990s. Moreover, they have enjoyed only limited success in curbing the volatility and unpredictability of pension costs for employers.
That’s changed. The Pension Protection Act (PPA) cleared the air on cash balance legal issues. More importantly, it provided, for the first time, a framework for rationally sharing and apportioning retirement-related risks, rather than simply shuttling them between employers and employees.
PPA-related proposed regulations published about a year ago explain how employers can provide cash balance “interest credits” based on “market rates of return.” The rates of return can be tied to external indexes, such as mutual funds, or may be based on the pension trust’s rates of return.
A pension plan design that takes advantage of this new paradigm – what we call a ReDefined Benefit (ReDB®) plan® – provides unique opportunities to both employers and employees. Fundamental to ReDB® design is a careful management, and alignment, of the relationship between the interest credits granted to employees and the returns on the plan’s assets. This alignment enables a ReDB® to produce steady, predictable costs, just like DC plans, without having to shift plan assets to a low-return, all bond portfolio, especially in today’s interest rate environment.
Unlike other designs, the ReDB® plan allows the employer to fine tune which risks and how much risk are transferred to employees. Some risks – like interest rate risk – that can be significant (even catastrophic) to the employer but are comparatively insignificant to the employee, may be best absorbed by employees. Other risks – like longevity risk – that are significant (even catastrophic) to the employee but (because of the size of the employee risk pool) are comparatively insignificant to the employer, may be retained by the employer.
Yet other risks – like investment risk – may be shared, with the employer providing institutional expertise and guarantees, while employees share in upside returns based on a formula of the employer’s choosing. Employer guarantees and plan expenses can be financed by capping the interest credit and/or crediting something less than the full “market rate of return” on account balances. A ReDB® can even vary interest credits among employees to reflect their different investment horizons.
But wait, there’s more
Compared with “freeze, de-risk, DC”, ReDB® plans enjoy several other advantages. Retirement investments are managed “institutionally” with resultant bottom line improvement in performance, producing higher benefits and/or lower costs. Also, ReDB® investment decisions are not constricted by “overfunding” risk – concern about overfunding frozen DB plans puts significant limits on how much “upside” risk can be undertaken.
A ReDB® plan can form a company’s core retirement program. In conjunction with employee 401(k) deferrals, which employees can use to tailor overall retirement savings and investing patterns to meet their individual needs, employers should consider this design as part of a broad de-risking strategy, a way to produce stable, predictable costs while still providing crucial help to employees as they plan for retirement.