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Planning for retirement presents a host of risks for employees. Are they saving enough? Are their investments appropriate and efficient? Will they retire when and how they desire? Will their retirement assets last for the rest of their lives? Explore alternative retirement strategies and help your employees navigate risk with our Market Based Cash Balance Plan.
Historically, many employers shouldered most of these risks by sponsoring traditional defined benefit (DB) pension plans. Under these plans, 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 traditional pension plans in favor of alternative retirement strategieslike401(k) plans. The movement has greatly accelerated since 2000, as weak stock market performance and all-time low interest rates have driven up costs. Increased volatility of costs, due to jittery financial markets exacerbated by “mark-to-market” oriented changes in pension funding and accounting rules have also proven problematic. Today, many believe that employers should no longer be in the business of underwriting retirement-related risks.
The emerging consensus among retirement professionals today is: “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.
Employers have pursued these alternative retirement strategies because the traditional DB approach is no longer viable in a global economy seeking more transparency and focused on volatility and risk. We think 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” by 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 lower than ever, 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.
As a result, from the employer’s point of view, the “freeze, de-risk, DC” strategy can be problematic. And when you take a broader view, the picture is even worse.
Moving from a DB to a DC plan will ultimately move risks off company books and onto employees. And there is mounting evidence that employees are unable to effectively manage those risks themselves. In some cases, these are the same risks the company can no longer tolerate. In fact, employees are probably worse at managing many retirement-related risks than companies are.
Financing retirement is 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 a “win.”
Cash balance plans have long been touted as “hybrid,” middle-ground designs. These plans feel like DC plans to employees because they express benefits as account balances. However, their growth was stifled by legal uncertainties beginning in the late 1990s. Moreover, they have enjoyed limited success in curbing the volatility and unpredictability of pension costs for employers.
That has 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, instead of shuttling them between employers and employees.
PPA-related proposed regulations published in 2011 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 can be based on the pension trust’s rates of return.
Alternative retirement strategies that take advantage of this new paradigm – what we call a Market Based Cash Balance Plan® provide unique opportunities to both employers and employees. Careful management and alignment of the relationship between the interest credits granted to employees and the returns on the plan’s assets is fundamental to an MBCB plan design. This alignment enables an MBCB plan to produce steady, predictable costs, just like DC plans, without having to shift plan assets to a low-return, all–bond portfolio.
Unlike other designs, the MBCB plan allows the employer to fine tune which risks and how much risk are transferred to employees. Interest rate risks can be significant (even catastrophic) to the employer but are comparatively insignificant to the employee. Risks like these may be best absorbed by employees. Other risks — like longevity risk — that are significant 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. The employer provides institutional expertise and guarantees, while employees share in upside returns based on the employer’s formula. 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. An MBCB plan can even vary interest credits among employees to reflect their different investment horizons.
Compared with “freeze, de-risk, DC”, MBCB plans have several other advantages. Retirement investments are managed “institutionally,” which results in bottom line performance improvements, higher benefits, and/or lower costs. Also, MBCB investment decisions are not constricted by “overfunding” risk – concern about overfunding frozen DB plans limits how much “upside” risk can be undertaken.
An MBCB 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. This design produces stable, predictable costs while providing crucial help to employees as they plan for retirement.
Rethink your retirement strategy and help employees navigate retirement risk. With October Three, you can:
Find long term solutions to your plan needs that align with your goals.
Have a partner to design a plan that meets your firm’s unique needs.
Get designs that take advantage of automation, reducing costs.
Contact us to learn more about alternative retirement strategies.