Variable annuity designs: promise and pitfalls

While corporate America continues to move away from defined benefit (DB) plans, these designs have enjoyed a sharp uptick in popularity in some market segments in recent years. The trend is due in part to enabling legislation (the Pension Protection Act (PPA), enacted in 2006), which has sparked a wave of innovative plan design solutions.

Variable annuity plans (VAPs) are an example of an old design – prior to the Pension Protection Act of 2006 (PPA) the only significant guidance on these plans comes from Revenue Ruling 53-185, issued in 1953. VAPs have garnered a lot of interest in recent years, and deservedly so. This design provides an innovative approach to ‘risk sharing’ between employers and employees.

On their face, these plans look like traditional defined benefit plans, which define an annuity benefit payable at normal retirement age. The VAP wrinkle is that formula benefits are adjusted annually based on the return on plan assets compared to a ‘hurdle rate’ typically, 5%. For example, a participant with an accrued benefit of $10,000 in a VAP would see his benefit increase to $10,190 if plan assets earned 7% and the plan used a 5% hurdle rate [$10,000 x 1.07 / 1.05]. On the other hand, if assets earned only 3%, the benefit would be adjusted down to $9,810 [$10,000 x 1.03 / 1.05].

However, there are significant employer risks associated with this design, particularly when combined with a lump sum payment provision.

VAPs and lump sums: the big issue

Some consultants are positioning VAPs as, in essence, account balance plans that eliminate the risk to the sponsor of underfunding, regardless of how the plan’s assets are invested. If true, this obviously would be a very appealing design for many firms.

But this is a risky interpretation. Under current law, VAPs are required to ensure that lump sum benefits, if available, comply with ‘minimum lump sum’ rules based on market interest rates published monthly by the IRS. But the calculations are complex, particularly for VAPs, and the IRS has not been forthcoming to date with guidance on the issue.

Here’s the problem: VAPs track an ‘account balance’ that moves with plan assets, but, as mentioned above, they also define an ‘accrued benefit’ – an annuity at normal retirement age – that is adjusted based on plan asset returns above or below a ‘hurdle rate’.

So, a 40-year old employee with an ‘account balance’ of $321,516 has a corresponding age 65 annuity, based on a 5% hurdle rate, of $90,000. If the IRS ‘minimum lump sum’ interest rates are below 5% (like they were during the second half of 2012), the value of a $90,000 annuity at age 65 is greater – almost 18% greater ($378,438) based on July 2012 rates.

Even if market rates are above 5%, the minimum lump sum rules may be problematic due to expected increases in the plan’s annuity benefits related to future returns on assets above the hurdle rate. In this context, it is worth noting that plans that provide other forms of benefit indexing (such as a post-retirement cost-of-living adjustment) are required to reflect the value of such provisions in minimum lump sum calculations. Reflecting, for example, an 8% assumed rate of return in the example above produces a lump sum of almost $600,000, 85% more than the ‘account balance’.

There is a term for these calculations – “whipsaw” – which describes a two-step process of (a) projecting benefits to normal retirement age using one rate, then (b) discounting these amounts back to today using a lower rate. This concept has been successfully invoked over the past decade in favor of pension participants and to the detriment of plan sponsors.

Sponsors of VAP plans draw some comfort from favorable determination letters issued for these plans by the IRS. But these letters do little to protect against participant lawsuits, and that is where the real risk is.

It is not clear how willing employers are to take on the risk, and possible cost, of being required to pay lump sums that are significantly greater than the plan’s ‘account balance’, or how willing consultants are to indemnify sponsors against such risks.

Other VAP issues

Apart from the ‘lump sum’ uncertainty, VAP plans, as a practical matter, often fall short of the goal of eliminating sponsor underfunding risk. Two potential sources of asset/liability mismatches are:

Contribution timing lag. Generally, sponsors will need to understand the timing of benefit accruals based on plan document language and ensure that the timing and amount of contributions be ‘synced up’ with these provisions. This is one issue that many VAPs can overcome, but only with careful attention to document language and firm timing preferences.

Benefit distribution lag: Typically, pension distributions are not made until 2-3 weeks after they are calculated. This window creates a disconnect between assets and liabilities that can easily be 5%, given market fluctuations. This risk is eliminated under a plan that uses daily valuation, but we are unaware of the adoption of daily valuation among VAP designs.

Sparse guidance is another handicap for these designs. PPA clarified some issues (e.g. age discrimination requirements), but, outside of some fairly narrow issues, there remains little in the way of guidance for these plans.

As an example, consider the IRS interpretation of non-discrimination rules. The current IRS view is to calculate ‘accrual rates’ reflecting current plan experience. So, for example, if assets earn 12% in a year, a plan that indexes benefits based on this return may need to project benefits to retirement ages on this basis, producing massive instability in non-discrimination testing that could result in a plan failure.

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Bottom line: we think VAPs have some desirable risk sharing properties, but we have serious concerns about using these designs as vehicles for lump sum benefits tied to ‘account balances’.