During the past 15 years, virtually every law firm in the Am Law 100 has adopted a defined benefit plan to provide their Partners with enhanced retirement benefits. While each Firm may have different objectives for what they wish to accomplish, certain general themes are shared when it comes to key design considerations.
- Flexibility around who is covered by the plan and the level of benefits provided within the eligible group are paramount.
- The annual contribution/cost for each participant should be clearly identifiable – each Partner should pay only for his or her own benefit.
- Financial risks related to investment volatility, interest rate volatility, and retiree longevity should be minimized to the extent possible, producing predictable annual contributions year over year and minimum exposure to unfunded liabilities over time.
- Plan sponsors want to avoid regulatory uncertainty, especially with regards to key issues such as general nondiscrimination testing, age discrimination, etc.
- Simplicity, ease of understanding and access to information must be provided without sacrificing any of the key considerations listed above.
Understandably, some plan design structures accomplish these objectives more effectively than others. In this article, we will examine those structures most prevalent among major law firms and rank each on how well it addresses these important issues.
Career Average or Final Average Pay Plans (Traditional DB)
As defined benefit plans were initially introduced to the law firm community, Traditional DB Plans that have been used in Corporate America for decades seemed like a natural choice to provide increased benefits to Partners. Unfortunately these “legacy designs” were less than perfect in many ways.
- Some degree of design flexibility does exist with this structure (different groups of Partners can accrue benefits at different rates). However, by its very nature the plan is focused on lifetime benefits at retirement age, and the value or cost of a particular Partner’s accrual will change each year to reflect numerous factors (age, compensation, etc.).
- Identifying and allocating costs to the various Partners is complex and inefficient. While the cost of the current year’s accrual can be calculated with some precision, the impact of interest rate or other assumption changes on past accruals is also absorbed by the Firm (and therefore its Partners) and is not easily communicated to the affected parties. Also, any increases in cost related to former Partners who have left their benefit in the plan must be absorbed by the remaining Partners.
- Benefits are defined as an annuity, but most often the preferred benefit payment option is a lump sum. This causes the plan to be subject to interest rate risk – as interest rates change, so does the lump sum value. This phenomenon has created a great deal of concern as Firms are seeing plan costs related to lump sum distributions skyrocket as interest rates have declined. Furthermore, since benefits are not aligned in any way with changes in the value of the underlying assets, investment risk is introduced when asset returns do not match the internal actuarial rate of return.
- Communicating benefits in a way that can be easily understood and appreciated is challenging at best. This is an issue corporate plan sponsors have struggled with for years and is a major reason why many have moved away from defined benefit plans in favor of defined contribution plans.
Overall, this type of structure scores one out of four stars (*) – although it can be used to accrue significant benefits for Partners, it is difficult to assign costs equitably and is subject to a tremendous degree of risk from a variety of sources.
Why should the firm take on these additional complexities and risk when other options are available?
Variable Annuity Plans (VAP)
These structures trace their existence back to a few pre-ERISA Revenue Rulings. While seldom used in a corporate setting, they gained some initial popularity with several law firms about 15 years ago. However, after the passage of the Pension Protection Act of 2006, (PPA), many firms decided to shut down their VAP due to continued uncertainty about how the plans complied with PPA and the subsequent Hybrid Plan regulations. The core issues surrounding these designs continue to be significant.
- On the surface, they can deliver many of the characteristics Firms are looking for, namely flexibility to provide different levels of benefits to different groups of Partners; the ability to easily charge Partners for the cost of the benefits they earn each year; and the reduced exposure to risks such as investment risk, interest rate risk and longevity risk.
- However, despite these attributes, the delivery of these benefits is provided via an extremely complicated structure that may or may not comply with current law and regulations. There is so little guidance on how these plans comply with the current regulatory environment. Plan sponsors must continue to rely on a single IRS Revenue Ruling issued over 40 years ago.
- Most of the VAPs utilized by large law firms face a number of thorny regulatory issues, including age discrimination claims and non-discrimination testing problems. It raises the simple question of why a Firm would want to take on these additional complexities and risks when other options are available that deliver the same benefit promise with the full backing of current laws and regulations?
- When a firm decides to terminate one of these plans, additional problems arise. Upon termination, participants have the right to receive their payment in the form of a variable annuity. While most participants generally elect to take a lump sum, if a participant elects a variable annuity, it is very difficult (if not impossible) to settle such an annuity promise with an insurance company. This can be a real problem for plan sponsors in a termination scenario.
Overall, this type of structure scores two out of four stars (**) – although it goes a step beyond the Traditional DB Plan by reducing investment risk and providing a better cost allocation process, the underlying “legislative” risk, the reliance on an extremely complex design construct, and the inability to easily terminate the plan makes the design less attractive than other options more prevalent in the marketplace today.
First Generation Cash Balance (CB) Plans
Cash Balance Plans have without question, been the most popular design structure for law firm defined benefit plans over the past 10 years. The basic CB design has most of the important attributes plan sponsors are seeking, but does not effectively address one important area – managing contribution volatility.
- Design flexibility and cost allocation are optimal – benefits accrue as a specific “credit” to participant accounts each year, making it easy to assign the cost of the plan among the various Partners so each is responsible for his or her own benefit.
- Benefits are generally paid out in terms of a lump sum, so at termination or retirement, there are no conversion issues and thus no interest rate or longevity risk.
- The shortcoming of the original CB design is the presence of investment risk – the impact of the annual “mismatch” between the plan’s specified interest crediting rate on the account balances and the actual return on the underlying plan assets.
- Most Firms set the interest crediting rate equal to the 30 year treasury rate as published by the IRS each year. While many plan sponsors employ an investment strategy designed to “meet or beat” this rate each year, the reality is that investment volatility still exists (underlying assets behave differently than plan liabilities).
- This became most evident as Firms struggled with the financial turmoil of 2008 and 2009. Many that believed they were “conservatively” invested experienced 25-35% investment losses, causing substantial increases in contribution requirements for Partners at a time when the entire economy was struggling.
- In an effort to avoid a repeat of this scenario, some plan sponsors adopted investment strategies aimed at precisely matching the plan’s specified interest crediting rate year over year. While this may make sense from a loss prevention perspective, the cost to achieve this can be extremely high and underlying investment volatility may be reduced, but it is certainly not eliminated.
Overall, the CB Plan design structure scores three out of four stars (***) – it avoids the regulatory uncertainty of the VAP, and is far easier to understand and communicate than either the Traditional DB Plan or VAP. The down side is the continued presence of investment risk – the inability to efficiently and effectively create an asset strategy that exactly matches the movements of the underlying plan liabilities.
Market Return CB designs are structured so that firms can invest the pension assets the way they want.
The Next Generation Cash Balance (Market Return CB) Plans
The Market Return CB Plan design is the latest evolution of the cash balance structure, quickly becoming the design of choice for most major law firms. In addition to delivering all the positive features of the initial CB Plan, this design structure addresses investment risk by taking full advantage of the flexibility afforded under PPA and subsequent hybrid plan regulations.
- Rather than attempting to develop an investment strategy that will match the way the liabilities move, the Market Return CB plan is structured so that plan sponsors can invest the pension assets to reflect their specific risk tolerance. The plan’s “interest crediting rate” – the rate used to “grow” the cash balance account each year — is then based directly on the performance of the plan’s underlying assets.
- In this way, the liabilities now move in tandem with the plan assets, up or down. Not only does this design structure substantially eliminate investment risk, it frees up plan sponsors to adopt investment strategies that make sense for the Firm and are not driven by an annual goal to achieve a pre-determined “bogey” each year that has little or nothing to do with their objectives for the plan.
Market Return CB plans score an impressive four out of four stars (****) – they represent a superior design for large law firm Partner retirement plans as they address all the key considerations Firms look for.
- Benefit levels can be designed to meet the needs of the individual Partners as well as the Firm as a whole;
- Each Partner’s annual cost is tied directly to his or her cash balance credit;
- Investment risk, interest rate risk, and longevity risk are minimized if not totally eliminated;
- Predictable annual contributions are provided year over year; and
- Through recent technological advances, benefits can be communicated in the same fashion as the Firm’s 401(k)/Profit Sharing Plan.
If your retirement plan is not a “four star” plan, we would welcome the opportunity to speak with you about moving to a more current design structure. Contact October Three for additional information.