Benefits March 1, 2023

Defined Benefit Plans Live On as Older, Wise Neighbors, Where DC Plans Can Borrow Ideas

A plan sponsor, academics and pension benefit expert agree that defined benefit plans are largely on the way out, yet optimal pension features should survive.
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Art by Georgie McAusland

Although some have asserted the pension could roar again for private-sector workers, traditional final-pay pensions are effectively obsolete, as a plan design, in the corporate workplace, sources said.

Despite that, the final pay defined benefit plan—a workplace pension plan arranged to pay a vested participant retirement income for life based on salary at retirement or average salary—does have a bright future ahead, only not as a prevalent retirement solution in the future, explain academics and plan sponsor benefit experts.

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However, defined benefit plan features, designs and philosophy have powerful lasting effects for the future of defined contribution plan designs and therefore will live on well into the future, explains Judy Bobilya-Feher, chief financial officer, at Aunt Millie’s Bakeries.   

“[Defined benefit plans aren’t] necessarily dead or frozen like they’re said [to be] right now,” she says. “It maybe seems like they’re frozen but the concepts that we’re talking about for our retirees and [like in-plan] annuities [are] right into that world, so I don’t think they’re dead by any means.”

Informed by academic research in behavioral economics and experiences with workers, defined contribution plan sponsors have copied many features of defined benefit plans to improve employees retirement outcomes. As defined contribution and defined benefit retirement arrangements each have several significant flaws, both designs should borrow—like neighbors—from one another, says Feher.

The future for defined benefit plans requires not throwing out the DNA of pension plans. Instead some deliberate thinking from the retirement industry is required, wherein defined contribution plans must meet their predecessor retirement plans to bolster workers’ retirement outcomes, say sources.  

Greater ‘SECURITY’

The Secure 2.0 Act of 2022, a package of retirement reforms, made modest modifications to defined benefit plans.

“The basic story is the same: In the private sector, DB plans are going away and they’re never coming back,” says Alicia Munnell, director, at the Center for Retirement Research at Boston College and the Peter F. Drucker Professor of Management Sciences at Boston College’s Carroll School of Management. “I view [the SECURE 2.0 changes] as tiny and nothing really that will change the trajectory of these plans.”

The new legislation could curtail further defined benefit plans, explains Teresa Ghilarducci, professor of economics and policy analysis at the New School for Social Research.

SECURE 2.0 included more requirements for defined benefit plans with additional disclosure in the annual communications, says Ghilarducci. 

She seconded that neither of the SECURE laws, including the SECURE Act of 2019 made large or helpful changes for DB plans.

“SECURE 2.0 is more of the same: Congress for the past 20, 30 years now, really favoring defined contribution plans and really punishing defined benefit plans,” says Ghilarducci. “SECURE 2.0 gave a lot more requirements for defined benefit plans [and] there’s more disclosure in the annual communication.”

The 2022 bill did include some better guidance for “pension risk transfers and [some] other things, [but] I view them as tiny and nothing really that will change the trajectory of these plans,” says Munnell.  

The two retirement reform packages in the past three years plotted improvements to DC plans by adding into DC plans -features that make them operate more like defined benefit funds.   

Borrowing From  Pensions For 401(k)Plans   

Critical to porting over optimal DB features to DC plans to make them more useful is shared responsibility for workers’ retirement, with shared risk—between employer and workers for retirement. It is important to ensure that the  onus for decades of saving, investing through market volatility and finally, decumulation, is not solely on the shoulders of plan participants.

“One of my concerns [for future DB plans] would be heavily employer contribution related, and didn’t get a lot of participant contribution,” says Feher.

A plan design that blends participant salary deferrals and employer retirement contributions—in a plan designed with increased worker security, lower employer costs and higher total assets for workers—leading to a more optimal retirement outcome for workers by using defined benefit type features, but with greater portability would be ideal, adds Feher.   

The optimal retirement plan design is some combination of the best of both worlds: the portability of DC plans with the lifetime security offered by pensions in a plan design that creates risk-sharing for the bulk of contributions and investments, between employers and workers,  experts say.

“Ideally, [the U.S]  would want to move towards some system of risk sharing so that neither the employer nor the employee bore all the risks,” adds Munnell.

U.S. retirement plan designs could be informed by Canada and the Netherlands. Both countries provide national models, which the U.S. could borrow or follow, she says.  

“They do [share risk] in the Netherlands and Canada…but we don’t do it here and so we’ve got this extreme where we have DB plans [on one hand] where the employer bears all the risks and we have the [DC] plans where the employee bears all the risk,” explains Munnell.

Pension Prevalence

Workplace pension plans will persist in lesser numbers and be limited to certain industries, says Brett Dutton, head of investment strategy and analysis for nonprofit, pension and insurance solutions, at Vanguard Group.   

While corporate pension plan sponsors have reduced benefits, frozen and terminated defined benefit plans for private sector workers, public employees remain more likely to be eligible.   

“There are certain employers, certain industries, certain employer types, that recognize the long-term value of having a defined benefit plan—probably in conjunction with a defined contribution plan, not instead of the defined contribution plan—so believe that there is a long-term future for defined benefit, believe that some employers have recognized that it’s a valuable benefit to attract and [will use it to] retain highly motivated employees,” he says. “There is a long-term future for defined benefit plans, because some employers see it as a differentiation tool.”

Final salary pensions are expensive for employers because the plan sponsor must be able to pay out benefits to eligible beneficiaries, even after the lifetime of the plan participants.  

In February, LIMRA data showed 70% of retiree respondents said between Social Security, traditional pensions and annuities, they expect to have sufficient lifetime-guaranteed income to cover all their basic living expenses. However, workers without a traditional defined benefit pension will have to patch together their sources for guaranteed income in retirement.

“In the state [and] local area, we will continue to see defined benefit plans,” says Munnell. “The employer  [has a] broader [funding source] in the sense that it’s taxpayer and the workforce is less mobile and so it would seem a place where they can work.”

Defined benefit plan have advantages over defined contribution plan in three main ways, says Ghilarducci.

“You can’t opt out of the defined benefit plan,” she says. “If you work for an employer with one and you’re eligible you’re in, you’re a participant: you can’t opt out. And that means that you’re accruing credits or in the case of a DC plan, you’re accruing assets despite your yourself.”

In fact, she adds, “when I was a trustee of the Indiana Public Employees Retirement System, we let our participants save their money in the defined benefit system, so that they got the rate of return that the defined benefit system gets, which is about one or 2% higher than they could get elsewhere.”

Benefits March 1, 2023

Cash Balance Plans Gain in Popularity

Combining features of DB and DC plans, these hybrids especially appeal to small and midsize businesses.
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Art by Georgie McAusland

Cash balance retirement plans are the fastest-growing sector of the retirement plan market, with more than $1 trillion in assets nationwide, say findings from FuturePlan by Ascensus, a third-party administrator.

According to the “2020 National Cash Balance Research Report,” the firm’s most recent data, the number of new cash balance plans increased 17% from 2017 through 2018, versus just a 2% growth in new 401(k) plans. There are two factors driving the growth: 1) The plans provide a way for small to midsize businesses to receive a significant tax cut for employee contributions to the plan, and 2) they allow participants to accelerate retirement savings on a tax-advantaged basis beyond what they could put into a 401(k).

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FuturePlan defines cash balance plans offered by large businesses as those having more than 10,000 participants, but these plans generally are conversions from older, traditional defined benefit plans, the report says.

In a tight labor market, the cash balance plan’s benefits could also be a way to attract talent, as opposed to offering equity in a business, says Jerry Cicalese, senior vice president of strategic partnerships at Sentinel Group. As these plans become more popular, industry experts say, business owners looking to implement a plan or companies seeking to convert their traditional defined benefit plan must work to explain carefully these plans’ complexity and their pros and cons.

How Cash Balance Plans Work

Cash balance plans are defined benefit plans that accrue assets in two ways: a pay credit, which is the employer contribution, and a guaranteed interest credit rate, the mandated participant earnings, says Daniel Kravitz, FuturePlan’s cash balance practice leader. As with traditional defined benefit plans, the employer bears the risk of the investment performance.

The Department of Labor describes cash balance plans as a type of DB plan whose promised benefit resembles that of a defined contribution plan—i.e., having a stated account balance.

They’re often called hybrid plans because they have the look and feel of a DC plan, says Kristy Wrigley-Durer, senior counsel at law firm Crowell & Moring. The accounts are hypothetical, however, as payments are calculated based on a formula like any defined benefit plan.

Also like 401(k)s, the plans are portable, so participants may take their savings with them when they leave the employer and either roll the amount into an individual retirement account or a plan at their new employer. “Withdrawing yourself from a traditional DB plan is nearly impossible,” notes Bob Smith, president at Sage Advisory. “That portability is a major attraction for the cash balance plan.”

The Source of Cash Balance Growth

Big corporations with traditional DB plans have converted them to cash balance plans because the latter remove the interest-rate risk that led to the constantly changing value of liabilities in that traditional DB, the FuturePlan report says. Additionally, the cash balance plan structure allows for more consistent contributions to employees, rather than basing contributions by age. That also keeps business’s costs down as, under traditional plans, employee costs rose as workers neared retirement age.

FuturePlan’s research shows the greatest growth in cash balance plans to be in small to midsize businesses with fewer than 100 employees—especially, over the past seven years, in companies with fewer than 25 employees. Pension Benefit Guaranty Corporation coverage and fees start once more than 26 employees have enrolled in a cash balance plan, says Steve Sansone, a managing director at SageView Advisory Group.

Often, one of these plans is offered along with a 401(k) as another way for participants to save, income tax-deferred, beyond the DC plan’s combined employee/employer contribution limit—for 2023, $66,000. High-income participants in the cash balance plan could receive up to $300,000 in contributions on their behalf annually—up to $3 million over their lifetime, indexed to inflation

The plans are popular with professional service firms, such as those operated by doctors, lawyers, investment advisers or other professionals, where much of their income is taxed as ordinary income, Kravitz says.

Bob Smith, president of Sage Advisory Services, says a key reason for a small to midsize firm to offer a cash balance plan is it enables sheltering considerable taxable income beyond the 401(k) limits. The type of earner who profits from the tax-sheltering benefit is one who makes $300,000 or more. If the partnership or business owner can’t afford to take advantage of the income-tax savings, “then there’s no reason to have one [of the plans],” Smith says.

The lure of a cash balance plan is that high earners can accelerate tax-deferred savings, but to open a plan, the IRS requires that companies pass discrimination and coverage tests. To reap the biggest of the tax savings for their high earners, companies must be able to contribute 5% to 7.5% of employee compensation into a profit-sharing 401(k) that benefits all their employees, Sansone says.

“The owners are getting large deductions, but the rank and file are getting 7.5% of pay. It’s a very generous contribution,” he says.

Because these are Employee Retirement Income Security Act plans, they are sheltered from creditors in case of bankruptcy or lawsuit, Cicalese says.

Points to Consider With These Plans

Cash balance plans require actuarial work and cross-testing, making them about two to three times more costly than a 401(k) plan design, Sansone says. Contributions must be made annually, so the plans work only for firms that are consistently profitable—able to make the payments to all the employees; this is different than in a 401(k) plan where companies can easily freeze employer contributions.

Sansone says there are certain circumstances under which plans may be frozen. He did that for some plans in 2020, after COVID-19 hit, since plan participants hadn’t reached 1,000 hours of service for the year, which is one way to legally freeze contributions.

The plans are also legally binding. Kravitz says they must define the pay credit, which can be a percentage of pay or a fixed dollar amount, and specify the guaranteed interest crediting rate. Kravitz uses a 4% fixed crediting rate. For example, a medical group with a shareholder doctor may have a contribution credit of $250,000, and the employees receive a pay credit of 8%, plus a guaranteed return of 4%.

It’s hard to exactly hit the interest credit rate annually, so sometimes plans can be slightly over- or underfunded. If a plan is underfunded in a given year, there are a few options the company may use to bring the plan to full funding, including contributing more in a one-time payment to cover the shortfall, Sansone says.

Making up any shortfall is necessary because, if the plan runs into significant deficits, this affects portability, Smith says.

More recently, some plans have started using a variable crediting rate instead of the fixed crediting rate. Using a variable rate allows the plan to use the investment performance of its assets for a particular year vs. a fixed amount as the credit rate, Sansone says. This helps address the occasional underfunding. However, any shortfalls that do occur must be trued up when a plan participant leaves.

Since the costs to start and terminate a plan are high, business owners should plan to operate these plans for at least three to five years to make them economical, Sansone says. There is no formal IRS rule stating how long a cash balance plan must exist; the agency’s point of view is that the plans should have some permanency.

Cicalese says that’s why cash balance plans are for well-established businesses with a history and a pattern of earnings to support contributions. He says his firm designs these with the idea that they’ll be open for five years, while the maximum benefit to the participant comes by year 10. The plans have some flexibility; they can be frozen or amended if the benefits are too rich, and the plans may be terminated, but the IRS requires good reasons, he says.

“You need to go into this with the mindset that I’m going to make at least three years of required contributions,” he says.

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