Variable/Adjustable Pension Plans

There is a new defined benefit (DB) plan design that can be used for any plan type—public, multiemployer or single employer. However, single-employer pension plan sponsors have reporting requirements that highlight the need for an alternative plan design.

There has been a lot of interest lately in new pension plan designs. Many employers are interested because:

• When employers face the change to defined contribution (DC) plans, they typically face issues of cost and stability. We have developed a way to deal with these issues in a DB plan.
• Changing to a DC plan adds long-term costs due to an aging workforce. The workforce ages because of an inability to retire with guaranteed income and the added costs come from increased disability and health care costs. In some industries, this is more pronounced than in others.
• Changing to a DC plan hurts mid-career employees more than others as the employer shifts money away from older workers to provide a higher level of benefits to younger workers.

For single-employer pension plans, the Pension Protection Act of 2006 (PPA) added a great deal of volatility to the cost of providing pension benefits to employees. PPA added required interest rates and mortality tables, which change the cost of benefits each year. So when an employer designs a plan with the actuary, it knows the cost of providing the benefits for this year but not in future years. How many companies are willing to write a blank check like that?

Many firms have resurrected the variable annuity plan that was first introduced in the 1950s. As with every plan design, it has its pros and cons, and there are people who favor the plan and some who don’t.

One of the issues brought up with the variable annuity plan is the risk of not knowing what the future will bring and the potential for a sudden drop in benefits during retirement at a time when the retiree may not be able to handle the drop. This fear led to the development of a new plan design which adjusts future accrual rates rather than accrued benefits.

The Adjustable Accrual Rate Plan provides the employer with a fixed contribution amount so it can budget for future contributions and provides fixed guaranteed income for life to retirees so they can retire and not worry about running out of money. How can this be done? Let’s go through a sample plan and see how it works.

With the adjustable plan, the employer determines the contribution rate it is comfortable with. The actuary then runs the covered population through a valuation model to determine the cost of providing benefits. For discussion, let’s assume the employer will contribute 6% of pay each year to the pension plan and this level of contribution will buy an annual benefit of 1% of pay. This will work for the first year but not in future years due to changing interest rates, mortality projections and demographics.

When the IRS publishes the new interest rates and mortality tables, a new valuation is run to estimate the liability for the following year and the assets are projected to the end of the year. A new valuation is also run to estimate funding percentage of the plan as well as the impact on costs. The accrual rate (in this case 1% of pay) is reset to ensure the expected contributions will meet the annual cost of the plan.

So, if there is an investment loss and the funding percentage drops, more of the contributions will be needed to shore up the pension fund and less will be available for benefits. This will cause the accrual rate to drop. Similarly, if interest rates drop, the cost of providing additional benefits will increase, so the accrual rate will drop to keep the costs in check with the contributions. For discussion purposes, let’s assume the accrual rate drops to 0.9% of pay to protect the contribution level. If a participant earns $60,000 in year one and $62,000 in year two, the accrued benefit they would have earned after two years is $1,158 (.01 x $60,000 + .009 x $62,000). As you can see, the initial benefit accrual is unchanged and only future benefits are affected.

Of course, if the opposite occurs, we see an investment gain or interest rates increase, the future accrual rate will increase.

The plan design is simple enough in design but addresses many concerns of employers and even actuaries when it comes to dealing with these new pension plans.

Risk Mitigation: The design not only addresses the investment risk as is done with variable annuity plans, but also addresses interest rate risk, mortality risk and all other assumptions used by the actuary since the focus is on the funded status of the plan and not just the investment return.

Valuation: The plan is relatively easy to value—assuming the plan sponsor does not create many different pools of participants with different contribution rates and different benefit accrual rates. With variable annuity plans, it is not very clear how to value a single-employer pension plan due to using mandated interest rates rather than the actuaries’ best estimate. In this design, the valuation works exactly the same as any other plan

Design Options: As with any plan design, there are many options that can be added. With this plan design, some additional options include:

• Capping the annual change in accrual rate;
• Capping the highest allowable accrual;
• Putting a floor on lowest allowable accrual;
• Setting a targeted funding percentage (typically 100% to 120%); and
• Having an amortization period to spread out unfunded liability or surplus assets (not greater the IRS required period but may be shorter).

Richard Hudson, FSA (rhudson@factuarial.com) is a consulting actuary with First Actuarial Consulting Inc. (FACT). He has more than 30 years of experience working with pension plans and, since the passage of PPA, has been using his engineering background to develop financial forecast models and plan designs to help employers and employees address the U.S. retirement crisis.