Variable Benefit Plans a Solution for All Types of Plan Sponsors

Plan sponsors and others in the retirement plan industry have been showing an increased interest in new defined benefit (DB) plan designs that minimize cost volatility and/or provide risk sharing.

During a recent webinar on the subject, Rachel Barnes, a member of the pension committee at the American Academy of Actuaries, noted that many corporate plan sponsors have been taking steps to transfer or eliminate their traditional DB plan obligations. While some have moved to a defined contribution (DC) plan as their retirement benefit offering, others question whether these are adequate for securing optimal retirement outcomes. This concern has been driving increasing interest in other plan designs, such as variable annuity plans, also known as variable benefit plans.

Barnes said variable benefit plans offer predictable contributions for plan sponsors, protection against inflation and guaranteed income for participants.

Corporate Plan Sponsors

Lee Gold, a member of the retirement system assessment and policy committee at the academy, said there are different types of variable benefit plans to help plan sponsors meet various objectives.

In addition to the features Barnes noted, Gold said he hears other reasons plan sponsors are interested in these plans, including that they allow the full employee base to participate and that employees are not left to make savings and investment decisions on their own as they are in a DC plan. In addition, “being able to tell a candidate, ‘We still have a pension plan that provides lifetime income,’ can provide recruiting and retention value,” Gold said.

Variable benefit plans are not new; they were introduced in the 1950s. With a pure variable benefit plan, liabilities and assets stay 100% in sync all the time, Gold said. Benefits are adjusted monthly, and each monthly payment adjustment is 100% aligned with investment performance. He said he is not aware of a plan sponsor that has adopted a pure variable benefit plan, mostly because of the administrative headache of adjusting benefits monthly. “We see a move to annual adjustments,” he said.

“Plan sponsors are using different flavors of variable benefit plans to try to achieve benefits stabilization,” Gold continued. “Some plan sponsors have reintroduced ‘fixed’ benefits for some of the benefit payments and are using benefit indexing versus actual asset matching and taking different investment approaches. The reason for the desire for benefits stabilization is it can be very troubling if a benefit fixed at retirement gets adjusted down,” he said.

As an example, Gold noted that a variable benefit plan could have a target benefit of 1.5% of pay for each year of service that will be adjusted based on investment returns; however, a plan sponsor could put in a floor or a ceiling on the adjustment, so that the return for determining a downward benefit adjustment will never be less than X% and a return for determining an upward benefit adjustment will never be more than Y%.

When using a floor or ceiling, if investment returns are below the floor, the plan will have an unfunded liability, and if returns are above the ceiling, the plan will have a surplus to apply to a benefit stabilization reserve, Gold explained. “The theory is that over time, plan funding will balance out,” he said.

Sometimes, instructions for using the stabilization reserve are codified in the plan document, but other times they’re discretionary, Gold said. The reserve could be used to limit downward benefit adjustments in the future. Plan sponsors can also consider allocating the reserve to those who really need it. For example, Gold said, a retiree would need benefit support more than a younger employee.

In a variable benefit plan, benefits are adjusted each year in relation to a “hurdle rate” defined by the plan sponsors for asset returns. If the asset return equals the hurdle rate, there is no adjustment to the participant’s accrued benefit. If the asset return exceeds the hurdle rate, accrued benefits are increased proportionately. If the asset return is below the hurdle rate, accrued benefits are decreased proportionately.

Gold said he sees plan sponsors using split hurdle rates. For example, benefits adjust down if returns are below 4.5%; benefits adjust up if returns are above 5.5%; and there is no change in benefits if returns are between 4.5% and 5.5%. The issue with this is the law says if a plan uses a hurdle rate below 5%, it is not a statutory hybrid plan—kicking in a three-year vesting schedule versus a five-year vesting schedule. Gold said he doesn’t know if using split hurdle rates as in the example would cause the plan to not be considered a statutory hybrid plan.

As for different investment approaches, variable benefit plans have traditionally used a single pool of assets for all participants, according to Gold. However, some plan sponsors are now creating an active pool of assets and a retiree pool. The active pool is likely invested more aggressively. More recently, he said, plan sponsors are considering a target-date approach, in which participants are grouped by year of birth to determine which asset allocation pool they belong to.

Multiemployer Plan Sponsors

Mariah Becker, a member of the academy’s multiemployer plans committee, said corporate plan sponsors aren’t the only ones using or considering the variable benefit plan design.

She noted that the Major League Baseball (MLB) retirement plan is a multiemployer plan and has been a variable benefit plan since inception. “Variable benefit plans have been around a long time, and there is real interest in these plans going forward,” she said.

Multiemployer plan sponsors consider variable benefit plan designs for similar reasons as corporate DB plan sponsors, but they bring some different perspectives to the table, Becker said.

“The discussion of plan designs comes up as part of collective bargaining, usually when withdrawal liability is a concern or when benefits go down a lot, like they did during the 2008/2009 recession,” she said. “Contribution rates for multiemployer plans have nearly doubled since then. At the same time, these plans have matured, so there is a concern about withdrawal liability being higher.”

Becker explained that withdrawal liability can affect plan sponsors’ access to credit, but there is also a recommendation before accounting standards entities to require withdrawal liability to be reported as a line item on employer’s financial statements. These two factors are driving plan sponsors’ fears.

From a union perspective, variable benefit plans are an alternative to a DC plan; allow for lump-sum payments versus a lifetime income stream; allow for benefit variability for active, retired and terminated, vested participants; and allow risks to be mitigated through plan design. From an employer perspective, these plans offer level and predictable funding and managed withdrawal liability exposure.

Becker talked through the example of the United Food and Commercial Workers (UFCW) National Fund, which included Kroger and Albertsons as members. They were among the three largest employers in the fund that successfully negotiated a withdrawal and started a variable benefit plan. In this case, they paid withdrawal liability settlements to the multiemployer plan in upfront lump sums.

Features of the new variable benefit plan included:

• A floor benefit plus a variable benefit component;
• A hurdle rate equal to 5.5%;
• Returns in excess of 7% going toward a fund stabilization reserve; and
• Withdrawing employers contributing a total of $45 million to a prefund transition reserve for certain grandfathered participants.

Becker said that with this conservative approach, the new plan could end up with a substantial reserve.

Moving from a multiemployer plan to a variable benefit plan brings different considerations than plan sponsors might face when moving from a traditional corporate DB plan, Becker said. Plan sponsors moving from multiemployer plans might need to consider whether the variable plan will be a part of the old plan or separate. If it’s a part of the old plan, do employers have to withdraw to use the variable benefit formula? And how will withdrawal liability be paid? She noted that communication is also more complex as there are multiple employer members.

Public Plan Sponsors

Tom Vicente, member of the American Academy of Actuaries’ Public Plans Committee, discussed how variable benefit plans can be a solution to concerns for public plan sponsors. As with other plan sponsor types, public plan sponsors are attracted to variable benefit plans for their ability to reduce contribution volatility.

The plan designs also help public plan sponsors manage balance sheet deficits. Vicente said this addresses concerns about the credit rating of the state or locality, and it helps avoid public criticism of the plan and the use of taxpayer dollars. Variable benefit plans also make costs and risks clear to all interested parties, aiding in transparency efforts.

Currently, there are three approaches in the design of variable benefit plans in the public sector, according to Vicente.

With a benefits gain-sharing plan, design benefits only get adjusted up and the adjustment is triggered when a preset metric exceeds its target. He said this is most often applied to post-employment adjustments.

Vicente shared the example of the Arizona public safety retirement system. The cost of living adjustment (COLA) is tied to the plan’s funded ratio and is 0% if the ratio is less than 70%, 2% if the ratio is more than 90%, and it uses a sliding scale in between 70% and 90%. Public plans in Maryland and Louisiana also use a variable benefit plan design, with the COLAs tied to investment returns in Maryland and tied to investment returns, funded ratio and the Consumer Price Index (CPI) in Louisiana.

In a benefits risk-sharing plan design, benefits can be adjusted up or down, which can impact accruing benefits for active participants or post-employment benefits. Vicente said this plan design is used in Wisconsin and South Dakota. Wisconsin uses an annuity reserve account concept—if the reserve exceeds the benefit value, benefits increase, and if it is less than the benefit value, benefits decrease. He added that the state uses five-year smoothing of benefits adjustments and a floor on how much benefits will decrease.

Also currently in place is a costs risk-sharing plan design, by which participants experience higher or lower costs for the plan. There might be caps, thresholds and ranges for costs borne by participants, and plan sponsors typically use some smoothing of costs over a period of time to avoid frequent changes.

Vicente said this type of plan design is used by some plans in California and Wisconsin. For the plans in California, active participants pay 50% of the normal cost of the plan, subject to caps. In Wisconsin, active participants pay 50% of the actuarially determined contribution.

The unique considerations for public plan sponsors that would like to adopt a variable benefit plan design include local laws and regulations (e.g., contract laws). These can prevent change for existing participants, leading to a long transition from an old plan to the new plan or to multiple benefit tiers to administer within the plan.

As with all plan sponsor types, public plans need to determine whether the cost of moving to a variable benefit plan design is feasible and whether it is worth the advantages that might be gained.