Most defined benefit pension sponsors are facing a financial slug in the gut this year in the form of a spike in required funding contributions resulting from the 2007-2008 stock market crash and the drop in interest rates.
The average increase in net cash contributions for 874 corporate pensions polled will be 400%, according to a recent survey by Mercer, the giant consulting firm.
In theory, the funding burden won't be quite as brutal for many sponsors that, in recent years, shifted from final pay or career average payout formulas to cash balance or some other "hybrid" pension models.
Will this latest development ignite another uptick in conversions to hybrid pension designs that followed the enactment of the Pension Protection Act of 2006, the law that, among other things, validated the legitimacy of cash balance plans? Or will it simply push sponsors of traditional"DBs to pull the plug on their plans and move entirely to the 401(k) world? And might it even spur some longstanding cash balance sponsors go 100% defined contribution, as IBM did in 2008?
The answer, of course, is "it depends," because the companies for whom the decision was a no-brainer, or at least relatively uncomplicated, have already made their choice. Nevertheless, enough is happening on several fronts today to prompt some DB plan sponsors revisit those fundamental benefit strategy questions.
Rethinking plan designs
Evidence of rethinking was apparent in the results of another sponsor survey, by Hewitt, released in December. Half of the pension sponsors Hewitt polled reported they were considering freezing their DBs to existing members, versus only 17% when the prior survey had been conducted 18 months ago.
When asked about their current thoughts on plan design, as contrasted with 18 months earlier, 14% reported they were "more likely" to convert to cash balance, yet an equal percentage reported they were less likely to do so. Twenty-one percent reported they had already made the switch.
In its analysis of its survey results, released in February, Mercer drew a distinction between the current environment, and the last major market correction in 2000. Today's economic climate, combined with limited availability of credit, Mercer declares, "places many sponsors in a difficult position."
That's putting it mildly.
But why might cash balance sponsors be in any better of a position than sponsors of a career average or final pay plan today, even if only a little bit?
As Kevin Wagner, a retirement practice director for Towers Wyatt explains it, "cash balance plans typically have a lower asset base and lower liability for benefit payments [than traditional plans] since payments to terminated employees are made at the time of separation of service rather than for the life of the employee."
"This smaller asset base," he adds, "will have a lesser dollar change from poor asset performance."
Don Fuerst, a senior retirement consultant for Mercer, concurs. "If you go to a cash balance plan or pension equity plan, those will decrease your [cash flow volatility] somewhat - in the 20% to 30% range - but by no means eliminate it."
The picture may be more complicated than that for many sponsors, however. For example, if an employer only recently changed to a cash balance formula, it still carries all the liabilities for benefits accrued under the old plan, which will dwarf those accrued under the new formula.
In addition, Stewart D. Lawrence, Sibson Consulting's national retirement practice leader, points out that if a cash balance plan is less than 80% funded, it would not be permitted to make any lump-sum payments to departing employees before receiving a big enough cash infusion to get it above that 80% threshold.
That would also be the case for a similarly underfunded plan with a career average formula, Lawrence says. But the important difference is that, as noted earlier, the prime selling point of a cash balance plan to employees is precisely its ability to cash them out when they quit or retire. Most traditional pensions don't offer a lump sum payout option.
SunTrust among early converts
Among the companies that made that switch shortly after PPA's enactment was SunTrust Bank, whose conversion occurred on January 1, 2008. But that switch wasn't a knee-jerk response to Congress giving its blessings to the cash balance concept in the PPA. Executives had already essentially decided to make that change prior to PPA's enactment.
"We did slow our process [toward implementation] because we were confident Congress would act, and we wanted to know what the final rules would be," recalls Donna Lange, SunTrust's senior VP of corporate benefits.
In fact, cash balance plan sponsors are still waiting for IRS regulations that will add flesh to the legislative language of PPA - a frustration that may be keeping some sponsors of traditional DBs eyeing cash balance conversion waiting on the sidelines until those regs are issued later this year. Sponsors are particularly anxious to see the IRS's views on acceptable formulas for setting rates on minimum interest credits. Coca Cola set its 2010 crediting rate at 3.8%.
SunTrust employees with 20 or more years of service were allowed to stay in the original plan, although the bank "ratcheted down" their benefit accruals going forward, Lange says.
The pay credits under the formula SunTrust settled on range from 2.5% of pay to 5%, depending on the participant's age and length of service. The interest crediting rate is pegged to Treasuries, with a floor of 3%.
As typically occurs in a cash balance conversion, SunTrust beefed up its 401(k) to offset the effective reduction in pension benefits under the cash balance plan for some employee groups.
Why not make a clean break with the defined benefit world?
SunTrust just wasn't ready to do that. Not surprisingly, many of its financial services industry competitors still maintain a DB plan, Lange notes. Thus pulling the plug entirely on the DB might have put the company at a competitive disadvantage in recruiting talent.
Other hybrid designs
Companies that want to move right up to the DB-DC boundary (without stepping over it) to minimize their exposure to spiking liabilities can choose the "variable defined benefit" model. Fuerst is one of its key architects and biggest boosters. Mercer began promoting that pension model in 2005.
There is no free lunch, however. The reason the sponsor's liability is minimized, Fuerst explains, is because the size of retirees' pension annuity rises and falls with the investment performance of the underlying pension fund, thereby keeping assets and liabilities in balance. "But unlike with a 401(k) plan," Fuerst says, "you can never run out of money. There is an absolute guarantee of lifetime income, it's just that the amount might go down."
So far, however, the VDB hasn't exactly caught on fire. "The concern is that they aren't giving people that guarantee" of a predictable retirement annuity, Fuerst says. Still, he can point to two recent adoptions: one in the public sector, and another in the private sector.
If a VDB plan sounds too radical, it is also possible to sponsor, in effect, a watered-down VDB. One company that does is the 60-year-old El Secundo, Calif.-based Aerospace Corporation, a nonprofit entity.
From early in its history, the company has sponsored a DB plan that incorporates both a career-average benefit formula and a variable benefit component. The career average benefit accrues at about 0.5% of pay per year, as does (if all goes well) the variable portion.
That variable component, explains Charlotte Lazar-Morrison, the company's general manager for HR, is built around the assumption of a 4% annual return on the underlying pension portfolio. Variable pension credits are earned over time with dollar-equivalent values based on the fund's performance relative to that 4% benchmark. In effect, the pension is only 50% variable.
Once a year, retirees have the option to shift the variable component of their annuity, in effect, to a very conservative underlying portfolio with limited volatility. But Lazar-Morrison says that only about 10% of retirees have made that one-time, irreversible election. Presumably that's because they anticipate they'd pay for that stability with lower benefits over time.
Another kind of hybrid pension, the "pension equity plan," like the VDB, so far hasn't attracted many converts. "It's really a cash balance plan based on your final pay, as opposed to career pay," says Lawrence.
Lawrence sums up his assessment of the more exotic hybrids this way: "The problem with some of these intriguing designs is that they are intriguing to pension professionals, but confusing to participants."
Looking at the larger picture and the long-term disappearing act of the garden-variety pension, one hears relatively few appeals from actuaries to stick with the old model. Occasionally a survey will be issued pointing to the traditional (and expected) superior investment performance of DB assets versus that of the average 401(k) participant's account.
"It makes sense," says Wagner. "The people managing pension assets are professionals. The rest of us out here are just a bunch of rookies."
Interestingly, one such survey, released by Towers Watson in February, was striking in revealing how slim the margin of DB portfolios' oft-touted superior returns over 401(k)s were in 2008. Specifically, that survey showed average pension portfolios cratering by 25% that year versus a 26% average decline for 401(k) accounts.
One looming threat from Washington that may dampen any renewed interest in hybrids is The Retirement Fairness Act (H.R. 4126), proposed by Texas Democratic Congressman Lloyd Doggett. The measure would rewrite pension discrimination tests, and its implications for cash balance plans would be "devastating," warns Lawrence.
But Wagner says the big question that's looming for companies that have frozen their DB plans - with or without starting a hybrid plan - is "how to wind up those plans, get them off their balance sheet and get the obligation over to an insurance company to totally settle the obligation."
When that will occur, Fuerst says, will be greatly influenced by financial market performance. "Today, a lot of companies don't have enough money to make that a viable solution. But when companies can afford to settle those obligations, I think a lot of companies with frozen plans will do that."
Richard Stolz, a former EBN editor and publisher, is a freelance writer based in Rockville, Md.
