To Be, Or Not to Be, Using Defined Benefit Plans: Part II
In the first part of our series, we highlighted why hybrid defined benefit plans, commonly referred to as cash balance plans, are providing attractive possibilities to smaller companies and entrepreneurs, but in many larger companies, the traditional defined benefit plans are losing their appeal.
Unlike cash balance plans, traditional pension plans are designed to project benefits into the future, similar to Social Security. Using an assumed investment return rate and interest rate, actuaries determine a future value for the company’s contributions, which represents the contribution liability to fund lifetime annuity payments for each plan participant. As you can imagine, these assumptions tend to place financial stress on plan sponsors, particularly during unstable market environments and low interest rate environments. The volatility in funding requirements for traditional defined benefit plans has forced many plan sponsors to search for alternative retirement plan solutions, or seek an exit strategy entirely.
What has caused the push to leave traditional defined benefit plans?
Although the markets in 2013 ended on a positive note, the 2008 recession is still being felt across industries and companies, and many traditional defined benefit plans continue to be underfunded. The traditional defined benefit plan relies on market performance to help reduce the funding liability. Market volatility along with the low current interest rate environment has heightened the uncertainty and funding burden plan sponsors face. Large companies in particular feel the weight when looking at the volume of employees who are owed an annuity or lump sum once they retire.
In addition to market volatility concerns, the Pension Benefit Guarantee Corporation (PBGC) has increased the required annual premiums paid to insure participant benefits. Combining increased funding liability and increased premiums, defined benefit plan sponsors are looking for creative de-risking strategies as they plan for the future termination of their defined benefit plans.
Formerly used as a tool to retain and attract employees, the traditional defined benefit plan no longer carries the same appeal. In the current work environment, it is rare for an employee to stay with the same company for their entire career, so the potential for benefits is significantly smaller in a traditional defined benefit plan. Moreover, since these plans can’t be easily accessed or valued like a 401(k) plan, it is difficult for younger employees to appreciate and understand their value.
How do you effectively exit a defined benefit plan?
For companies interested in freezing or terminating their defined benefit plan, it is important to thoroughly formalize an exit strategy. Before a company can terminate a plan, it does not simply need to fund 100% of the assets it has agreed to pay to employees; it actually needs to be between 110% to 120% funded.
The first step is to reaching this funding goal is to reduce the plan’s investment portfolio by limiting the equity exposure and begin matching the liability duration to the fixed income duration. By taking this immunization approach, companies can better define the timeline for an exit strategy and feel more confident in reaching its plan termination goals.
It’s important to consult a retirement plan advisor to help with this transition as there are several ways to provide a more conservative approach and minimize the impact of market volatility. Moreover, there are expenses associated with terminating a plan that need to be accounted for and incorporated into the strategy.
In addition to developing an exit strategy, a critical next step is developing an alternative method to allocate the company’s benefit budget. Sitting down with a retirement-focused professional advisor can help your company determine how best to redeploy benefit dollars, but in general, there are typically three ways to go about the process:
- Deploy benefit dollars into a defined contribution plan. With the additional funds, your company may now have more flexibility within these plans to provide a greater contribution (employer match, profit sharing contribution, etc.) or additional incentives to encourage employees to save more.
- Develop a profit sharing plan. In the appropriate situation, profit sharing plans can help create a culture of ownership and encourage employees to see the link between their work and their reward by tying the contribution to company performance.
- Transition to a cash balance defined benefit plan. As described in our previous article, To Be, Or Not to Be, Using a Defined Benefit Plan: Part 1, cash balance plans can provide a great deal of benefits for key employees and business owners.
Of course, there are other alternatives or hybrid options that can work in tandem when restructuring or terminating a traditional defined benefit plan. Working with a retirement consultant can be a great asset not only in improving your bottom line (especially if you are struggling with a traditional defined benefit plan), but also in providing valuable benefits to attract and retain key employees.
If you are considering terminating or freezing your company’s current defined benefit plan, our Retirement Consulting Services team is available to help you through the process. Feel free to reach out to Paula Hendrickson, Director of Retirement Consulting Services, at 303.531.8100 to discuss your company’s specific financial situation.