The ultimate custom-designed solution for managing pension risk

Managing risk is currently top of mind for corporate pension plan sponsors. That’s especially true right now, as passage of the American Rescue Plan Act of 2021 (ARPA) has given sponsors more breathing room to reassess their risk management strategies and decide on the best ways forward.

With the growing popularity of pension risk transfer making headlines in recent months, plan sponsors looking to manage risk might be tempted to offload their liabilities to third-party insurers.¹ They might be considering freezing their defined benefit (DB) pension plans and relying on defined contribution (DC) plans, or de-risking via a glide path or liability-driven investment strategy. By jumping straight to these types of solutions, however, plan sponsors are ignoring what should be the crucial first step in managing risk: choosing the right plan design.

Plan participants also face increased uncertainty, particularly those benefiting only under DC plans. In addition to having to choose among an array of investment options, they face the very real risk of outliving their money into retirement.

Corporate pension plan sponsors have more options than they might think when it comes to retirement plans. No one plan works exactly the same for every employer, but by embracing the flexibility and customization options that come with hybrid plans—such as cash balance plans and variable annuity pension plans (VAPPs)—employers can create retirement incentives that meet their specific financial and human resources goals while balancing risk, weathering market volatility, and providing secure lifetime income protection for plan participants.

What are hybrid plans?

Hybrid plans share certain aspects of both DB and DC plans. Because of their unique mix of features and flexible designs, hybrid plans tend to balance risk more equitably between plan sponsors and participants than either traditional DB plans or DC plans. Plan sponsors working with their advisors can fit their unique needs with those of plan participants, forming the ultimate customized plan design under which risk is shared by both. In this article, we focus on two major types of hybrid plans and compare their distinctive features and advantages with those offered by more traditional DB plans. We also point out some key differences between what we typically think of as cash balance plans and VAPPs, including the Milliman Sustainable Income Plan® (SIP).

Cash balance plans

One of the best-known types of hybrid plans, cash balance plans are becoming an increasingly popular choice for employers offering pension plans. According to industry research, new cash balance plans increased 17% in 2020—compared with just 2% growth for 401(k) plans—and now make up 42.1% of all defined benefit plans.²

In a cash balance plan, employers pay contributions each year into participants’ (hypothetical) accounts, and the participants also receive investment returns based on a predetermined benchmark rate that is usually linked to bond indices, such as the 30-year Treasury, and can also be linked to actual investment returns, like VAPPs. A cash balance plan is a DB plan in that the plan sponsor bears the responsibility of investing the assets and paying the participants a defined amount. But it differs from a traditional DB plan in that the payout is structured more like that of a DC plan, with the benefit expressed as a total account balance rather than an annuity paid out at the end of an employee’s career.³

While small and midsize businesses in particular have embraced cash balance plans, larger companies have also shown increased interest in this type of hybrid plan over a more traditional DB plan. Among the 14% of Fortune 500 employers that offered a DB plan to salaried new hires in 2019, 71% offered a cash balance plan while only 18% offered a traditional final average pay plan; the remaining sponsors offered alternative DB plan designs.⁴

Variable annuity pension plans (VAPPs)

Reflecting the need for additional alternatives to traditional DB plans, another hybrid variant has been generating interest in recent years. VAPPs adjust participants’ benefits each year based on the investment returns of the plan’s assets. In this way, VAPPs can remain well funded regardless of market conditions (neither investment returns nor bond yield curves cause underfunding), and they combine the guaranteed lifelong income protection characteristic of DB plans with the stable costs for employers offered by DC plans such as 401(k)s.

A distinctive feature of a VAPP is the “hurdle rate,” an internal rate (generally between 3% and 5%) included within the plan’s provisions. Participant benefits fluctuate each year according to the difference between investment returns and the hurdle rate. If returns exceed the hurdle rate, benefits increase; if they don’t, benefits go down. Unlike most traditional DB plans or even a cash balance plan, VAPPs are expected to provide some protection against inflation. Returns in excess of the hurdle rate will grow the benefit over time, providing participants with benefit increases even during retirement.⁵

Since 2014, when the Internal Revenue Service (IRS) issued regulations providing guidance for hybrid pension plans,⁶ employers have had more options when it comes to modifying VAPPs as their chosen plan design. Many VAPPs are Sustainable Income Plans (SIPs), which include a stabilization reserve, where a portion of investment returns in good years are held back to prevent benefits from decreasing in years when the hurdle rate is not met. In order to fund a stabilization reserve, SIPs typically establish a cap on returns. Investment returns that exceed the cap are automatically placed in reserve to provide downside protection in leaner years.

How hybrid plans can work for both plan sponsors and participants

Even as passage of ARPA has given plan sponsors some breathing room in the form of increased pension relief, concerns about rising inflation may provide additional motivation for many employers to reassess their pension risk management strategy. Hybrid plan designs offer a solution for plan sponsors that may be concerned about the sustainability of their current pension plans, but still believe DB plans are the best option for providing real retirement security for their employees.

In contrast with traditional DB plans, hybrid plan designs are extraordinarily flexible tools that can be designed to fit an individual employer’s needs. While many cash balance plans offer benefits in the form of lump sums rather than annuities, and VAPPs usually provide for annuities rather than lump sums, both options are allowable within each plan—along with many other customization options.

Similarly, hybrid plans offer guaranteed lifetime income to plan participants concerned with eventually spending down account balances during retirement.

In the end, an effectively designed hybrid plan meets the particular needs of the plan sponsor and participants. It balances risk equitably between employer and employees, reduces the risk of underfunding, can protect participants’ benefits against the effects of inflation, and goes a long way toward protecting both sides from market volatility.

More equitable distribution of risk

In traditional DB plans, the plan sponsor bears the weight of the major risks associated with retirement plans. These include (1) investment risk, the risk that the value of plan assets will decline due to market losses; (2) interest rate risk, whereby lower interest rates bring pension liabilities up and create volatile funding requirements; and (3) longevity risk, the risk of not knowing how long plan participants will live. DC plans, on the other hand, shift the full weight of investment and longevity risks to plan participants. In DC plans, participants are responsible for investing their account balances and managing withdrawals during their retirement.

A hybrid plan balances retirement risk more equitably between plan sponsors and participants. In a cash balance plan, the plan sponsor is responsible for investing the plan’s assets and paying participants a defined benefit (similar to a traditional DB plan). Assuming the sponsor employs basic asset-liability management strategies to mitigate investment risk, this type of plan can result in fully secured benefits with limited market risk for either participants or the plan sponsor.⁷ In a SIP, retirement risk is balanced even more carefully. Interest rate risk is essentially eliminated, which ensures that plan liabilities stay predictable over time. The inclusion of a stabilization reserve provides additional downside protection for both plan sponsors and participants.

Of course, it’s impossible to eliminate risk entirely, and there’s always the possibility that plan participants can collectively outlive the actuarial tables. Though hybrid plans require employers to bear the weight of such longevity risk, pooling large groups of participants together allows mortality experience to become more predictable. Plan sponsors will find this a very manageable risk compared with the substantial volatility involved with investment returns and interest rates.

Lower cost and reduced underfunding risk for plan sponsors

The cost of hybrid plans for plan sponsors can be less than for traditional DB plans. While in final average pay DB plans, the amount of compensation in a pension plan is determined by a formula including a final average salary—usually the last few years of an employee’s career, or the highest-paid years—the cash balance plan and VAPP designs are based on a career average pay accrual pattern. This benefit accrual pattern generally remains steady throughout the employee’s career, helping employers avoid the higher-cost leveraging effects of traditional DB plans, a particular concern currently due to uncertain inflation expectations.

In the case of a VAPP, which insulates plan sponsors from investment risk and interest rate risk, the plan remains fully funded in all market environments, with assets and liabilities remaining at the same level. This equilibrium ensures that sponsors avoid Pension Benefit Guaranty Corporation (PBGC) premiums associated with underfunding. As a result, sponsors get to make predictable contributions and enjoy increased stability of accounting results without worrying about market volatility.⁸

Lifelong income protection for participants

Employers want to sponsor a retirement benefit that meets their human resources objectives while keeping their costs and liabilities manageable. Pension plan participants want a benefit that’s not only meaningful but is going to be there into retirement. A hybrid plan can meet both of these standards.

With the prevalence of 401(k) and other DC plans in today’s retirement market, a majority of Americans face the risk of not having any guaranteed income in retirement. Cash balance plans, although they resemble DC plans in some aspects, provide greater security for plan participants. Because cash balance plans are still DB plans, participants can elect to receive their benefits as a stream of annuity payments rather than a lump sum payout upon retirement.⁹

Participants in a stabilized VAPP get the same secure lifelong income protection that a DB plan offers, but they receive an added benefit of some expected protection from inflation even in retirement. As plan assets are typically invested with a target return that is higher than the hurdle rate, excess returns can be expected to drive growth in the benefit over the years that continues during retirement, helping retirees meet rising medical costs and cost-of-living expenses affected by inflation.¹⁰

Hybrid plans can work for everyone

The idea that cash balance plans, variable annuity pension plans, and other hybrid options work best for small businesses is swiftly becoming outdated. Because of their flexible structure and array of options, hybrid plans can work just as well for businesses with 10 to 15 plan participants as for those with thousands, particularly plans reflecting collectively bargained benefits.

When it comes to pension risk management, plan sponsors would do well to start with the plan design phase first, rather than jumping right to freezing plans, transferring risk, or relying solely on DC plans. This is especially true in the current climate, with the additional pension relief measures put in place by ARPA.

With solid guidance and expertise, plan sponsors need to look beyond traditional DB plans and find the exact platform that works for them, based on their risk tolerance and their specific needs as well as risk sharing with plan participants. The ultimate flexible and well-designed hybrid plan will better balance risk between employers and participants, guard against market volatility, and provide genuine lifetime income protection for participants when they need it most.

¹Light, L. (May 25, 2021). Special Report: Will Pension Risk Transfers Someday Control All DB Plans? Chief Investment Officer. Retrieved September 30, 2021, from https://www.ai-cio.com/news/special-report-will-pension-risk-transfers-someday-control-all-db-plans/.

²FuturePlan. National Cash Balance Research Report 2020. Retrieved September 30, 2021, from https://www.cashbalancedesign.com/resources/research-report/.

³Bottelli, R. and Wadia, Z. (2010). Cash Balance Renaissance. Benefits Quarterly. Retrieved September 30, 2021, from https://www.milliman.com/-/media/milliman/importedfiles/uploadedfiles/insight/eb-published/cashbalancerenaissancepdf.ashx.

⁴McFarland, B. (June 25, 2020). Retirement offerings in the Fortune 500: 1998-2019. Willis Towers Watson. Retrieved September 30, 2021, from https://www.willistowerswatson.com/en-US/Insights/2020/06/retirement-offerings-in-the-fortune-500-1998-2019.

⁵Camp, G. (January 30, 2014). A balanced approach to retirement risk. Milliman Retirement Town Hall. Retrieved September 30, 2021.

⁶Federal Register. Additional Rules Regarding Hybrid Retirement Plans: A Rule by the Internal Revenue Service on 09/19/2014. Retrieved September 30, 2021, from https://www.federalregister.gov/documents/2014/09/19/2014-22293/additional-rules-regarding-hybrid-retirement-plans

⁷Bottelli, & Wadia, op cit.

⁸Coffing, K. and Camp, G. (2015). Can Stabilized Variability Annuity Pensions Deliver? Workspan. Retrieved September 30, 2021, from https://www.milliman.com/-/media/milliman/importedfiles/uploadedfiles/insight/2015/workspan-vapps.ashx.

⁹Bonsee, P. and Wadia, Z. (2010). Cash Balance Plans Provide Practical Option for Today’s Retirement Environment. The Spark Journal, Vol. 20, No. 3. Retrieved September 30, 2021, from https://us.milliman.com/-/media/milliman/importedfiles/uploadedfiles/insight/eb-published/cashbalanceplansprovidepdf.ashx.

¹⁰Camp, G. (January 30, 2014), op cit.