This article was originally published in October 2014. It was updated in January 2017 to reflect nomenclature change. Thanks go to Jessica Gardner, Scott Preppernau, and Frank Thoen for these updates.
A basic variable annuity pension plan (VAP) maximizes a participant’s retirement income for each dollar of contribution, provides lifelong (although potentially volatile) benefits to participants, and does so without the contribution and accounting volatility that has plagued plan sponsors of traditional defined benefit (DB) plans. A Milliman Sustainable Income Plan™ (SIP) design enhances the VAP by virtually eliminating the possibility of benefits decreasing in retirement, which provides secure and increasing retirement benefit payments to participants while maintaining predictable employer contributions. Now that we have a retirement plan design that addresses the needs of both participants and plan sponsors, we need to address how a plan sponsor can move to a SIP.
Whether a plan sponsor currently offers a DB plan, a defined contribution (DC) plan, or both, or even if an employer doesn't have a retirement plan at all, a SIP is a rational, sustainable choice that maximizes the benefit provided for each dollar of employer contribution at a stable and predictable cost.
SIP from scratch
If an employer doesn’t currently offer any plan to employees, but wants to, a SIP is a great choice. Employers that provide retirement plans have a competitive edge in hiring and retention, allowing them to attract and keep the best employees. SIPs maximize the retirement benefits resulting from employer contributions, offer retirement security to employees, and provide stable costs that won’t jeopardize the company’s profitability. With no traditional DB plan liability, each year’s contribution simply pays for the benefits earned by the employees in that year. Because a SIP eliminates funding surprises, the future contribution requirements will be stable and predictable—very much like a DC plan. Under a SIP, benefits that are stable will encourage orderly retirements by allowing employees to retire with a meaningful and secure lifelong benefit, which will ease workforce management concerns.
DC to SIP
If an employer currently offers a DC plan, there are several ways to transition to a SIP that range from immediate termination of the DC plan, maintaining both a SIP and a DC plan, and converting the DC plan into a SIP. Each of these options is discussed further below.
Terminating the DC plan
If an employer would like to maintain only one retirement plan and would like to start a SIP, it could choose to terminate its DC plan. In a termination situation, employees may roll their assets into an individual retirement account (IRA) or other tax-qualified investment and retain the assets for retirement. However, employees would also have the option of taking all or part of their DC savings as cash, which would deplete their retirement savings and may eventually lead to workforce management issues if they cannot retire as they near retirement age because of insufficient personal savings.
Maintaining both a SIP and a DC plan
A SIP works very well in combination with a DC plan. Although DC plans alone do not provide the same level of retirement security for each dollar of contribution compared to a DB plan, DC plans help facilitate the traditional three-legged stool of retirement security (which consists of Social Security, an employer-sponsored retirement plan, and individual savings) by providing a convenient and tax-advantaged way for employees to build their individual savings. As a result, many plan sponsors will wish to maintain their current DC plans, but will decrease or eliminate employer contributions to them. In general, plan sponsors will either allow only employee contributions to the DC plan going forward, or provide a small matching contribution to help employees build their individual savings by encouraging them to contribute to the DC plan.
In either case, the addition of a SIP will build better retirement security for participants, through professional asset management, lower expenses, and longevity pooling. A SIP provides lifelong income that will allow participants to retire with confidence. Under a SIP, employer contributions will be stable and predictable, just like they are in a DC plan.
DB to SIP
If you currently offer a DB plan, whether it is open, closed, or frozen, converting to a SIP can provide all of the advantages that led you to provide a DB plan in the first place, but without the funding and accounting volatility that you have no doubt experienced over the years.
Because SIP benefits do not meaningfully increase the risk to employers, opening a closed or frozen DB plan to new accruals is a way to continue to provide lifelong income to employees in the most cost-efficient manner without adding any contribution or balance sheet volatility.
If you have an open DB plan and it is not causing you headaches now, you may think that converting to a SIP is unnecessary. However, as plans mature, DB risks increase dramatically (because the contribution becomes ever smaller compared to the size of the plan), making funding volatility large compared with payroll. Market downturns and yield curve volatility can result in very large contribution requirements that may eventually rival the operating budget of the entire company. Over time this burden can distract from core business needs and even impact the viability of a business. In the last decade, underfunding of traditional pension plans helped push many plan sponsors to the brink of, or even into, bankruptcy. It is clearly undesirable for a retirement plan to have the ability to bankrupt a plan sponsor, but as a traditional DB plan matures, that is the situation many plan sponsors find themselves in.
Because SIPs stay fully funded over time (regardless of investment returns or the assumed interest rates used to determine plan liabilities), the size of the plan is not a driver of the size of the contribution requirement. The SIP contribution is only tied to the benefits earned in that year by the current active employees. Once funded, that year’s accrual will remain funded for the life of the plan. Note that a well-designed SIP will maintain a small reserve to absorb demographic gains and losses, future assumption changes, and benefit payment timing mismatches during the year, before benefits are adjusted.
As participants begin SIP accruals, the risks of the current traditional DB plan are eliminated one year at a time. It will take many years to move the entire plan to a SIP design. During this time, any legacy liability still subjects the employer to all the risks it currently faces but new risk is not added. There are several strategies to mitigate this legacy risk from the current design.
- Current DB benefits could be converted to SIP benefits. This would require funding the opening SIP benefits at the hurdle rate or setting the opening SIP benefits lower than the current DB benefits and allowing the traditional benefit to wear away.
- The assets backing the legacy liability could be invested in such a way as to reduce risk. The liabilities could be backed by bonds either by immunizing the liabilities or dedicating bonds to match cash flows. This is an expensive option currently with interest rates at historically low levels, but may become more appealing if the economic environment changes in the future.
- Terminate and allow lump sums or annuities to be purchased to settle the legacy liability. This, also, is currently an expensive option because of the low interest rate environment. However, plan sponsors have the option of offering lump-sum windows to groups of participants in order to decrease the size of the pension plan while also saving on future administrative cost and Pension Benefit Guaranty Corporation (PBGC) premiums.
As the SIP benefits account for a larger portion of the plan, stability and sustainability will become a reality.
Regardless of an employer’s current retirement program, SIPs offer a balanced approach to retirement risk that should be seriously considered by employers who want to provide meaningful lifelong retirement income to their employees. By insulating the employer from market risks and pooling longevity risk for participants, SIPs provide controllable employer costs, like DC plans, and they provide employees with lifelong retirement income, like DB plans.