The word “pension” can mean so much more: recruitment, retention, reward, retirement.
In the “new” millennium this word has been rebranded, and has now become firmly linked to volatility and risk. Can pensions be duly unchained from this stigma?
What if year-to-year cash flows could be stabilized? What if the investment risk could be eased?
I know. I know. Hypotheticals are little more than devilishly idle hands. Corporations operate within practical realities.
But what if this was not hypothetical? Seriously: What if the volatility and risk could be significantly drawn down?
The challenge with a defined benefit (DB) plan is just that—the benefit is defined. The economy is fluid. Industries are dynamic. Yet “traditional” pension plans are intractable. Because the plan design does not respond well to an ever-changing business environment, a formidable challenge is left to the employer. Thus, corporations become exposed to volatility and risk.
One natural conclusion is that employers (and by extension, employees) need a pension plan in which the benefit is not so obstinately defined. In other words, the plan and the benefits it provides need to be flexible; they need to be able to adjust to the seemingly whimsical undulations of modern macroeconomics.
It turns out there are pension plan designs that do accommodate some flexibility, and some plan sponsors have started taking good, hard looks at these alternatives. There are a few variations on these new designs, which go by many names, including:
• Variable annuity pension plan
• Adjustable pension plan
• Variable benefit plan
Milliman’s work in this area includes the white paper “Variable annuities: A retirement plan design with less contribution volatility” and the blog article “Variable annuity plans may benefit employers and employees.”
Within a variable annuity pension structure, each participant’s total benefit annually rises or decreases based on the overall fund’s asset performance (this applies to both active and retired participants). This feature naturally results in a significant degree of pension responsiveness in adverse markets and imparts some inflation protection for retirees when returns are high.
Rather than varying the annual payment a retiree receives each year, a pension plan may change the amount that active participants accrue each year. Again, this adjustment in accrual rate would be based on asset performance in the prior year(s).
Under the variable accrual model, the plan document could even include a provision under which asset returns that are sufficiently poor (i.e., the portfolio return was negative for the prior year) would result in zero accruals that year. In this case, the plan would effectively be frozen during tough economic conditions. (This is similar to employers suspending 401[k] matches during the first years after the global financial crisis in 2008.)
With these alternative designs and the resulting responsiveness, a pension plan can keep up with the business needs of the employer and becomes much less volatile from a sponsor’s point of view.
Keep in mind that reduction of volatility is truly achieved on a plan-by-plan basis. The finer points of the plan design will vary depending on the needs and priorities of each plan sponsor. Details to consider include: investment allocation, size of the plan, maturity of the plan’s population, and specific plan sponsor concerns (i.e., financial reporting, contributions, Pension Benefit Guaranty Corporation [PBGC] premiums).
Whatever the particulars, a key takeaway is that within a defined benefit plan framework, risk can be shared between employer and employee. This seems a happy medium between the “all or nothing” risk distribution under traditional pensions and 401(k)-type defined contribution (DC) plans.
Over the last decade the question has been asked often and hotly debated: How can we get DC plans to “behave” more like DB plans? Usually this “behavior” refers to the lifetime income guarantee and retirement security that participants receive from a traditional pension.
To be fair, defined contribution plans have their own desirable qualities. Employer contributions to a 401(k) are typically a fixed percentage of salary each year, and with a 401(k) the employer is completely insulated from investment losses. Here we are back at volatility and risk.
Perhaps an equally poignant thought is: How can we get DB plans to behave more like DC plans? What would this entail? Answer: Give the plan sponsor more control over its cash flow responsibilities to the pension and lessen employer exposure to investment or interest rate risk. We can achieve both of these and also provide an adequate lifetime benefit by making pension benefits more flexible.
When external forces change, businesses adjust. So can pension plans. So should pension plans.