A stabilization reserve could ease possible declines in VAPP benefits

The Variable Annuity Pension Plan (VAPP) is now the Milliman Sustainable Income PlanTM (SIP).

Variable annuity pension plans (VAPPs) have a lot going for them. They stay fully funded and have contribution and accounting stability like 401(k) plans. However, benefits increase or decrease depending on whether a plan’s investments return more or less than the set “hurdle rate.” With a basic VAPP, retirees will experience decreases in their benefits some years, but there is a benefit stabilization strategy that maintains the funding stability and dramatically diminishes benefit declines. Milliman’s Grant Camp and Kelly Coffing provide some perspective on this strategy in their article “Making the case for variable annuity pension plans (VAPPs).”

Here is an excerpt:

A stabilization reserve is built to keep benefits level during down markets. We call it the cap and shore-up method:

Build a stabilization reserve (by capping benefit increases in high return years).

A stabilization reserve could be developed in several ways. Two possibilities are described below:

  • Limit VAPP benefit increases to a certain maximum increase per year, say 10%. When the plan’s investment return would result in benefit adjustments greater than 10%, benefits would only increase by 10% and the excess return would be used to build a reserve.
  • Build the reserve with a portion of the return directly above the hurdle rate. For example, if the hurdle rate is 4%, do not provide benefit increases on the portion of the return between 4% and 5%. Benefits would only increase when returns are greater than 5%.

Spend the reserve in down markets to prevent benefit decreases (shoring-up benefits).

When benefits would otherwise decrease, use a portion of the stabilization reserve to prevent benefit reductions. The intent is to protect each retiree’s high-water mark (i.e., the highest level of monthly benefit received in retirement) to the greatest extent possible.

For example, if a retiree’s underlying VAPP benefit decreases from $1,000 to $900 per month, the stabilization reserve would provide $100 a month to shore up the benefit, maintaining a total benefit of $1,000 per month. The retiree has not had his benefit payment decrease.

The next year, the underlying VAPP benefit of $900 per month will be adjusted based on the plan’s investment return. If the underlying benefit exceeds the prior high-water mark of $1,000 per month, the underlying benefit is paid (this becomes the new high-water mark) and no payment is made from the reserve. However, if the underlying benefit is still less than the prior high-water mark, a portion would again be paid from the reserve.

Figure 4 from the article illustrates how a retiree’s basic VAPP benefit would have performed compared to a stabilized VAPP benefit from 1984 to 2013.

 

Leave a Reply