Are Traditional Defined Benefit Plans Coming Back as Variable Annuity Pension Plans?

Plan sponsors have moved away from the Traditional Defined Benefit (DB) Plan because of the cost and risks in maintaining these plans.

What is a Traditional Defined Plan?

A Traditional Defined Benefit Plan defines the retirement benefit as a monthly annuity based on a formula which is often a percentage of compensation (or average compensation) for each year of service with the employer. A lump sum distribution option may be provided where the payment amount is determined based on mandated fluctuating interest rates set by the IRS.

What is a Variable Annuity Pension Plan?

A Variable Annuity Pension Plan (VAPP) is a defined benefit plan where benefits increase or decrease based on the return of the plan assets. Operationally, the plan defines an assumed investment rate, which is referred to as the Hurdle Rate (HR). If the investment return on plan assets is equal to the HR, the plan becomes exactly like a Traditional DB Plan. If the actual investment return is more or less than the HR, all benefits earned to date are adjusted to reflect the fluctuation. Every participant, including those receiving a pension, will be subject to investment fluctuations. As a result, retirees may experience annual benefit increases or decreases.

Recently, a union in the hospitality industry replaced their existing 401(k) Profit Sharing Plan with a VAPP to provide meaningful benefits to their members with contribution stability for the contributing employers. The investment risk is shared by the plan sponsors and the participants. With favorable investment returns, participants can expect greater accrued benefits. Further, plan assets are pooled and generally professionally managed.

When Congress took action by adding 401(k) Plan provisions to the Internal Revenue Code about 40 years ago, the original intent was to create a plan design to provide supplemental benefits. The industry trend, however, was to move the pension liability from the plan sponsor to participants. This movement replaced the Traditional DB Plan with the 401(k) Plan to provide substantially all the benefits a participant will have available at retirement.

The 401(k) plan benefits participants that electively defer a portion of their compensation in a disproportionate manner compared to those who do not defer at all (i.e., because of their own deferrals and employer-matching contributions). Even with automatic enrollment and employer-matched contributions based on elective deferrals and profit sharing contributions, the 401(k) Plan may be underutilized. Further, participants may not have the training, interest, or time to manage investments effectively. Finally, a 401(k) Plan cannot provide a guaranteed stream of income for life without a transfer and purchase of an annuity contract from an insurance carrier.

As a result, saving only through a 401(k) Plan may not be sufficient to secure the retirement years. By sharing the retirement investment risk with employers, active participants, vested terminated participants and retirees, the VAPP in combination with a 401(k) Profit Sharing Plan may be the answer to a more secure retirement.

Contact William Nusblat ([email protected]) if you are interested in learning more, or if you think the VAPP may be a good fit for your organization.