Actuary Makes the Case for Variable Benefit Plans

Variable benefit plans are a type of defined benefit (DB) plan and have been around for decades, according to Matt Klein, a principal and leader of the actuarial services practice at employee benefits consulting firm Findley Davies in Cleveland.

However, few sponsors and retirement plan advisers know much about them, he says, estimating that there are fewer than 100 of these types of plans in the United States. Nonetheless, he believes that sponsors and retirement plan advisers might be interested in them since they shift the investment risk off of the sponsor’s shoulders onto the participant’s—while moving the longevity risk over to the sponsor.

Employers continue to shut down their pension plans, redeploying their employees into defined contribution (DC) plans, Klein notes. But unless participants are automatically enrolled into their DC plan at meaningful deferral rates into an appropriate qualified default investment alternative (QDIA), most DC participants fail to make appropriate investment and deferral decisions, he says. The DC system fails to properly prepare most people for retirement, he says.

A variable benefit plan is a type of pension plan that, unlike a traditional DB plan that promises a set return every year, fluctuates with the market, he explains. Hence the name variable benefit.

“Sponsors interested in a comprehensive benefits package that will be able to provide employees with a comfortable retirement might want to consider a variable benefits plan, which eliminates the traditional risks associated with defined benefit plans and provides a stable cost and contribution policy that fits better with companies’ goals and objective in the 21^st century,” Klein says.

In a traditional DB plan, the employer takes on the investment risk, he explains. But when a pension plan faces a market correction, such as the 2008 financial crisis, assets decrease significantly while participants’ promised benefits remain intact, requiring the sponsor to make additional contributions to fund the plan at the precise time when they are typically facing a recession, Klein notes.

NEXT: Accrual and hurdle rates

Like a traditional DB plans, a variable benefit plan uses an accrual rate whereby the sponsor contributes a percentage of each participant’s salary to the plan each year and ensures that the assets are professionally managed. Unlike a traditional DB plan, however, a variable benefit plan establishes a hurdle rate, which is the percentage return goal for each year, Klein says. If the returns are actually higher than the bogey hurdle rate, the sponsor can increase the participants’ benefits—but if it is lower, they can reduce the benefits, Klein says.

“You would invest the assets in a variable benefit plan very differently than a traditional DB plan,” he says. “A lot of traditional DB plans are doing some sort of asset/liability matching or glide path strategy, matching bonds to expected cash flows coming out of the plan. With a variable benefit plan, you don’t have the downside risk keeping employers up at night. One way to approach investing in a variable benefit plan is to treat it like an endowment while still being cognizant of the downside risk.”

From the participants’ perspective, the key benefit of a variable benefit plan is that, like a traditional DB plan, when they retire, they receive an annuity that pays them a set monthly income, as opposed to a lump sum they would receive from a DC plan or even a cash balance plan, Klein notes.

He believes that because DC plans are so prevalent today, sponsors and participants are now accustomed to variable returns—and the fact that their balances could decrease—and that they might be more receptive to variable benefit plans.

“Part of my passion here is to try and educate employers and advisers that these plans do exist,” he says. “They meet all of the legal hurdles and requirements of the IRS, DOL and ERISA. They are a win/win for both plan sponsors and plan participants while splitting the investment and longevity risks between the employer and the participant.”

An additional reason why an employer might consider a variable benefit plan is that, unlike traditional pension plans that are typically underfunded and that require DB plan sponsors to pay 3% of their underfunding each year to the Pension Benefit Guaranty Corporation (PBGC), variable benefit plans remain 100% or very close to 100% funded. The reason for this is that the benefits rise or decrease as the plan’s returns exceed, meet or fall below the hurdle rate, Klein says. Therefore, variable benefit plan sponsors do not have to pay the annual penalty to the PBGC, only the minimal per-head cost, he says.

Findley Davies has created a white paper outlining the benefits of variable benefit, DB, DC and cash balance plans, titled, “The Future of Retirement Plans: Variable Benefit Plans.”  The paper makes the case that variable benefit plans strike the right balance between investment, interest or inflation, and mortality risk.