Attention to defined benefit plans has been increasing, as plan sponsors determine what benefits can attract and retain employees—not to mention what strategies can best help participants prepare for their golden years. DB plan consultants have suggested that sponsors consider alternatives to the traditional DB plan, such as cash balance or variable rate plans, to eliminate funded status volatility concerns. During the 2023 DB Summit, a webinar PLANADVISER presented in March, speakers explored the prospective role of DB plans in Americans’ retirement security. Topics probed were long-term investing, decisionmaking factors, pension risk transfer and alternative DB plan designs. Coverage of two sessions follows.

Alternative DB Plan Designs

A DB cash balance plan is an account paid into by the employer yet operating similarly to a 401(k) plan for participants; these plans also give retiring or terminated employees the option of a lifetime income annuity or lump-sum payout. Thanks to the reversal of an IRS interpretation of wording in the Pension Protection Act now allowing for plan payouts to align with employee tenure, companies may start considering DB cash balance plans again, said John Lowell, a partner and consulting actuary at October Three Consulting LLC. 

Of late, many organizations were either ignoring this plan option or freezing the cash balance plan they had because “they couldn’t stand the volatility” in managing it, due to market fluctuations, Lowell said. The plans also had a major disadvantage—regulation forbade them to vary the retirement income check based on tenure. 

“It’s very technical, but essentially [regulators] said almost any cash balance design you have with a variable interest crediting rate has to have back-pay credits,” Lowell said. “That means that if you give a 5% pay credit to a person who’s 20 years old, you have to give a 5% pay credit to a person who’s 60 years old. You can’t have any variability.” 

Under the PPA, cash balance plans tended to have graded pay credits. To return to that more attractive option, Lowell said, industry players were told they needed a Congressional fix. 

SECURE 2.0 Does It 

That fix came with passage of the SECURE—for Setting Every Community Up for Retirement Enhancement—2.0 Act this past December. It allowed plan sponsors to assume an interest credit that is what the act called a “reasonable” rate of return—as much as 6%. 

“What that does is now say that participants can get a market rate of return on a basket of investments that they can invest in, in just the regular world or in their defined contribution plan,” Lowell said. 

For sponsors, if they know what the rates of return will be, they can hedge those by making the same or similar investments, he explained. This is key, because a sponsor’s plan assets and liabilities can track each other, essentially de-risking the plan and providing costs that are as stable and predictable as a 401(k) plan or a profit-sharing plan. 

“There’s really no difference from an employer’s standpoint in terms of cash flow perspective,” Lowell said. “But, from the employee standpoint, there’s an awful lot you get, from your choice of a lump sum in almost all plans to an annuity at fair prices.” 

Variable Benefit Plans 

Another trend in the DB space is what Steve Mendelsohn, pension director at Zenith-American Solutions Inc., called variable pension plans, which reduce risk to the funding sponsor. These types of plans have “struck a chord with Taft-Hartley” trustees, or multiemployer benefit trusts, he said. 

There are two types of variable plans, said Richard Hudson, consulting actuary at First Actuarial Consulting Inc. In one, the participant’s end-benefit fluctuates depending on market returns. This type “generally shows its benefit in terms of shares in the plan,” Hudson said. “A benefit formula might be $100 per month per years of service for one person, to pay whatever it might be; you take that benefit, and you convert it to a number of shares.” 

Those share values will increase and decrease each year with the investment performance trust fund, Hudson noted. One concern is that anyone retiring during a market downturn could lose 20% of his benefit. To offset that, some plans set up a reserve to protect retirees from a downturn. Either way, this market-tied defined benefit may be a challenge for sponsors to manage due to market fluctuation. 

In the second scenario, the employee will get a fixed contribution; what will change are the future accruals within the trust, Hudson said. “The general idea of this plan is to provide the employee with a fixed contribution,” he said. This plan is “not subject to volatility and ensures that the contribution is sufficient by adjusting for future benefits. It then allocates those dollars between newer pools and underfunding in the plan and paying that off.” 

These plans do have drawbacks, said Hudson. Those include the necessity to design the plans without the designer knowing the future investment market; there are also some gray areas as to how the IRS values variable benefit plans. 

In the end, sponsors can go back and forth while weighing benefits of the two designs, Hudson said, “but ultimately, the deciding factor will be: ‘What can we communicate to our participants? And what will they understand?’ That decides which plan you’re going to deal with long term.” 

Long-Term Investing

Given the volatile stock market and high interest rates, pension plan sponsors may want to consider custom, liability-driven investment strategies, according to the panel of experts. 

Mike Gheen, a vice president and director of retirement plan services at Oswald Financial Inc., said investment managers need to create customized portfolios that match pension plan sponsors’ particular liabilities. 

While sponsors can buy off-the-shelf products, Gheen said, these may not necessarily match specific liabilities. “You really need to be buying individual securities to maximize that matching potential,” he said.  

Historically, if a plan had assets of less than $250 million, it often had to be satisfied with an off-the-shelf investment option. But Gheen said he has seen this dramatically change over the past few years, and customization is now available for plans all the way down to the $10 million mark. He said investing in a combination of longer-duration bonds and equities is a viable strategy. If a pension is underfunded, he said, it is important to maintain a component of growth assets. “No two plans are the same, so no two portfolios are going to look the same.”  

For sponsors looking to terminate their plan, Kate Pizzi, a partner in, and senior consultant for, Fiducient Advisors, said sooner may be better than later, because interest rates are high and liabilities are lower. The market is also expecting more rate hikes from the Federal Reserve this year. One of the “biggest nuances” in pension management right now, Pizzi said, is deciding when is the right time to offer lump-sum distributions as part of a de-risking strategy on the liability side. 

When offering participants a lump sum, she said, the investment strategy needs to consider the interest rate the payout will be based on. Many calendar-year plans base a lump-sum payment on a “look-back rate.” For instance, any lump sum that is payable this year may be based on rates from late 2022, which could potentially be much higher than those at the time of payout. 

In order for plan sponsors to understand and calculate their liabilities, Pizzi said, they should form a strong partnership with their actuaries, especially as interest rates continue to fluctuate. Pizzi also said rising interest rates are surprisingly “good news” for the pension investor because they have caused liabilities to shrink.

Session Speakers

Mike Gheen
Vice president, director, retirement plan services, Oswald Financial Inc.

Richard Hudson Consulting actuary, First Actuarial Consulting Inc

John Lowell
Partner and consulting actuary, October Three Consulting LLC

Steve Mendelsohn Pension director Zenith-American Solutions Inc.

Kathryn Pizzi Partner and senior consultant, Fiducient Advisors