CURRENT CHALLENGES FOR EMPLOYEES IN PRIVATE EMPLOYER SPONSORED RETIREMENT PLANS
James Bishop, Bryant University, Suite C217 Unistructure, 1150 Douglas Pike, Smithfield RI 02917, jabishop@bryant.edu, 401-232-6356
ABSTRACT
The focus of this paper is to examine recent retirement benefit issues arising from plans that derive benefits from account balances. Many private employers have changed their retirement plan from a traditional defined benefit (DB) plan to a “hybrid” plan. A hybrid plan earns benefit credit in the form of a lump sum rather than a monthly life annuity. At the same time, interest rates used in converting a balance to an annuity (or vice versa) has changed from fixed treasury rates to segment rates based on corporate bond yield curves. As a result, hybrid plan retirement annuities are subject to large variability. This is an undesirable result for the employee. A simulation model is used within to model the variability of annuities payable for two types of defined benefit plans.
Keywords: retirement benefits, cash balance, stable value, pension equity, life annuity
INTRODUCTION\BACKGROUND
In recent years, many private employers have transitioned from offering traditional defined benefit (DB) retirement plans to “hybrid” plans. A hybrid plan is legally considered a defined benefit plan, but has the balance accumulation feature of a defined contribution plan (such as a 401k plan). Hybrid plans have a variety of names such as: “cash balance”, “pension equity”, or
“stable value” [2]. These hybrid plans are completely employer funded, but unlike defined contribution plans that typically invest the contributions into the stock market, hybrid plan contributions earn stable growth defined by the plan [8] [9].
The benefit in a traditional defined benefit plan is based on a formula, computed upon retirement (or termination of employment) and based upon length of service and/or pay and is payable as a life annuity [5]. In contrast, the main feature of a hybrid plan is that the money available to the individual at retirement is a lump sum. The lump sum benefit is then converted to an actuarially equivalent life annuity (taking interest and mortality into account). This conversion factor is particularly sensitive to the interest rate in effect at the time of conversion, and these rates typically change annually.
We will focus on two types of hybrid pension plans within. First, a cash balance plan, which is an account balance that is supported by contributions from the employer as a percentage of the employee’s salary [7]. The contribution percentage of pay may increase as an incentive to older or longer service employees as well. Contributions are added to the account periodically, typically either monthly or quarterly. This is a notional account that earns either a fixed interest rate or one that varies based on a relatively stable economic rate (such as the 30-year U.S.
treasury rate).
Upon retirement from a company that sponsors a cash balance plan, the employee may or may not be eligible to take his or her cash balance as a lump sum. Pension plans must offer the employee a single life annuity if the employee is not married at the time of payment. Or, if married, the employee is offered an annuity benefit with at least 50% of the benefit going to the spouse in the event that the employee dies prior to the spouse.
For many cash balance pension plans, the cash balance (or possibly an amount more than the cash balance amount) may be taken as a lump sum at the employee’s termination of employment.
This money may then be rolled over to another retirement vehicle (IRA), particularly appealing for employees leaving a company prior to typical retirement age. The decision to take a lump sum benefit or life annuity benefit is an important one for employees who are preparing for retirement. The payment form chosen cannot be changed once elected.
The second type of hybrid plan we consider is a pension equity plan (stable value plan is another name for this plan type) For this plan type, the contribution credit is usually expressed as a percentage of pay, service, or age and the interest credit is usually defined as an indexed or fixed rate. Pension equity plans express the employee’s benefit as a lump sum amount payable at age 65, not immediately. Contributions are indexed based on increases in participant compensation, rather than a specified interest rate (Watson Wyatt, 2003).
Table 1 summarizes the key distinctions between a traditional defined benefit plan, cash balance plan, and pension equity plan.
Table 1 – Summary benefit features for pension plan types
Final average pay
plan Cash balance plan Pension equity plan Benefit formula
result Life annuity Lump sum balance Lump sum balance Age of assumed
payment
Normal retirement
date – age 65 Immediate Normal retirement
date – age 65 Interest growth None
Fixed rate or conservative economic
rate
Wage indexed Conversion to
alternate form of payment
Lump sum – PPA interest and
mortality
Life annuity – PPA interest and mortality
Life annuity – PPA interest and mortality
As part of the Pension Protection Act (PPA) of 2006, lump sum conversion interest rates and mortality were regulated. The required rates used are segment rates over three time periods based on corporate bond yield curves. The first rate is used for all discounting during the first five years, the second rate is applicable between years five and twenty, and the third rate is applicable for periods beyond twenty years.
As an example of the impact of benefit conversions, suppose an employee is age 64 and has a cash balance benefit of $500,000 payable immediately. The equivalent annual life annuity computed using an interest rate of 5% is $40,393 (the single life annuity factor is computed using the Pension Protection Act 2012 unisex mortality table). Instead, assume that this same employee works until age 65 and has a cash balance benefit of $515,000 payable immediately (assuming a 3% increase in benefit). If the interest rate at age 65 has changed to 6%, then the resulting annual life annuity is $39,042. Working an extra year has reduced this retiree’s life annuity income by 3.3%. This situation is not possible under a traditional defined benefit plan.
Employers typically send benefit statements to the employees (required by law every three years), showing current and projected future benefits. These projections are simplistic and assume constant yield, projected wage increases, and interest assumptions. These projections are likely to be quite different from the benefit actually payable at retirement. This poses a serious challenge when considering retirement.
SIMULATION MODEL
Rather than using the typical constant interest rate assumptions that are commonly used to project and convert benefits for a future retirement date, simulation techniques allow us to project benefits in a more realistic manner. In addition, we can compare and contrast variation in the single life annuity that is likely to be paid at retirement for three common types of defined benefit plans.
In practice, each of the three defined benefit plan types discussed here have numerous specific formula designs depending on the goals of the employer in establishing the plan. For the purpose of comparing the basic features of each of the three plan types, a number of plan features and employee characteristics have been held constant across the three plan types. First, we consider full careers (40 years of service) and a constant wage increase that is the same for all three plans. Also, the choice of the specific benefit multipliers have been set to make each of the three plans give approximately the same annual annuity benefit.
The traditional final average pay plan has an arbitrarily set plan formula at with a 1.5%
multiplier. This value is considered one possible benchmark for the industry because when multiplied by 40 years of service, gives an annual benefit to a retiree that is approximately 60%
of their final average pay. Combining with social security, this benefit is considered a reasonable retirement income.
The initial goal of the simulation presented within is to set the multipliers for the cash balance plan formula and pension equity plan formula to be such that the annual annuity benefit is approximately the same of each other and the final average pay benefit as well. This serves two purposes, the first of which is to see how generous the benefits are for the three plans relative to each other. Also, our main goal of the simulation is to see how much variability is in the annual annuity result. Therefore, we hold the median of the three plan annuity values approximately constant across the three plans.
General assumptions for each model:
wage increase 3.8% (last 20 year geometric average of the U.S. national average wage index)
starting pay $50,000 at age 25 retire at age 65
The following models are used to compare the three defined benefit plans under consideration:
Final Average Pay Plan:
benefit formula = 1.5% x years of service x FAP5; where FAP5 is the final five years of annual pay prior to retirement.
benefit payable as an annual annuity = constant value $119,406 per year
No simulation necessary for the final average pay plan as the annuity is fixed once the wages are known. Since all three benefit plans are based on the wage increases, these values remain constant across all benefit plans for the purpose of a fair comparison.
Cash Balance Plan:
benefit formula =
cb% = 8.25% = cash balance pay multiplier contributions are made mid-year
simulation of ik = annual interest rates utilize discrete uniform random selection based on 30-year U.S. treasury rates from 1988 – 2010.
simulation of v is used for the conversion to an annuity as part of the factor , based on discrete uniform random selection of annual corporate moody (Aaa) bond yield from 1976 – 2010.
benefit payable as an annual annuity = benefit formula ÷
Where = P(person age 65 survives for k more years).
The cash balance simulation has two parts. The first part is to project the forty year future values for “typical” fluctuation in the interest credit rate applied to the cash balance account. Secondly, once the final balance is known at retirement, simulation is performed to convert the final cash balance account to an annual single life annuity.
Pension Equity Plan:
benefit formula =
PEP% = 13.25% = pension equity plan pay multiplier
contributions are made at the end of each year
ssk = annual wage increase 3.8% used to annually increase balance
The benefit formula simplifies to $6,000 x 40 x 1.03839 = $1,134,861.
simulation - conversion to annuity using factor discrete uniform random selection based on annual corporate bond yield from 1976 – 2010.
benefit payable as an annual annuity = benefit formula ÷
The pension equity plan simulation only produces one value per run. Once the final balance is known at retirement, simulation is performed to convert the final pension equity balance to an annual single life annuity.
An initial series of sets of 1,000 simulations is performed using the Excel random number generator and discrete uniform selection of historical 30-year treasury rates and corporate bond yield rates. For each simulation, 40 years of projected 30-year treasury rates is produced and the final age 65 cash balance lump sum benefit determined. Then, one corporate bond yield rate is simulated to create an actuarial factor that converts the lump sum benefit to an annual life annuity benefit.
The initial simulations are run using various cash balance formula multipliers (6% – 10% by 0.25% increments) and the median resulting annual annuity closest to the final average pay plan annuity is chosen. For the same simulation numbers, the pension equity formula multiplier (10%
- 15% by 0.25% increments) is similarly chosen.
Finally, a set of 1,000 simulations is performed in order to determine the standard deviation of resulting annuities for both the cash balance plan and the pension equity plan.
RESULTS
The initial sets of simulations produced the Key Formula Benefit Levels for the cash balance and pension equity plans as displayed in Table 2. The cash balance plan value of 8.25% produced a median annual single life annuity benefit closest to the final average pay plan value of $119,406.
Similarly, the pension equity plan value of 13.25% produced a median annual single life annuity benefit closest to the final average pay plan value of $119,406.
A final set of 1,000 simulations produced benefit results for the cash balance plan and pension equity plan. A summary of results for life annuity benefits payable at age 65 is displayed in Table 2.
Table 2 – Summary single life annuity data for pension plan types
Final average pay
plan Cash balance plan Pension equity plan Key Formula
Benefit Levels 1.5% 8.25% 13.25%
Median Single Life
Annuity $ 119,406 $ 117,191.34 $ 119,024.84
Standard Deviation of the
Median
$ 0 $ 23,157.38 $ 22,061.04
Standard Deviation as Percentage of the
Median
N/A 19.8% 18.5%
Assuming a stable projected wage increase the final average pay plan formula chosen here results in a constant annual single life annuity benefit of $119,406. In order to approximately match the final average pay annuity, the cash balance plan multiplier of 8.25% is required. This multiplier is quite high as compared to existing cash balance plans in the industry. Typical multipliers are in the range of 5.0%. Likewise, the pension equity plan multiplier is determined to be 13.25%. This value is moderately high as compared to commensurate plans in the industry.
Typical multipliers are in the range of 10.0%.
The standard deviation (SD) associated with the cash balance plan is close to 20% relative to the median projected single life annuity benefit. This may be a cause of concern for an employee planning for retirement under this plan type. The pension equity plan has an 18.5% standard deviation as a percentage of the median annuity benefit. This is a surprising result because unlike the cash balance plan, the only source of variation is the life annuity factor used to convert the lump sum to an annuity.
Both the cash balance and pension equity plans used the same simulation numbers to convert the final age 65 lump sum amounts to life annuity values. Therefore this source of variation is the same for both plans. The small difference between standard deviations for the two plans is created by the simulated projection of the cash balance plan interest rates. This projection created very little additional variation in results.
CONCLUSION/DISCUSSION
Retirement planning is an area of concern in recent years. Employers are eliminating or converting traditional defined benefit plans into benefits derived from account balances. A stable life annuity promise offered through the employer has almost become a thing of the past.
Combined with this trend, the economic downturn in 2007 has added to retirement instability because of the sharp stock market decline. This has created a mistrust of account balance derived benefits. This paper confirms the mistrust of benefit stability, but in the case of cash balance and pension equity plans the culprit for benefit instability is interest rates used to convert the balances to life annuities.
One major purpose of recent account balance pension designs has been to stabilize account balance benefits so that they are not subject to the wide market variability that exists in defined contribution (401k) plans. Ironically, due to the interest rates used in the conversion from an account balance to a life annuity, the resulting annuity is unstable at the point that an employee is actually choosing to take their benefit.
As a final perspective for employees who are concerned with receiving an adequate life annuity benefit, we consider the differences between traditional defined benefit, new defined benefit (cash balance and pension equity), and 401k plan offerings. If we keep wage increases constant across plan types then the traditional defined benefit plan produces a fixed annuity – standard deviation of 0. The new account balance defined benefit plans have variability (SD) close to 20% relative to the median value of the projected life annuity. Finally, defined contribution plans that are subject to market variability have variability (SD) in the range of 100% [1].
REFERENCES
[1] Bishop, J., Schumacher, P., Olinsky, A. (2011). Retirement Plan Simulation. Northeast Decision Sciences Institute Conference.
[2] Green, L. (2003, October 29). What is a pension equity plan?. Retrieved from http://www.bls.gov/opub/cwc/cm20031016ar01p1.htm
[3] IRS. (2009, September 5). Choosing a retirement plan: defined benefit plan. Retrieved from http://www.irs.gov/retirement/article/0,,id=108950,00.html
[4] Lowman, T. (2000, July 7). Actuarial aspects of cash balance plans. Retrieved from http://www.soa.org/files/pdf/actuarial_aspects.pdf
[5] McGill, D, Brown, K, Haley, J, & Schieber, S. (2005). Fundamentals of private pensions.
Oxford, NY: Oxford University Press.
[6] Watson Wyatt. (2003, September). Court rules that cash balance plan and pep are age discriminatory.
http://www.watsonwyatt.com/us/pubs/Insider/showarticle.asp?ArticleID=11812
[7] McCourt, S. (2006). Defined benefit and defined contribution plans: a history, market overview and comparative analysis. Retrieved October 25, 2009, from http://www.ifebp.org/PDF/webexclusive/06feb.pdf
[8] Employee Benefit Research Institute. (2006, March). Hybrid retirement plans: the retirement income system continues to evolve. Retrieved from http://www.ebri.org/publications/ib/index.cfm?fa=ibDisp&content_id=80
[9] Benefit Systems, Inc, Initials. (2008). Cash balance plans. Retrieved from http://www.benefitsystems.com/newsinfo/newsfiles/cashbalance.pdf
