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Need to Know: Defined Benefit Plans

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A 2023 MFS global retirement survey found that retirement confidence is on the decline, with 58% of respondents indicating they would need to work longer than planned and 32% indicating they would not be able to retire at all. Furthermore, the survey showed that 75% of respondents ranked “receiving a predictable stream of income payments throughout retirement” as one of the top three elements they want to see in a retirement portfolio.


There has been a great deal of effort in the retirement industry to develop products that incorporate guaranteed income features, such as annuities to be offered within defined contribution (DC) plans. However, uptake of these solutions has been relatively low as they tend to be difficult for participants to understand and present administration and governance challenges. Accordingly, many sponsors are hesitant to be first movers. For sponsors who are thinking about retirement income options in the DC plan, the answer may be staring them in the face with their frozen or closed DB plans. Defined benefit plans are the time-tested way to provide lifetime income while pulling longevity and investment risk for participants.


What kind of Defined Benefits plan?

Plan sponsors have many options today with regard to the type of DB plan offered to employees. Traditional DB plans tended to have final average pay formulas, where benefit accruals increased in value as participants neared retirement. Other designs, such as cash balance and variable benefit plans, have evolved, which offer employers alternatives to delivered DB benefits that can avoid the steep cost increases that come with traditional final average pay formulas.


What is a cash balance plan?

  • DB plan where benefit is defined as an account balance that grows with pay credits and interest credits.

  • Assets are held in a DB plan trust, not individual accounts like a DC plan.

  • Pay credits, typically based on a percentage of pay, can vary by age or service and can be based on base pay or total pay.

  • Interest credits can be based on a fixed rate, a floating rate, or a market-based rate.

  • In a market-based plan, although returns can be negative in any given year, the total return over a participant’s career must be at least 0%, and the annual return can be capped.


LDI works!

Liability-driven investing LDI has been a well-established strategy for many years, with 77% of DB sponsors now indicating they employ some form of LDI within their investment policy statement. And why not? LDS strategies have demonstrated their effectiveness over the past decade, with glide path strategies systematically reducing risk as funding status improves and carefully constructed fixed-income portfolios moving in line with plan liabilities as interest rates rise and fall. In 1991, there were roughly 26 million active DB participants versus 36 million active DC participants. By the end of 2020, active DB membership had declined to 12 million compared to 85 million DC participants. Furthermore, as of March 2022, only 15% of private sector workers had access to a DB plan. Digging deeper, only 23% of workers who participate in a DB plan are in a plan that provides accruals to all members, meaning there are millions of workers with a frozen DB benefit. The decline in DB participation is a result of plan sponsors freezing, closing, and terminating plans in response to several trends over the past two decades, including:


  • Changes to pension funding rules, starting with the Pension Protection Act of 2006, followed by numerous iterations of funding relief over subsequent years, which allowed sponsors to defer contributions into the future, hampering funded status improvement.

  • Changes to accounting standards, which required mark-to-market accounting on the balance sheet for DB funded status and unpredictable P&L expense patterns.

  • Increased liabilities due to declining interest rates.

  • Mortality improvements that further increased liabilities.

  • Increased Pension Benefit Guaranty Corporation (PBSC) premiums and other administrative expenses.


Combine these factors with the significant market declines of the early 2000s and the global financial crisis in 2008, and pension-funded status has hovered between 80% and 90% for much of the past decade.


This market volatility often resulted in unpredictable contribution patterns, balance sheet adjustments, and P&L expenses for plan sponsors who were not carefully managing these risks. However, despite challenging market returns in 2022, rising interest rates reduced DB plan liabilities, improving funded status for many corporate plans, resulting in many plans now at or above 100% funded status for the first time in years.


As funded status has improved, we have seen significant annuity buyout activity, with expectations that this trend will continue, and there are still substantial obligations that plan sponsors will need to manage over the coming decades. While the risks noted above have driven plan sponsors to freeze and close DB plans, DB plans still exist and can be effectively managed. Now might be the time for plan sponsors to reconsider how they view their DB plan.


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