Transcript

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Zorast Wadia: Hello and welcome to Critical Point, brought to you by Milliman. I’m Zorast Wadia, a principal and consulting actuary in Milliman’s New York office, and I’ll be your host today. In this episode of Critical Point, we’re going to talk about corporate pension plans—specifically why some plan sponsors are deciding to reopen frozen defined benefit (DB) plans or introducing new hybrid plan designs.

I’m the lead author of Milliman’s Pension Funding Study and the Milliman 100 Pension Funding Index, which analyze the funded status and financial health of plans of the 100 largest U.S. corporate sponsors. Twenty years ago, we saw many of these companies begin closing their traditional pension plans to new entrants, freezing pension accruals for existing participants, and utilizing defined contribution (DC) plans, like 401(k)s, for their retirement benefits delivery. But now, some of these companies are reversing course, shifting retirement spending from defined contribution plans back into defined benefit plans. IBM perhaps surprised the pension world in 2023 when it announced that it would reopen its frozen defined benefit plan starting at the beginning of this year. In fact, we’ve seen smaller employers do this also. I’ll mention that the reinstatement of pensions were also a central issue in last year’s United Auto Workers strike.

So what’s behind this shift? Is it viable for other employers? If so, how can plan sponsors avoid the mistakes that led them to freeze DB plans in the first place?

Joining me to discuss this are two of my fellow pension actuaries who wrote papers on this subject recently. I’m pleased to be joined by Ryan Cook, a consulting actuary out of our Boise office.

Ryan Cook: Hi, Zorast. Happy to be here.

Zorast Wadia: Great. I’d also like to welcome Lee Townsend, a consulting actuary out of our Chicago office.

Lee Townsend: Hello, Zorast.

Why IBM reopened its frozen defined benefit plan

Zorast Wadia: Let’s start off with a discussion on IBM. Ryan, can you describe what IBM did and their motivations, also touching upon why other companies might be doing the same?

Ryan Cook: Yeah, thanks, Zorast. So IBM, like a lot of corporate plan sponsors, has had a defined contribution plan, specifically a 401(k) plan, for their participants for the past couple of decades. In this 401(k) plan, they’ve allowed their employees to defer some of their income as contributions into a savings account, and they’ve offered a matching contribution of 5% of the participant’s pay into these accounts for their employees. What they did that was surprising this year is, starting in 2024, they elected to turn off this 5% match into the 401(k) and instead go back to their legacy frozen defined benefit pension plan that they’d closed a few decades ago and open up a new type of benefit in that account. That’s specifically a cash balance benefit, where they will contribute 5% of pay credits into these participants’ cash balance accounts.

Lee Townsend: Yeah, and Ryan, just to add a little color to that for the audience, the cash balance is a special type of defined benefit pension that really is designed to have the look and feel of the 401(k) plan. Participants will have their own individual account balances, and those are credited with contributions and returns based on a specific benchmark that’s specified by the plan document.

A contribution holiday for sponsors of overfunded frozen plans

Ryan Cook: The idea with this switch is that it’s supposed to be a rather small change for participants, in that before they were getting a 5% contribution into their 401(k) plan and now they’re getting a 5% contribution into this cash balance plan. Cash balance plans are structured to look a lot like DC plans, so they grow with interest, they grow with contributions. The difference is just kind of a legal one on whether one’s considered defined benefit versus defined contribution. And that legal distinction is a large reason why we think IBM may have made this change, which is that their legacy frozen pension plan that still had participants in it from a few decades ago has slowly accumulated quite a bit of excess assets in it. By moving their current retirement benefit strategy back into the defined benefit space, they can tap into those excess assets and use them to pay for the contributions that they’d be having to make into these participants’ accounts for the next few years. So it’s essentially going to give them a contribution holiday for possibly as many as five to 10 years of not having to pay additional cash into employee benefits.

Zorast Wadia: Lee, can you tell us about why companies might want to consider a defined benefit design even if they don’t have a frozen defined benefit plan?

Lee Townsend: Yeah, for sure. Defined benefit plans have kind of lost favor over the past few decades in the rise of the 401(k) plan revolution, as 401(k) plans have become more popular. But we might be set for a comeback in the coming years. I guess I should say they’ve lost favor in the large organization market. There kind of still is the thriving market for defined benefit plans in the small professional service firms space.

The advantages of defined benefit retirement plans for employers

Lee Townsend: But I guess we can kind of look at it in two contexts. So on the finance side, and Ryan touched on this earlier, but in the 401(k) design, companies are putting in those annual contributions directly into participant accounts, and that is an annual cost that sponsors have to make to their employee, for employee benefits. Whereas in the defined benefit plan, there’s a little bit more flexibility in the funding, and they can kind of structure how they contribute over time a little bit more flexibly. In the past, with the traditional defined benefit plan, this had risk for the sponsor, but some of the new hybrid designs that are allowed kind of allow some risk mitigation that we’ll talk about.

And then on the other dimension we have the human resources aspect of defined benefit plans, and in that regard, they are a unique offering nowadays, and in the employment landscape really differentiating companies that offer this type of benefit. It can really attract top talent. And then what we’re also seeing is a lot of employees are working beyond what we might call normal retirement or Social Security normal retirement because they don’t have adequate income to retire. So these plans can provide employees with lifetime income. That’s one of the nice benefits of a defined benefit plan is they do provide that life annuity, or that lifetime income as a benefit under the plan design.

Zorast Wadia: Good point. And I’ll add to this by noting that I’ve worked with plan sponsors in the financial and not-for-profit sectors that have significantly smaller plans than IBM, where they’ve also reopened their frozen plans via cash balance designs. So it’s not necessarily a one-size-fits-all solution, and the strategy is indeed available and customizable for different types of sponsors.

Now, switching gears from the employer perspective, I’d like to hear how retirement benefits through a DB design can affect employees. Ryan, can you start us off?

Pros and cons for employees when companies offer DB plans

Ryan Cook: Yeah, so, like all changes, it’s going to affect different groups differently, and there’s both advantages and disadvantages. So, if we focus in on the type of change that IBM made, switching from matching contributions in a 401(k) plan into salary credit contributions into a cash balance plan. For employees, the biggest advantage is that a cash balance plan offers easy access to lifetime income. When participants retire, they can easily, within the plan, convert the balance that they’ve accumulated into an annuity that will provide them income for the rest of their life, regardless of how long they live. They don’t have to worry about outliving their savings. In addition, interest credits in a cash balance plan are guaranteed. Participants’ balances are never allowed to decrease, so they don’t have the same risks that they would with a 401(k) plan of the markets turning down right before they retire. And then thirdly, it’s that with the matching contribution to the 401(k) plan, that was conditioned on the employees being able to afford to make their own 5% contribution into that plan. If the employee is going through a rough year and they can’t afford to make that 5% contribution in a certain year, then they don’t get the match from their employer either. Whereas with this cash balance plan, they’re guaranteed to get that full 5% of salary credit to their plan every single year from the employer.

Now, on the flip side, there are some cons. In the cash balance plan, the plan sponsor—the employer—picks how those balances are invested. Employees don’t get to make their own investment choices in it. That results in the interest credits that the cash balance plan gives, on average, tend to be a little bit smaller than the returns that employees could get if they invested long term in the equity market. And then the third con is that without the matching contribution being offered in the 401(k) plan, it could remove some of the incentive that some of the employees had to make contributions to that plan. That’s one of the nice things of a matching contribution, is it encourages employees to be proactive and set aside some of their money for retirement. When you remove that matching contribution, you might remove a little bit of that incentive.

Other things aren’t going to change. Both with the 401(k) matching contribution and the cash balance plan, account balances are still fully portable. If the employee leaves the company, they can take their balance with them to the next company. In addition, even with the switch to a cash balance plan, the 401(k) plan’s still there for employees to make whatever contributions they want to make into that of their own money. That doesn’t go away just because the employer’s moving from a match to a cash balance plan. So there’s pros and cons to it. How it’s going to affect individual employees is going to depend on their situation, and also, it’s going to be heavily dependent on the plan design the plan sponsor goes with.

Employer spending strategies to encourage retirement readiness

Zorast Wadia: So in the case of IBM, they decided to stop making employer contributions to their 401(k) plan. For other employers who are interested in shifting their retirement spending strategy, are there alternative approaches that can be taken?

Lee Townsend: Absolutely, and one of the key reasons you might not want to completely eliminate the match is that that might discourage some of your employees from contributing to the 401(k) on their own. As we see, a lot of employees contribute to the 401(k) simply to get that 401(k) matching contribution. In the 401(k), there is non-discrimination testing that’s done on an annual basis, and in order for the highly compensated employees to completely take advantage of the full contribution that they’re able to defer as an employee, generally the lower income earners on the plan have to make certain contributions as well. So removing that match could negatively impact the ability of higher-income employees of the employer to fully reap the benefits of those plan designs. So you can have that as one negative, and also just the worse outcomes for all employees due to having lower savings.

One idea that companies are considering is stretching those matching dollars that they were previously already committing to the plan. So rather than moving all of the matching dollars to the cash balance design, maybe take half and leave that remaining half in the traditional match. But instead of your old formula where you were giving dollar for dollar, maybe go for 50 cents on the dollar. In that case, you might see that participants continue to contribute to the plan at the same level that they were prior to your change in the structure of your retirement program. You might want to structure this kind of with an overall eye to the overall retirement benefits package, and an eye toward retirement readiness so that participants have enough to retire with adequate savings.

Hybrid plan designs including cash balance, variable annuity

Zorast Wadia: Makes sense. Although IBM reinstated defined benefits via a cash balance design, there are other hybrid plan options. Variable annuity plans are actually an attractive option for plan sponsors given their ability to maintain the plan’s funded status. These types of plans permit benefit adjustments so that their liabilities can respond directly to asset performance. Participants also appreciate them given their built-in cost-of-living features. Variable annuity plans are a great example of how retirement and investment risk can be better shared between the employer and the plan participant, and this pretty much results in a win-win situation for both.

Ryan Cook: Good point, Zorast. There’s a lot of considerations to keep in mind when you’re picking the DB plan design. It’s not just go with cash balance or go with variable annuity. Even within those, there’s a lot of different levers that can be pulled to try to balance the risk best.

Why the timing may be right to reopen a frozen defined benefit plan

Zorast Wadia: Let’s conclude by discussing why plan sponsors should be considering reopening their frozen defined benefit plans at this time in particular. Lee, can you please start us off with that?

Lee Townsend: Yeah, sure. There’s been some legislative changes recently that have certainly been encouraging on the defined benefit front. Congress has made some favorable changes lately, after more than a decade of punitive changes. Variable rate premiums on the PBGC side are no longer indexed to increase the national average wage, and there is talk of future reforms, which is very good news. There is funding relief, which has been extended, and that allows plan sponsors additional flexibility in their contribution timing. And there has been, finally, clarity given in the rules and regulations around hybrid plans, including cash balance plans. In particular, the type of cash balance plans that provide the market rate of return that can provide a lot of flexibility in how the benefits are structured.

Ryan Cook: Yeah, that’s a good point, Lee. Another thing that’s been changing recently is just that these legacy plans have become better funded over the last decade or so. If you look at the last 10, 15 years, market returns have done pretty well on average. I know there’s been a couple of down years, but overall they’ve done pretty good, and that, coupled with the large rise in discount rates we’ve seen over the past couple of years, has resulted in a lot of plans being close to 100% funded or overfunded. Zorast, you mentioned at the top the Milliman 100 Study that we do every year, where we look at the 100 largest pension plans in the U.S. I was digging into that data recently, and in addition to IBM, I was able to identify 27 other companies out of that 100 that looked like they had frozen pension plans that were in a surplus position that might be able to take advantage of this, just like IBM did.

The impact of higher interest rates on liability-driven investing

Zorast Wadia: I’d also like to highlight the economic environment that has been very opportunistic for plans sponsors, namely with respect to higher interest rates. These higher rates are beneficial in liability valuation for defined benefit plans since costs are accrued over a participant’s working lifetime. Not only is there a liability reduction on balance sheets, but plan sponsors also have the opportunity to invest assets in less risky portfolios while capturing a decent rate of return. This really paves the way for liability-driven investment management, a strategy that is very familiar to IBM and many of the plan sponsors in the Milliman 100 Study. With significant improvements in asset-liability management techniques over the past decade, and pension discount rates still at relatively high positions, this becomes an important risk-management consideration for plan sponsors who are resuming defined benefits delivery.

Ryan Cook: Yeah, and then the last reason why this has been relevant now, that I was thinking about, is just with the pandemic that hit in 2020 and lingered, ever since then employers seem to really be struggling with recruiting talent and then retaining the talent that they have. There’s just a lot of employees that are shopping around, looking to see what other employers can offer them. So now is a good time to look at what you can do to make your company look more appealing, to try to hold onto your best talent, and a defined benefit plan that offers lifetime income is something that other employers that you are competing with may not be offering their employees.

Zorast Wadia: So Ryan and Lee, I’d like to thank you for joining me today. You can find the case studies referenced in this podcast, along with the Milliman Pension Funding Study, on our website, Milliman.com.