Transitioning from a Defined Benefit to a Defined Contribution Program | Part II: The Migration Study

The goal of any defined benefit migration (DB) study is to provide plan sponsors with sufficient information to make an educated decision. The study must include an analysis of the ongoing DB plan costs versus the combined costs of the frozen DB plan and the replacement defined contribution (DC) plan, as well as an understanding of how employees will be affected by the transition.

As noted in Part I of our series, freezing a DB plan does not necessarily eliminate the need to contribute cash into the plan. While freezing halts ongoing benefit accruals and reduces future annual funding requirements, employers are still required to fully fund any shortfall attributable to past benefit accruals. This can potentially lead to higher interim costs while plan sponsors fund both plans.

Many organizations have an idea of how much they would like to spend on a competitive retirement program, however, they must also determine their ability to digest higher costs in the short term. This secondary budget parameter is essential for understanding the amount that can be spent on a new DC program while continuing to fund the frozen DB plan. Additionally, organizations must determine their ability to provide enhanced or supplemental contributions to a select group of “senior” employees if there is intent to do so.

While younger employees have the ability to plan accordingly - even small changes in spending habits or an slight increase in their savings rate can make a large impact come retirement - older employees lack the time necessary to make up for their benefit losses and tend to be the most negatively impacted by moving away from DB-style plans.

Providing enhanced contributions to these older employees’ attempts to minimize the impact of the transition for those who may otherwise feel like the rug is being pulled out from underneath them. These initial conversations are the most important aspect of any migration study and they must occur before the real analytical work begins.

As plan sponsors begin the process they should ask the following questions:

  1. What is the targeted long-term cost for the retirement program as a percentage of payroll?
  2. What can the organization afford in the interim while funding both the DB and DC plans?
  3. Are enhanced contributions a possibility?

We find that most plan sponsors are unwilling, at least initially, to budget more than the expected costs under their current DB program. Their reasoning is linked to the lack of immediate savings; however savings begin to mount as the DB plan shrinks over time and its funding level improves (requiring less in annual contributions).

Once a budget has been established, it is time to take a serious look at both the short- and long-term goals of the organization.

More often than not, we find that a proposed budget will fall short of the plan sponsors’ intended goals. While it is commonly agreed that participants should be saving anywhere from 12%-15% of their salaries in order to achieve an “Income Replacement Ratio” of 80% at retirement, most employees and plan sponsors find it difficult to meet this goal.

Encouraging employee participation and increasing deferral amounts are essential to maximize successful retirement outcomes and require a combination of targeted employee communications, automatic enrollment/escalation, and matching contribution plan design features on behalf of plan sponsors.

For some employers, cutting costs is the only key factor, while other organizations may look to mitigate the impact of lost benefits to its older and longer-service employees. For most it is a delicate balance that also includes the potential impact to the balance sheet and employee demographic considerations, including retention and the ability to maintain a competitive benefit program. It is a lot to juggle, which is why defining the budget comes first and everything else follows.

In some cases, maintaining a less rich DB plan may be the best option for organizations. Those concerned with the impact to their older employees may decide that a “soft freeze” is appropriate. A “soft freeze” allows the organization to maintain the current DB plan in some form or for some set period of time for all, or a portion of, current participants, while establishing a DC plan for all new employees (and possibly some subset of current employees). The main benefit of this approach is time. Delaying the freeze of benefit accruals allows younger participants time to adjust and make necessary preparations, while those closest to retirement remain relatively unharmed (assuming they would reach the plan’s Normal Retirement Age within the established “sunset” period). The drawbacks include the additional cost and complexity associated with administering two plans covering distinct employee populations working side-by-side.

The long-term target budget provides the framework, but it is the short-term budget, along with the lost benefit analysis, that ultimately determines the structure of the final program. These essential preliminary discussions enable us to define the possibilities.

Winners & Losers

The lost benefit analysis provides plan sponsors with the value of benefits lost or gained due to freezing the DB plan and transitioning to an alternative DC program. Based on the DB plan formula and participants’ current age, service and salary information, we can determine the participants’ accrued benefit as of the freeze date, along with their projected benefit at retirement, to determine how each employee will be affected.

For example, a 55-year-old participant with 15 years of service has a recent salary of $51,500 and historical annual salary increases of 3%. Based on a DB plan formula that provides a benefit equal to 1% of highest three-year average earnings ($50,000), multiplied by years of service, the accrued benefit as of the proposed freeze date (1/1/2016) is:

$50,000 x 15-years x 1% = $7,500

Now, if the DB plan were never frozen and the participant were to continue in employment, with annual salary increases of 3%, the projected accrued benefit as of 1/1/2026 (the employee’s Normal Retirement Date as of Age 65) would be:

$67,215 x 25-years x 1% = $16,804

Based on the final earnings of $69,211 prior to retirement, the ongoing unfrozen DB Plan would provide the employee with an annual income of $16,804 and produce an annual Income Replacement Ratio of 24.3% (i.e., $16,804/$69,211).

However, if the plan is frozen as of 1/1/2016, then the employee would only receive an annual benefit of $7,500; for an income replacement ratio of 10.8% (= $7,500/$69,211). This represents a loss in annual retirement income of $9,304. To provide for that lost income, the employee would need to accumulate $112,000 in additional savings.

While part of the loss would be recuperated by employer contributions to the new DC plan, the majority of the burden would be on the employee. In order to make up the lost retirement income, the participant would either need to save more, defer retirement past age 65, or both.

The analysis of lost DB benefits and the projection of benefits under alternative DC formulas enable plan sponsors to select a DC program that maximizes participation while minimizing the negative impact on its older employees. This will be the focus of Part III: A Case Study in our Transitioning from Defined Benefit to Defined Contribution series.

Stay tuned for Part III of the “Transitioning from a Defined Benefit to a Defined Contribution Program” series - A Case Study.

Note: This feature is to provide general information only, does not constitute legal advice, and cannot be used or substituted for legal or tax advice. Opinions expressed are those of the author, and do not necessarily represent the opinions of Cammack Retirement Group.

Investment products available through Cammack LaRhette Brokerage, Inc.
Investment advisory services available through Cammack LaRhette Advisors, LLC.
Both located at 100 William Street, Suite 215, Wellesley, MA 02481 | p 781-237-2291