Transitioning from a Defined Benefit to a Defined Contribution Program | Part III: A Case Study
In an effort to make the ideas and topics concrete, we will present a mini case study highlighting the difficulties plan sponsors face when transitioning from a defined benefit to a defined contribution program.
Company ABC has sponsored their defined benefit (DB) plan for 40 years. Historically, the plan's cost has been about 5.75% of payroll, but contribution requirements have steadily increased since 2006 and are projected to go much higher. Below are the projected annual contributions as a percentage of total payroll:
The projections show that once the plan is fully funded on an ERISA basis (2028 Plan Year), the plan's long term annual cost to the employer will revert back to 5.75% of payroll. Company ABC would like to freeze their DB plan and institute a defined contribution (DC) plan that will provide them a fixed long term budget of 5.50% of payroll, once the DB plan is terminated.
Assuming that the DB plan is closed to new participants and all accruals are frozen effective 1/1/2016, we can run a second set of projections to determine the cost of the frozen DB plan along with a new DC plan established for all employees beginning 1/1/2016. The total cost of the new retirement program is shown below:
As you can see, the long-term costs are projected to settle at 6.00% until the DB plan is terminated due to administrative costs associated with maintaining a DB plan, even if it is fully funded.
More importantly, however, is the fact that short-term costs are about 1% higher due to maintaining both plans. This is typically the case unless the DB plan is well-funded and the majority of the annual contribution is attributable to ongoing benefit accruals rather than funding the plan's shortfall.
If the plan sponsor cannot afford higher short-term costs, then the replacement DC plan must provide smaller benefits. However, assuming that Company ABC is comfortable with the higher short-term costs in order to transition from its current volatile DB plan into the fixed long-term costs a DC plan provides, the next significant challenge is the lost benefit analysis.
The lost benefit analysis provides sponsors with the value of the benefits lost or gained due to the change in the retirement program. In the sample case presented in Part II of the series, we demonstrated that a 55-year-old participant with 15 years of service had a frozen accrued benefit $7,500 as of 1/1/2016 versus a projected benefit of $16,804, assuming they continued earning benefit accruals until age 65.
Under the proposed replacement DC plan, this participant will receive annual employer contributions of 5.5% of their salary. Assuming the participant managed to earn a 6.50% annual return on their account balance (every year), the projected balance at age 65 would be approximately $46,000. That is enough to provide the employee with an additional $3,822 in annual retirement income, representing an income replacement ratio of 5.5% (=$3,822/$69,215). However, the participant still faces a loss of $5,482 in annual retirement income compared to the $16,804 the participant would have received if the DB plan was never replaced.
Retirement Income as a Percentage of Final Earnings
Note that each participant will have their own lost benefit percentage and an individual contribution rate to get them back to even.
To make up the current 7.9% shortfall in retirement income, the participant will need to begin saving nearly an additional 8% of their annual earnings over and above whatever they may be currently saving.
Due to the nature of DB and DC plans, employees near the participants age group will see a loss in benefits, while younger employees (such as those in their twenties) may be better off in the new DC plan due to investment gains over 40-years worth of time.
Depending on the size of the organization, we typically provide this analysis either by person or by representative groups based on age and/or service.
Illustrated below are the lost benefit rates under our sample DB plan (1% accrual x highest 3-year average earnings x service, capped at a maximum of 30-years), along with the replacement DC plan providing 5.5% contributions to all participants:
As previously mentioned, a DC plan is a blunt tool that cannot replicate the benefits provided under a DB plan.
There are ways to minimize the impact of the changeover, specifically by providing larger contribution rates to older and/or longer service employees and providing smaller contribution percentages to younger, newer participants (while maintaining the targeted budget).
In this case, for example, we modeled a second alternative DC plan (that averages out to about 5.5% of payroll) which provides a graded schedule of contributions based on employee age as follows:
Comparing the benefits lost or gained under the two alternative DC plans shows that allocating a larger portion of employer contributions towards older employers has some effect, but not enough to make-up for the full shortfall.
Under the graded DC alternative, we are able to reduce the sample participant’s lost benefit from (7.9%) to (6.5%).
We can continue modeling alternative plans, attempting to shift more and more benefits towards older employees, however this approach has its shortfalls. It is not generally possible to fully negate the impact on older employees without blowing past the budget or running into issues when testing for nondiscrimination.
With any recommended age -or service- based formula, we perform testing on the current data to ensure that it would satisfy nondiscrimination testing with enough of a margin to feel comfortable it will not fail in the immediate future.
We advise sponsors against establishing a plan that pushes the envelope or one that does not make sense long-term, once the current DB employees have retired or left employment. However, it is impossible to predict the future and if the underlying plan demographics change substantively over the course of a few years, the very same plan that passes one year may fail in the next.
If the plan sponsor has an adequate budget, a non-qualified plan arrangement or cash in the form of a bonus or salary increase maybe worth considering in order to avoid the added administrative and legal complexity.
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.
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