Although defined contribution (DC) plans include many great features—including flexibility, ease of understanding and stable sponsor costs—many plan sponsors and policymakers, recognizing the shortcomings of a DC-only retirement program, have been seeking ways to reintroduce defined benefit (DB) plan features into DC plans. Two executives from actuarial and consulting firm October Three, Jeff Stevenson, president and CEO, and Larry Sher, partner, spoke with PLANSPONSOR about a more natural and comprehensive solution built on an existing DB design that they call a “market-return” cash balance plan, or the ‘Modern DB’ plan.
PS: What do we mean by market-return cash balance plan?
Sher: It’s a lot like a DC plan, even more so than a typical cash balance (CB) plan. Participants have an account balance, but like all cash balance plans it’s a notional account balance. Benefits are expressed as account balances, pay credits, which are analogous to employer contributions in DC plan, are deposited periodically into accounts, and interest credits, which are analogous to investment returns, are credited. What distinguishes it from a traditionally-designed cash balance plan is that the interest credits are based on real market rates of return rather than bond yields.
PS: Which particular market returns are credited to these accounts?
Sher: There’s quite a bit of flexibility in terms of how one might credit a market rate of return. That would be the employer’s choice in designing the plan. The simplest approach would be to just credit the actual return on the pension plan’s assets each year, whether positive or negative. For example, in a given year, if the return on the plan’s assets is 8%, then all account balances would grow by 8%. There is one exception: when an individual is about to take money out of the plan or start an annuity, the account balance cannot be less than the sum of the employer pay credits. The return can fall below zero in a given year, but cumulatively it can’t be below zero.
Plan sponsors could segment the asset returns if they don’t want to include certain assets in this calculation, and they can use other types of returns. For example, the plan could specify a mutual fund as the basis to develop the interest credits under the plan.
PS: How does this plan design help stabilize sponsor costs?
Stevenson: Traditional DBs tend to have volatile and unpredictable plan contributions and accounting costs. If the stock market is down one year, or interest rates fall, required sponsor contributions and accounting costs will likely rise. When the market is up or interest rates rise, they can contribute less and enjoy lower accounting costs.
Even a traditionally-designed cash balance plan is susceptible to financial instability because the plan’s assets and participant account balances will be out of sync. But, in a market-return cash balance plan stability is achieved because the plan’s assets and participant account balances will move in tandem. That is assets and liabilities will be “in-sync.”