London Market Monitor – 30 September 2021
September delivers some ups and downs: Equity and bond markets mostly fell, risk-free rates rose, UK inflation increased, and volatility notched upward.
A Milliman client wanted to re-evaluate their current retirement program and modify it so that it would be attractive to future employees while also making it easy for the client to retain current employees and making it easy to understand. At the same time, they wanted it to have long-term costs to the client that are predictable and easy to manage. The client sponsors a defined benefit (DB) pension plan that had been closed to new participants for some time, with current participants continuing to accrue benefits in the plan under a Final Average Earnings (FAE) plan design. The client also sponsors a defined contribution (DC) plan with an employer matching contribution in which all employees participate.
In order to achieve their retirement program goals, the client was originally interested in terminating the DB plan so that future retirement benefits are earned only in the DC plan for all employees. At that time, the plan was in a well-funded position and could terminate, yet the client was reporting a large prepaid asset on the financial statements, which would initiate unfavorable accounting consequences upon plan termination. This large prepaid asset would have to be recognized as an additional expense in the client’s financials in the year of termination and the client was not in a position to absorb that expense in a single year.
The client wanted to keep an open mind when solving this problem, and in doing so, they enlisted our assistance to perform a comprehensive review of their existing retirement program. This included reviewing their current DB and DC plan designs as well as a number of alternative plan designs, and analyzing the projected impact that each design would have on the client’s net accounting numbers to determine which design would best fit the client’s overall business goals and objectives regarding their overall retirement program. Ideally, a solution would gradually and predictably reduce their DB plan’s prepaid asset each year via a moderate increase in annual pension expense until it reached a point where they felt comfortable absorbing the remaining prepaid asset all at once. At that point, they could re-evaluate the plan and decide to either terminate it or keep the DB plan if they decide that doing so is more advantageous to their current business strategy.
In our situation, the client was also sponsoring a DC plan that had a matching contribution available to all participants (whether they were participating in the DB plan or not), and this matching contribution was also generating an expense on their financials. The client also wanted the solution to be “expense-neutral” as it relates to their financial statements – in other words, the net combined accounting expense generated from the DB and DC plans in the long run under the new design had to be equal to the combined expense that the two plans are currently generating under the existing design.
Given this information, Milliman crafted a solution that would effectively transfer the accounting expense generated each year by the DC plan via the matching contribution to the DB plan. This was done by amending the DC plan to cease matching contributions for all participants and, at the same time, re-opening the closed DB plan with a cash balance plan design for new participants as well as for those DC participants not accruing in the DB plan previously, with the cash balance parameters (pay credits and interest credits) set at such a level that they would generate additional pension expense. On a year-to-year basis, that expense would be approximately the same as the expense that would have been generated by the client’s matching contributions to their DC plan. At the same time, the benefit formula for existing DB plan participants under the FAE design was enhanced slightly to make up for the DC match being eliminated.
Because the new plan design was crafted in such a manner that the additional annual DB plan expense will, in the long run, be relatively equal to the annual expense that would have been generated by the DC match just eliminated, the expense-neutral objective of the client is satisfied. At the same time, this solution will help the client to wear away the prepaid asset in their DB plan faster than under the old design because all of the accounting expense is now being generated in the DB plan (instead of being split between the DB plan and the DC plan under the existing design).
There are other potential solutions (such as a cost of living adjustment) that would absorb the prepaid asset and could be easily implemented within the DB plan without requiring changes to the DC plan. However, these options would not satisfy the expense-neutral objective of the client because the DB expense would be increased without any corresponding decrease to the expense generated from the DC plan.
As designed, the DB plan was reopened and that same year, the DC plan was amended to eliminate matching contributions. Today, a few years later, the DB plan is generating additional expense as was expected. That is reducing the DB plan’s prepaid asset while the client’s overall accounting expense remains stable.
Because the DB plan was already well-funded before these changes were made, the client has to this point not had to make a required cash contribution. This means that, in essence, so far the additional accruals are self-funded. This created an added bonus. The DC match was eliminated, and the client has additional cash on hand to use for other purposes. However, if they find themselves needing or choosing to make a contribution to the DB plan in the future, that cash is available to them.
While the plan remains well-funded and cash contributions are therefore not required, the client may consider maintaining the plan as it is regardless of the size of the prepaid asset. It may be more cost-effective for the client to use the well-funded status of the DB plan to fund future DB accruals instead of setting aside actual cash for matching contributions to the DC plan. In addition, these DB accruals will be cheaper than the DC match in the long run because, depending on the plan’s asset allocation, in most cases the expected return on plan assets from year to year will be greater than the interest credits earned on these accruals. In this scenario, the client can always retain the option to review their retirement program each year after evaluating the DB plan’s funded status, especially if after a period of poor market returns the client needs to make contributions to the DB plan higher than what they would have expected to make with the DC match.
Regardless of what the client decides to do with the DB plan in the future, the new design has achieved the client’s original objectives. The new plan design is mostly expense-neutral to the client on an accounting basis when looking at the DB and DC plans combined. The client also now has the means to deal with the DB plan’s large prepaid asset on their own terms and on their own schedule instead of having to immediately recognize it all at once if they do decide to terminate the plan.