Hybrid Retirement Plans

Transcription

1 watsonwyatt.com Hybrid Retirement Plans University of Illinois September 16, 2008

2 Introductions Julie Durkin Jeff Van Wagner Watson Wyatt Worldwide 7,000 associates 105 offices in 32 countries 2

3 What does Watson Wyatt do? Consult with employers to design, finance and administer benefit plans to attract and retain employees We balance these needs with the employer s financial constraints 3

4 Agenda Hybrid Plans Cash Balance Plans Changes Due to Pension Protection Act and Court Rulings Case Study Future of Retirement Plans Questions 4

5 Hybrid Plans What are they? Why were hybrid plans created? Why would an employer be interested in a hybrid plan? How will the Pension Protection Act affect hybrid plans? 5

6 Hybrid Plans Characteristics Defined benefit plans that are made to look and act like defined contribution plans, or Defined contribution plans that mimic accrual patterns similar to defined benefit plans 6

7 Hybrid Plans Examples Cash balance plan Defined benefit plan that expresses a participant s benefit with a hypothetical account balance Defined lump sum plan Lump sum at retirement based on pay credits OR fixed dollar amounts Age/Service based profit sharing plans Annual employer contributions (% of pay) Contribution % based on age and/or service 7

8 Cash Balance Plans What is a Cash Balance Plan? 8

9 What is a Cash Balance Plan? Pension plans that define a participant s benefit as a hypothetical account balance Combines strengths of Defined Benefit and Defined Contribution Plans Account grows with annual pay-related credits and interest credits Employees receive lump sum or annuity at retirement/termination 9

10 What is a Cash Balance Plan? Example Account is established for each employee (hypothetically, no actual asset allocated in the trust) Each year the account is credited with a deposit equal to 6% of the employee s pay Each year the account is credited with interest equal to a public index (5.5%) 10

11 What is a Cash Balance Plan? Example Year Pay Pay Credit Interest Credit Balance #1 $50,000 $3,000 $0 $3,000 #2 $52,000 $3,120 $165 $6,285 #10 $71,166 $4,270 $2,154 $45,580 #20 $105,342 $6,321 $7,247 $145,327 #30 $155,933 $9,356 $17,660 $348,111 Contribution is based on 6% of pay; Salary increases are 4% per year; Interest credits are based on the published rate of 5.5% per year 11

12 Comparison of Benefit Accruals 12

13 Cash Balance Plans Why Have Companies Implemented Them? 13

14 Why Have Companies Implemented Cash Balance Plans? Improve employee understanding and appreciation Easier to communicate Complement 401(k) plans Attract and retain talent Provide portable retirement benefits Meets the company s business strategy Potential savings More stable costs Balance sheet impact 14

15 Cash Balance Plans Why Have Companies Avoided Them? 15

16 Why Have Companies Avoided Cash Balance Plans? Does not meet the company s business strategy Uncertainty regarding the future of these plans Negative press Transition issues IBM Legal issues IBM (Cooper vs. IBM age discrimination) Xerox (Berger vs. Xerox whipsaw issue) 16

17 What is Age Discrimination? 5% of Pay Cash Balance Plan with Interest at One-Year Treasury Rate 16% Plaintiffs Argument Extra interest to younger employee causes age discrimination 16% PPA Future Years 5 Appeals Courts Past Years Extra interest to younger employee causes age discrimination 30 Years of Interest to age 65 5% 5% Age 35 Age 65 Age 35 Age 65 Pension law addresses future, Cooper decision addresses past 17

18 Comparisons of Plan Designs Not Age Discrimination Is Age Discrimination Hybrid Plan 5% of pay 7% of pay until age 40 5% of pay thereafter Traditional 1.5% x Final Pay x Service before 1/1/2000 1% x Final Pay x Service after 1/1/ % x Final Pay x Service until age 40 1% x Final Pay x Service thereafter 18

19 Pension Protection Act Covers Design not inherently age discriminatory Interest Crediting restrictions Minimum Conversion rules 3 year cliff vesting requirement Elimination of lump sum whipsaw 19

20 Minimum Vesting for Hybrid Plans 3-year cliff vesting No graded vesting alternative Applies to past and future years of service 20

21 Interest Credits Annual credits can not be less than zero preservation of capital rule Can use fund return credits with cumulative zero floor Cannot exceed market rate of return Reasonable stand alone or minimum fixed rate does not cause rate to exceed market rate Safe harbor rates include 30 year treasury rates and 3 rd segment (corporate bond) funding rate Need more guidance about fixed rates, combination of fixed and variable rates and potential relief for violating anti-cut back rules 21

22 Conversion Issues: No Wearaway Must provide at least A + B A: Benefit earned prior to amendment Pre-conversion Plan 1% x Pay x Service B: Benefit earned after amendment 5% Cash Balance Plan Post-conversion Pay = $50,000 Service = 10 Years A: Benefit earned at conversion is frozen 1% x 10 x $50,000 = $5,000 payable at age 65; Including early retirement subsidies B: Cash balance account + At conversion = $0 Year 2 = $2,500 Year 3 = $5,100 No different than a DC conversion 22

23 New Hybrid Designs Viable Vesting Conversions Funding Applicable Hybrid 3-year vesting A + B Cash flexibility A + B DC Plan 3-year vesting or 6-year graded Limited cash flexibility Investments Forms of Pay Design Flexibility Flexible - generally company controlled Annuities required Significant Flexible generally employee controlled Annuities optional Limited Cash balance plans and defined contribution plans will be on equal footing; each has some advantages over the other 23

24 Case Study 24

25 Sample Conversion Questions Given: An employer is considering a pension plan redesign. The plan currently provides a benefit equal to 1.5% of a participant s final average compensation multiplied by years of service. The employer is considering a cash balance plan that provides a benefit with pay credits equal to 3% of pay. 25

26 Why Would an Employer Consider This Change? Reduced volatility Less expensive plan on an ongoing basis Enhanced employee understanding Balance sheet impact Attraction and retention tool 26

27 How Will Employees View This Change? Reaction will depend on management s relationship with employees Employees will want to understand the reason for the change Reactions will vary dramatically depending on employees : Individual situation Understanding of the current plan and the difference in these types of plan 27

28 Other Issues How will the costs of these programs compare? Does the proposed plan provide competitive benefits? How would the balance sheet be different? Should grandfathered or transition benefits be considered? Should lump sums be offered? 28

29 Current Business Situation Not-for-profit health care organization recently lost a significant piece of business Organization needs to cut costs to remain viable with new projected revenue stream Mature population 29

30 Current Business Situation Employer has maintained an extremely paternalistic culture to date SFAS No. 158 requires an organization to report unrecognized losses and prior service costs on its balance sheet at end of 2007 fiscal year New President of organization effective July 1,

31 Objectives for Retirement Program Reduce plan costs Provide substantial benefits Enhance employees understanding and appreciation of benefits Improve balance sheet 31

32 Current Program Pension Plan: 1.25% of Final Average Pay multiplied by years of service payable at age 65 Vesting is 100% after 5 years Benefits are payable in the form of an annuity Current plan costs are approximately 8% of pay 32

33 Current Program 403(b) or tax sheltered annuity plan offered to employees through several vendors: Allows employees to defer money on a pre-tax basis Employer does not provide any matching contributions 33

34 Case Study Given this situation, what would your proposed plan design be? How would your proposed design satisfy the objectives? How do you think the employer/employees will respond to your proposal? 34

35 Proposal Implemented by Employer Discuss proposed program Rationale for proposed program Message to employees How was the message communicated? What information was provided or will be provided to employees? 35

36 Recommended Plan Design Freeze current pension plan as of December 31, 2007 Service Years Pay Credit Implement a service weighted cash balance plan 0-5 3% Pay credit equals scheduled percent of total pay each year according to the schedule at the right: % 5% Additional 4% for participants whose age plus service equaled 70 as of December 31, % 8% Over 25 10% 36

37 Rationale for Recommendations Current Pension Plan Expensive Population is maturing Significant cost increases from ages 55 to 65 Employees don t understand or appreciate the plan Plan sponsors are moving away from traditional plans $10M balance sheet adjustment for 2007 Recommended Pension Plan Rewards long service consistent with current plan Cash balance account paid as a lump sum Cash balance account is easier to understand Provides competitive benefits Eliminates balance sheet adjustment 37

38 Benefit Accrual Patterns Benefit Accrual Benefit Values as a Multiple of Total Pay Current FAP CB Svc Age at Termination or Retirement Employee age 30 with 0 years service. Pay of $40,000. Salary increase 3.5%. 38

39 Future of Retirement Plans 39

40 Future of Retirement Plans Baby boomers are retiring Uncertainty regarding social security system Phased retirement Retirement age Health Life expectancy Recent bear market 40

41 Defined Contribution Compared to Defined Benefit Plans Investment returns from were 100 basis points higher in DB plans compared to DC plans Asset allocation key determinant in accumulating wealth Workers key characteristics and preferences influence asset allocations 41

42 Retirement Consulting Design retirement programs based on changing objectives Determine cash flow for plans Contributions satisfying funding requirements Benefit payments Determine impact of new legislation such as the Pension Protection Act on plan funding Calculate pension expense under FASB # 87 and 132 and IAS #19 accounting standards 42

43 Retirement Consulting Calculate benefits Perform budget planning calculations Asset liability modeling Non-discrimination testing 43

44 Questions 44