Defined Benefit Pension Plan Strategic Value or Burden? 1. Doug Andersen Area Vice President, Arthur J. Gallagher 2. Bob Sloan Area Vice President, Arthur J. Gallagher 3. Chris Engelhardt Vice President Client Strategy & Solutions, Transamerica Retirement Solutions
Outline Section 1 The Defined Benefit Decline Section 2 Retirement Philosophy DB or DC? Section 3 Transition Options and Issues Section 4 De-risking Options 2
Outline The Defined Benefit Decline 3
DB Decrease by Plan Size (1985 2013) 70 60 50 67 Number of Defined Benefit Plans in Thousands 1985 1995 2005 2011 40 30 20 10 0 24 23 13 12 12 10 9 8 7 5 5 3 3 4 3 4 4 4 3 <25 Participants 25-99 Participants 100-249 Participants 250-999 >1,000 Participants Source: PBGC Premium Filings 4
DB Pressures Corporate Plans Public Sector Plans Church Plans Benefits Guarantees Anti cutback rules Contractual obligations None Insurance Required PBGC premiums Taxing authority None (unless elected) Funding Assumptions Funding Period Failure to Fund Corporate bond rates Mandated by IRS Mandated rolling 7 Years Long-term assumptions Discretionary Discretionary up to rolling 30 years Long-term assumptions Discretionary Discretionary 10% Excise Tax Political Pressure Varies Accounting Assumptions Recognition Corporate bond rates suggested by FASB Immediate recognition of Unfunded Liability Long-term assumptions suggested by GASB Immediate recognition of Unfunded Liability Discretionary Discretionary Result Volatility issues closures and freezes Pressure to study, but few transitions Uncertain 5
Outline Retirement Philosophy DB or DC? 6
Retirement Program Objectives Benefit Objectives Cost Objectives Provide a reasonable standard of living for long-term employees Achieve and maintain an appropriate funded status Provide benefits that are competitive for employee recruiting and retention Attain a manageable amount of contribution volatility & risk of future increases Provide benefits that are fair across the employee classes Attain a reasonable balance of contribution sharing with the employees Share a reasonable amount of investment risk with employees Attain a cost that is considered affordable with respect to all other competing priorities 7
Retirement Program Objectives Benefits Contributions Investment = + Earnings Administrative Costs Defined Benefit plans provide a fixed monthly benefit. Contributions will increase if investment earnings are less than an assumed amount and will decrease if earnings exceed an assumed amount. Defined Contribution plans provide benefits that will vary with investment earnings. contribution amount is fixed. The Regardless of the type of retirement program, benefits will be based on contributions plus investment earnings less administrative costs. 8
Comparison of DB & DC Features Defined Benefit Plans Defined Contribution Plans Investment Risk Maintained by Sponsor Maintained by Employee Participant s Retirement Benefit Fixed Benefit Variable Benefit Employee Cost Fixed Rate Fixed Rate Employer Cost Variable Cost Fixed Rate Benefit Accrual Pattern Accruals are relatively small early and relatively large near retirement Accruals are more consistent throughout career Advantaged Participants Employees closer to retirement Employees further from retirement Retention & Portability Subsidized Early Retirement Understandability Greater retention of employees (due to valuable accruals near retirement) Available Generally considered difficult for employees to understand Greater portability for employees (due to more valuable early accruals) Not Available Generally considered easy for employees to understand Post Retirement Risk Participant can t outlive benefits Participant must manage post-retirement mortality risk 9
Benefit Accrual Patterns Defined Benefit Defined Contribution Value of Benefit 25 30 35 40 45 50 55 60 65 Age The value of benefits earned differ significantly over the course of employment depending upon the type of retirement plan. 10
Outline Transition Options and Issues 11
DB to DC Transition Process Determine the true Defined Benefit cost first Total Contribution Requirement vs. Normal Cost Effect of assumptions Isolate the value to current employees Determine the benefit for participants Develop a replacement ratio for the current plan Compare to proposed plan Project Costs Legacy costs unfunded liability still exists New plan costs Transition Benefits Compromise on benefit reductions and cost reductions Mitigate adverse impact on employees 12
DB Cost Past and Future Components Participant Data Assumptions & Methods Plan Provisions Present Value of Total Benefits Present Value of Past Service Benefits Present Value of Future Service Benefits Value of Assets Unfunded Liability Required Contribution = Amortization of Unfunded Liability + Normal Cost 13
Normal Cost = Active Employee Benefit Value The percentages below demonstrate Normal Cost values for participants of different plan entry ages and under different assumptions. The higher the assumed plan return, the lower the assumed cost to provide benefits. The Normal Cost may be used to develop a comparable defined contribution rate. 15.0% 13.4% 14.6% 12.2% 12.4% 10.0% 5.0% 5.3% 6.3% 7.5% 7.3% 8.4% 9.6% 10.9% 9.8% 7.7% 8.8% 10.0% 8.0% 8.0% 8.0% 0.0% 20 30 40 50 All Actives DC Plan 8.0% Return 7.5% Return 7.0% Return 14
Recommended Replacement Ratios The replacement ratio is a tool used to measure benefit adequacy and equals Gross Income After Retirement Gross Income Before Retirement 100% 80% 60% 35% 38% 38% 37% 54% 39% 43% 47% 50% 53% 56% 40% 20% 46% 42% 40% 36% 33% 30% 28% 25% 22% 0% $20 $30 $40 $50 $60 $70 $80 $90 $100 $110 Pre-Retirement Income ($ in thousands) Replacement Ratio Needed From Other Sources Estimated Social Security Replacement Ratio 15
Hypothetical Employees Retirement Benefits Assumptions Retirement Age 65 Pay $40,000 140% 120% Projected Replacement Ratio ABC DB Plan Social Security Hypothetical Employee Hire Age Years of Service at Retirement 100% 1 25 40 2 35 30 80% 81% 61% 3 45 20 4 55 10 60% 41% 20% 40% 20% 42% 42% 42% 42% 0% Hire Age 25 Hire Age 35 Hire Age 45 Hire Age 55 16
Option A - Freeze and Close 5 to 20 years? DB January 1, 2015 Freeze & Close Terminate New employees enter DC plan DC Plan 17
Option A Typical Benefit Impact Ratio Change 40% 30% 4% Rate of Return 20% 10% DB 0% -10% -20% -30% -40% 20 30 40 50 60 Current Service Rate of Return Assumption 4% Positive or No Change 0% of Participants Negative Change 100% of Participants Ratio Change 40% 8% Rate of Return 30% 20% 10% 0% -10% -20% -30% -40% 20 30 40 50 60 Current Service Rate of Return Assumption 8% Positive or No Change 47% of Participants Negative Change 53% of Participants Current Age 20 35 Current Age 35-50 Current Age 50+ 18
Option B Close & Grandfather 20 to 30 years? DB Close Terminate January 1, 2015 Target Benefit Active participants over age 50 may choose to remain in DB Plan or receive future contributions from Target Benefit plan or 3% Plan. Participants may choose to rollover benefits New employees enter DC plan 3% DC Plan 19
Option B Typical Benefit Impact Ratio Change 40% 30% 20% 10% 0% -10% -20% -30% -40% 4% Rate of Return 20 30 40 50 60 Current Service Rate of Return Assumption 4% Positive or No Change 40% of Participants Negative Change 60% of Participants Ratio Change 40% 8% Rate of Return 30% 20% 10% 0% -10% -20% -30% -40% 20 30 40 50 60 Current Service Rate of Return Assumption 8% Positive or No Change 85% of Participants Negative Change 15% of Participants Current Age 20 35 Current Age 35 50 Current Age 50+ 20
Spectrum of Options There are a wide range of Defined Contribution plan designs. The following summarizes the spectrum of options ranging from the simplest to most complex. Fixed Defined Contribution Plan Fixed Defined Contribution with Grandfathering Target Benefit Plan Description All participants receive the same contribution All participants receive the same contribution except a grandfathered group that receives an additional contribution Contribution varies based on age and service with older and longer service participants receiving larger contributions Cost Compared to Current Plan Cost Neutral Higher Cost for Grandfathered Group Cost Neutral Fairness Some participants will receive more benefit and others will receive less than under the current plan Grandfathering helps to provide more comparable benefits to the current plan for older and/or longer service participants All participants will receive the same benefit (in theory) as under the current plan Employee Comprehension Easily understood More complicated for grandfathered group Most Complicated 21
Cost transition Variable to Fixed 12.0% Transition from a 6% Normal Cost DB Plan (with an unfunded liability) to a 6% of Pay DC Plan 10.0% 8.0% 6.0% 5.8% 5.6% 5.5% 5.3% 5.2% 5.0% 4.9% 4.7% 4.6% 4.5% 4.3% 4.2% 4.1% 4.0% 3.8% 3.7% 3.6% % of Pay 6.0% 4.0% 2.0% 0.0% 6.0% 0.2% 0.1% 0.1% 0.1% 0.1% 0.1% 0.1% 0.1% 0.1% 0.1% 0.1% 0.1% 0.1% 0.1% 0.1% 0.1% 0.3% 0.6% 0.8% 1.1% 1.3% 1.6% 1.8% 2.0% 2.3% 2.5% 2.7% 2.9% 3.1% 3.4% 3.6% 3.8% 3.9% 4.1% 4.3% 4.5% 4.6% 4.8% 4.9% 5.1% 0.2% 0.2% 0.2% 0.2% 0.2% 0.2% 0.2% 0.2% 0.2% 5.7% 5.4% 5.1% 4.9% 4.6% 4.4% 4.1% 3.9% 3.6% 3.4% 3.1% 2.9% 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020 2021 2022 2023 2024 2025 2026 2027 2028 2029 2030 2031 2.7% 2.5% 2.2% 2.0% 1.9% 1.7% 1.5% 1.3% 1.2% 1.0% 0.9% 0.8% DC Plan Base Contribution DC Plan Transition Benefits DB Normal Cost Amortization of UAAL 22
Outline De-risking Options 23
De-risking Options De-risking is any activity that attempts to reduce the size of a sponsor s pension liability or minimize the impact of pension assets on its financial statements 24
De-risking Options Risk Factors Common To All Pension Plans Interest Rate Volatility Capital Market Return Volatility Participant Longevity Changes in Pension Accounting and Funding Rules Increase in Plan Management Fees Additional Factors Driving Current De-risking Strategies Frozen Plans Have Little Strategic Value Lump sum Rates Equal Funding and Accounting Rates Termination Allows Distribution of Assets to Employees 25
De-risking Options Asset Actions Liability Actions 26
De-risking Options TV Cash Out Strategy Offered to terminated vested employees (TV) with frozen benefits to receive lump sum Many would elect cash today vs. benefit in the future No impact on benefits Provides choice to the TV to mitigate inflation erosion Potential opportunity to cash out liabilities at favorable rates 27
De-risking Options Annuity Purchases Purchase annuities for current retirees or TV s Liability is fully transferred to annuity carrier No impact on benefits Benefits fully insured to the state guaranty association limitations Longevity risk and market volatility mitigated Most costly option when considering current annuity purchase rates 28
De-risking Options Full Plan Termination Purchase annuities for retirees, remaining TV s and active employees Liability is fully transferred to annuity carrier No impact on benefits Benefits fully insured to the state guaranty association limitations Most costly option when considering current annuity purchase rates Will require cash infusion for underfunded plans 29
De-risking Options Liability Driven Investing A strategy based on the cash flows needed to fund future plan liabilities Investment portfolio strategies are matched to the plan s projected benefit obligation No impact on benefits Achieve improved cash-flow matching and reduced plan funded status volatility LDI does not eliminate all risks to plan sponsors Insured LDI is a variation where guarantees are given by insurance carriers 30
De-risking Options Insured Buy-In/Buy-Out Strategies Transfer of risk and potential liabilities to insurance carrier Buy-In Strategies Funded status not impacted; contract value is an asset of plan Reduces benefit risks such as investment risk, interest risk, and longevity Achieve matching of plan assets and liabilities to reduce volatility Buy-Out Strategies Annuity purchase Buy-In Strategies may lead to Buy-Out 31
De-risking Options Why de-risking makes sense today? Costs of Plan Sponsorship Growing retiree group Shrinking active participant base Ever changing regulatory environment ERISA Non-ERISA Church Plan Status a church plan is defined as a plan established and maintained by a church or a convention or association of churches Challenges to Church Plan Status Kaplan vs. St. Peter s Healthcare (3/31/2014) Rollins vs. Dignity Healthcare (12/12/2013) Chavies vs. Catholic Health East (3/28/2013) Stapleton vs. Advocate Healthcare (3/17/2014) 32
De-risking Options Challenges to Church Plan Status Plaintiffs looking for ERISA coverage Benefit Accrual and vesting Reporting and disclosure Fiduciary responsibility Funding Kaplan vs. SPHS the interpretive question here is whether or not a non-profit entity, purportedly controlled by or associated with a church, may both establish and maintain a church plan. Based upon the plain text of the statute, the simple answer is no. Starting with subsection A, it is clear that Congress intended for a church plan first and foremost to be established by a church. Once the church establishes the plan, the church must also maintain it 33
De-risking Options Challenges to Church Plan Status Catholic Charities??? Catholic Cemeteries??? Catholic Hospitals??? Catholic Educational Institutions??? 34