Developing a Strategy for Moving from Pension to 401(k) Benefits

Budgeting for next year’s cost of employer-provided benefits can seem daunting, especially when an organization sponsors both a defined benefit pension plan and a 401(k) defined contribution plan. Is it time to consider moving away from the defined benefit pension plan to avoid the volatility and risk? If so, plan sponsors should develop a well-thought-out process for analyzing the alternatives and impact to both employer costs and participant benefits. The overall strategy and objectives should be reviewed.

Each year, an actuary provides projections for the defined benefit pension plan and the amount required to fund seems to be ever-increasing. It feels like there’s no end in sight. Becoming fully funded seems to be a dream instead of a reality. Even in years when the assets in the plan had double-digit returns, there was either a new mortality table that needed to be adopted or the required interest rates dropped – all increasing the plan’s liability. This can be very difficult to manage going forward.

Strategy for Moving from Pension to 401(k) Benefits

While it is challenging to deliver an equivalent benefit in a defined contribution plan at the same level of contribution, defined contribution plans provide a predictable level of employer contribution each year. If plan sponsors are considering a transition to a replacement 401(k) plan, an analysis should be conducted to:

  • Determine the level of benefit desired for employees
  • Set a budget that provides the desired level of benefit when considering a defined benefit pension plan freeze

Performing the Analysis

When performing this type of analysis, we encourage companies to start by thinking of both the defined benefit pension and defined contribution plans together as a total retirement benefit. This allows the plan sponsor to contemplate its philosophy and develop a strategy related to short- and long-term goals for the retirement program.

Pension to 401(k) Benefits Flowchart

Establish Guidelines

Plan sponsors should start with a well-defined and proven process, taking the time to establish guidelines and understand the financial strategy. Begin by discussing the organization’s philosophy and define objectives for the retirement program to guide decision-making. These guidelines should include how the plan sponsor feels about management/budgeting of retirement plan costs, willingness to take on risk, providing benefits based on the organization’s ability to fund – discretionary vs. mandatory, the level of employees’ retirement benefits, and the competitiveness of benefits.

Determine Affordability

By evaluating all the current retirement plans and the projected cost and benefits, organizations will better understand the current and projected state of the plans and be able to determine the affordability of current plans over the long-term. The evaluation also allows them to discuss acceptable benefit levels and a cost strategy. A thorough analysis of the current and projected costs should include an outline of the current state of the program, including five-year projections under three scenarios for the defined benefit pension plan:

  • Ongoing plan
  • Closed to new entrants
  • Frozen accruals

In addition, the termination liability estimate under agreed upon assumptions should be calculated.

Determine Competitive Position

The guidelines and budgets are then coordinated with competitive market benchmarking to identify relevant alternatives to evaluate. Benchmarking the retirement plan benefits with competitive norms relative to the market allows the organization to measure the competitive position of benefits and expenses compared to industry/geographic region/employer size based on revenue or number of employees. The benchmarking helps the plan sponsor make informed decisions on the:

  • Form of benefit to be provided
  • Desired level of benefit for new hires/newly eligible participants
  • Impact on total compensation and the benefits package
  • Desired contribution allocation structure – pro-rata on pay, position-based, or based on age and/or length of service

Evaluate Alternate Strategies

Potential plan design alternatives including utilizing the current defined contribution plan should be developed based on previous discussions related to the organization’s philosophy, objectives and strategic direction for the retirement program. Alternative strategies can be assessed to determine the final strategic direction of the retirement program, such as modifying the current level of pension benefits or reduction/elimination of the defined benefit pension plan by freezing pension benefit accruals for all participants and moving toward a defined contribution plan only strategy.

Other strategies such as grandfathering selected participants or providing participants a “choice” between defined benefit and enhanced defined contribution benefits should be considered. If providing enhanced defined contribution benefits, determination of how the benefit will be provided – either with matching contributions and/or non-elective contributions in a fixed amount, performance-based, or based on a tiered age and/or service allocation – should be evaluated as well.

Modeling different plan designs that include variations of both defined benefit pension and defined contribution structures helps the plan sponsor compare costs and benefits. Based on the guidelines set upfront, these plan designs reflect the organization’s philosophical principles for providing these benefits to employees. The results of this analysis and each alternative are compared to the current plan(s) to show the overall impact on the employer-provided cost and level of employee benefit. Be prepared to study supplemental alternatives at this point because the first set may provoke additional thoughts or refinements.

Plan sponsors must be aware of compliance testing restrictions and be sure that any alternative considered will satisfy compliance rules — there is no point in studying an alternative that cannot be adopted due to nondiscrimination or coverage issues.

Making and Implementing the Decision

When all alternatives are reviewed, a final recommendation that ultimately links the retirement strategy with the philosophy and desired objectives is presented. Any potential transition issues or challenges should be outlined and a communication strategy should be developed. Establishing a formal communication plan is very important.

Develop and Document the Retirement Plan Strategy and Implementation Plan

The end result of the review should include a proposed retirement plan strategy to be presented to the board of directors. The proposed strategy should document the findings and conclusions of the review process and identify the steps necessary to carry out the recommendations within the strategy.

Change Management: Communicating to Employees

After the decision is made to change retirement benefits, communication to those impacted is key. This is the perfect time to remind employees of the retirement program and its overall value. In addition to government-required notices, you should also consider proactively sending out an individualized statement outlining the changes and providing the impact on participant’s benefits. It is important to make sure the changes are communicated clearly and that each participant understands the changes. Sometimes plan sponsors will hold group or one-on-one meetings with those impacted.

In Perspective

A change in the retirement program is a significant decision that affects the organization and its employees significantly. A thoughtful approach to a change like this can lead to better alignment of the overall program with organizational philosophy and goals, while still providing employees with competitive benefits.

If you have any questions regarding your options with transitioning from pension to 401(k) benefits, please contact Amy Kennedy at amy.kennedy@findley.com or Kathy Soper at kathy.soper@findley.com.

Published May 14, 2020

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Pension Mortality Updates May Decrease Liabilities

The Society of Actuaries’ (SOA) new Scale MP-2019 mortality improvement rates will lead to lower liabilities compared to the previous versions. Along with the improvement scale, the SOA’s Retirement Plans Experience Committee (RPEC) also released a set of new mortality tables, Pri-2012, both on October 23rd. The new tables and improvement scale may be used for financial reporting purposes now. The improvement scale is expected to be used in 2021 for PBGC, lump sum, and cash funding calculations.

Pri-2012 Mortality Tables

The Pri-2012 tables are the most recent private mortality tables released by the SOA since the RP-2006 tables. The SOA estimates that most plan liabilities will fall within 1.0% (up or down) of the liability they would have seen under the RP-2006 tables. The new tables were developed using data from 2010-2014 and reflect the RPEC’s commitment to update the base mortality tables every five years.

When compared to the RP-2006 tables, life expectancy for a 65 year old female remains at 87.4, while the life expectancy of a 65 year old male decreased from 85.0 to 84.7.

The new Pri-2012 tables are based on more multiemployer data compared to the prior tables. Mortality experience under multiemployer plans did not differ significantly from experience in single employer plans. The SOA determined that job classification (blue-collar and white-collar) is an increasing forecaster of mortality and more indicative of future experience than benefit amount.

The SOA identified that surviving beneficiaries had higher mortality than the general population and created separate mortality tables for this demographic with the Pri-2012 tables update.

MP-2019 Mortality Improvement Scale

The new mortality improvement scale MP-2019 is based on historical U.S. population mortality. This continues to fulfill the RPEC’s pledge to update the improvement scales annually.

Consistent with all prior updates since the first table (MP-2014) was released, the MP-2019 improvement scale will reduce liabilities for pension plans compared to the MP-2018 improvement scale. The SOA estimated that pension obligations will typically be 0.3% to 1.0% lower when compared to using Scale MP-2018.

According to the study, the observed age-adjusted mortality rate increased slightly from the prior year, yet it is fairly level relative to the last several years. Also, the age-adjusted mortality improvement rate averaged just 0.3% per year from 2010 to 2017, compared to 0.5% that was observed in the prior study from 2009 to 2016.

Implications for Pension Plans

Pri-2012 may be adopted for financial accounting disclosures and pension expense purposes. The adoption of the new tables will likely result in little change to liabilities. We expect plan sponsors will generally adopt the Pri-2012 tables to replace the RP-2006 tables.

Plan sponsors who have updated their improvement scale annually will generally adopt the MP-2019 improvement scale. As noted, it is expected to lower liabilities, and thus will result in lower pension expense.

We do not expect that the minimum funding calculations, PBGC premiums, and lump sum calculations will use the Pri-2012 table in the near future. However, the 2021 plan year will likely incorporate the MP-2019 scale based on the currently proposed intent from the IRS. Absent any other changes, this update will result in lower funding liability, PBGC liability and lump sum amounts for pension plans in that plan year.

More information regarding the Pri-2012 mortality table and the Scale MP-2019 mortality improvement scale release can be found on the Society of Actuaries’ website links above.

Questions? Contact the Findley consultant you normally work with, or contact Matthew Gilliland at matthew.gilliland@findley.com, 615.665.5306 or Matthew Widick at matthew.widick@findley.com, 615.665.5407.

Published October 28, 2019

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