Podcast Transcript

Speakers

Robert Krebner, Consultant, Princeton
John Redmond, Senior Vice President, Consulting Actuary, Chicago

Podcast transcript

Narrator: Governance, operations, investments, compliance. These are the four pillars of risk that defined contribution plan sponsors need to stay up on. Every quarter we're going to be giving you the scoop, the skinny, the lowdown on all the latest developments in the field; everything you need to know to stay current and informed. We're going to be talking regulatory issues, best practices, investment strategies, all of it, about what it all means and more important, what it means to you. So put on your swimsuit, we're going to be doing some deep dives. Welcome to the Retirement Plan Insider from Segal.

Robert Krebner: Welcome to another edition of the Retirement Plan Insider podcast, brought to you by Segal. I'm your host, Robert Krebner. My co-host Rick Reed, unable to attend today's discussion, but rest assured he will be back for the next episode. Today I'm super excited because we're going to be talking about something that is unique and outside the norm when you think about traditional retirement plans, and that's something called a Variable Annuity Pension plan. So joining us today to provide everything we need to know, we have a very special guest, no better person to discuss this topic with, it's Senior Vice President and Midwest Retirement Practice Leader, John Redmond. John, welcome. Why don't you tell the audience a little bit about yourself?

John Redmond: Sure. I'm, as Robert mentioned, Senior Vice President, Midwest Retirement Practice Leader. I've been with Segal for about 20 years, a little bit over. Work solely in the pension field, mostly with multiemployer plans and with one corporate plan, and really excited to have the opportunity to learn about Variable Annuity Pension plan several years back, and I've gotten a chance to present on the matter at a couple of conferences for other actuaries. Really excited about them and really enjoy working with them. I have several clients that have already made the change and like talking about it and like developing material for it within Segal.

Robert Krebner: Well, thank you, John. We're really glad you could join us today. So let me start with this. When it comes to retirement, I read the news and the theme for many years now is that the majority of Americans are either not prepared or not on track for retirement. So let's set the table with this. John, in your mind, what are some of the biggest reasons we ended up where we are today?

John Redmond: A lot of it is volatility. I mean, if you look at the studies, the Employee Benefits Research Institute noted that around 1979, roughly 40 percent of all Americans were covered by a defined benefit pension plan. So that means a pension plan that was going to pay them a lifetime annuity, a monthly benefit that they earned throughout their career and would be paid for the rest of their life. It's down to about 8 percent now, with those 8 percent pretty much all being union workforce or working for a federal state, local government. Companies no longer offer that traditional defined benefit plan. A lot of it is they froze or terminated those plans over the years because of the risks that were associated with the plans. Under the funding rules contributions were just so hard to predict. Since assets go up and down, the volatility in the investment market, interest rate changes, the corporate funding rules have been using very low interest rates for years, which produce large swings in contribution requirements. They had to pay too much money into it.

Couple that with PBGC premiums, the substantial increases and with the conservative assumptions you have to use over and on top of the standard premium, you also have a high variable rate premium. Risk management, just forced plans to close.

Robert Krebner: No, I definitely agree with you on that. And high risk, interest rate volatility between funding accounting and PBGC premiums, you mentioned there's just so many different rules to manage and it seems like plan sponsors just felt that it's simpler to offer 401k, 403(b), et cetera, but I think you would agree those defined contribution plans really weren't designed to support employee's full retirement income. Would you agree with that?

John Redmond: Absolutely. The employees left to manage their own retirement, even balances, hundreds of thousands of dollars or million may not be enough. Plus you get less investment returns when you're investing toward your own time horizon than what a defined benefit plan could provide you, because you've got more young people whose longer time horizon allows them to take a little bit better track on investment so you can get more returns. Plus you can outlive your 401k benefit. How do you spend it? Do you spend enough? In which case, if you spend too much, you outlive it. If you don't spend enough, you're really hurting your quality of life. You can't really plan for it because you're afraid of outliving it. I really think there needs to be the 401k was meant to be a supplement and part of the retirement picture, to add to that lifetime monthly income that is really missing in America today.

Robert Krebner: Right, right. So tell me from a pension perspective, can anything be done about all this?

John Redmond: I do think the world of traditional defined benefit arrangements, it's still very strong in multiemployer. But I think in corporate America with the current funding rules, I'm not sure that that traditional defined benefit, as we used to think of it, is really going to fill that gap. But there are some alternative plan designs that are really popping up that can. Specifically, I think of Variable Annuity Pension plans. It's certainly a place that can fill that hole.

Robert Krebner: Okay, so for those that are new to the concept, what is a Variable Annuity Pension plan, or a VAPP for short?

John Redmond: In the simplest terms possible, a VAPP is a type of defined benefit plan, but the benefits are linked to investments. So they go up and down based on how investments perform against a hurdle rate. A hurdle rate is a plan chosen rate, typically somewhere in the five to six percent range. So a lot like a defined contribution or a 401k plan. When investments do well, the benefits go up. When investments do poorly, the benefits go down. But unlike a defined contribution plan, you still get the benefit of those pooled investments, that longer time horizon. You also get a monthly benefit you cannot outlive.

Robert Krebner: Okay, so VAPP is a defined benefit plan, but you would say it's kind of like a hybrid DB and DC plan?

John Redmond: Absolutely, it is one of the alternative plan designs. It's similar to a cash balance, but one that provides a monthly annuity, so it takes a lot of the best of both worlds. So it takes the lifetime monthly income from a defined benefit plan and then adds that risk management that a defined contribution plan provides for employers.

Robert Krebner: Now, I mentioned in the beginning that this topic isn't really something you think about when you think traditional retirement plans. So why is that? I mean, when I first started in the industry, I didn't hear much about Variable Annuity Pension plans. So why am I hearing more about them now? Are they something new?

John Redmond: They're actually not new at all, they're quite old. They've been around for about 70 years. A handful of them adopted in the beginning, but they're becoming a little more common today. It's really employers and particularly unions are just taking a closer look. So there's a couple of dozen unions that have made the decision that they have converted their traditional defined benefit plans into something variable, and corporations are really starting to look at it as well. There's a handful, three or four corporations, that have already made that switch. This is a way to manage risk and have a little bit more predictability in the contribution requirements.

Robert Krebner: Okay, so you mentioned corporations. So tell me what type of organizations could benefit the most from adopting a VAPP?

John Redmond: I really think it's a good solution for corporate America for many of the reasons why plans offered or why employers offered retirement benefits in the first place. If you look back to the 70s and 80s, the idea of offering a pension was really to attract talent, first so for recruitment to retain talent for workforce management in a tight labor market, especially in a competitive industry where you're fighting over those talented workers that you want to keep and that you want to take from others and build your talent base. I think offering a Variable Annuity Pension plan, being able to provide those retirement benefits, I think it gives you a competitive advantage in that attracting and retaining talent. I know quite a few Segal colleagues who I've met over the years who have come to us from other firms, and one of the reasons I often hear is, "You know what? I'm so happy I've got a pension now."

Robert Krebner: Oh, definitely. So you did mention though, all those risks that caused traditional pension plans to freeze or terminate. So a VAPP being a pension plan, what happens to those risks in a VAPP design?

John Redmond: The two biggest risks that I think corporate plans face are investment risk and interest rate risk. So investment risk, when the stock market has a bad year, your assets go down. That's something that really affects the contribution requirement. Interest rate, whenever interest rates go down, liabilities go up. And there certainly have been times where those two have happened together. So all of a sudden you've got lower assets, higher liabilities, have significant underfunding. So contribution requirement is so much greater. Increased accounting costs, balance sheet reductions, higher premiums than PBGC, that's the government agency that ensures pension plans, and those premiums are compounded by variable rate premiums. The more underfunded you are, the higher that premium is, the more money that has to go into that insurance.

Variable Annuity Pension plans are a little bit different. Because the benefits go up and down with the investment returns, when those assets go down, so do the liabilities, and they go down pretty much in lockstep depending on how you design them. So that investment risk, instead of sitting with the employer, with the plan sponsor, it's passed on and shared with the participant. It allows contributions to be a little bit more stable, a little bit more predictable. Assets and liabilities move up and down together. Also, because those benefits fluctuate and continue to fluctuate with market experience, if you're valuing at a lower interest rate, it doesn't really impact plan costs, the benefits are usually just valued at the hurdle rate, that five or six percent. So you're able to have that more predictability on the liabilities and the contribution requirements as well, even in volatile interest rate markets.

Robert Krebner: Interesting. So I want to highlight what you just said there, which is investment risk and interest rate risk shifts to the employees. So if I'm understanding this correctly, what makes this a hybrid plan is that participants accrue benefits which are determinable and guaranteed at a certain age, just like a traditional pension, but the difference here is that benefits fluctuate with the market, so participants are helping to share that risk. Is that right?

John Redmond: Absolutely. In the old-style traditional defined benefit plans where you get a percent of pay for the rest of your life at retirement, the plan sponsor really bore all of the risks. So the mortality risk, the maturity, how long are you going to live? That was with plan sponsor, so was the investment risk, so was the interest rate risk, all of the demographic risks. These hybrid plans are really about risk sharing. So now the participant takes on a large portion of the investment risk while the plan sponsor maintains all those demographic risks, and really the interest rate risk is almost minimized. So everybody's sharing in a very tiny bit of interest rate risk and the other risks are spread more in an even or equitable manner, at least as far as many of these plan sponsors are concerned who are considering this variable annuity, it's really about sharing the risks more equally across employer and employee.

Robert Krebner: So let's now address the elephant in the room, which is that you said there's a chance that benefits could decrease. So wouldn't participants be unhappy about this?

John Redmond: I absolutely believe that a retiree whose benefit goes down is probably going to be a bit unhappy, but overall you'd be surprised that benefit variability just isn't all that concerning to employees overall. There was recently a study in 2022, I read a study done by The Society of Actuaries. They were conducting a survey and they were really ranking various plan features and trade-offs. They had 15 different things that they were asking people to choose among, design options and trying to determine utility, what was really important to people. Not that fixed versus variable, it was ranked 13 out of 15. It was far below other concerns. Participants were far more concerned about being able to retire when they wanted to. So the availability of early retirement revisions, the type of death benefits that a plan would offer, whether or not they'll offer disability benefits, the ability to have cost of living adjustments in retirement, so can your benefit go up in retirement, those were all things that individuals who were surveyed were making decisions of which pension plan they prefer based off of, and the fixed versus variable just wasn't.

It certainly is a concern, but it's just not as big as outliving your benefits and being able to retire when you want to. Also, when you design a Variable Annuity Plan, the idea is that in most years it's going to go up. So you just have to be able to handle those years when it doesn't.

Robert Krebner: Right. And aren't there ways that plan designs can protect against benefit decreases?

John Redmond: Oh, absolutely. A pure Variable Annuity Plan, so if you look at no bells and whistles, nothing really on there, that definitely goes up and down with markets. But there are stabilization measures that you could adopt, whether it's reserving or smoothing, it would lessen a decrease, and some of them prevent a decrease altogether.

Robert Krebner: Besides mitigating interest and investment risk, what are some other reasons you see plan sponsors consider VAPPs?

John Redmond: It really comes down to attracting top talent, retaining valuable employees, and doing so in a way with costs you can predict. Looking at the news just recently, you can see the machinists strike at Boeing. That's a huge glaring example of how important meaningful retirement income is. I just saw that several thousand people have their health benefits canceled because they're not willing to return to Boeing without a contract that includes retirement benefits. Being able to offer that meaningful retirement income to your employees in a way that's safe, secure, predictable, it's going to give a huge advantage to a corporation. It's even a bonus too. The benefits can be reasonably expected to grow even after retirement. It just makes that Variable Annuity Plan so much more attractive and appreciated.

So I really think that that's where corporations can look and really should be looking, just to give themselves an edge. Unemployment rates are extremely low. There's only so many people out there who are looking for work. So being able to offer a pension plan, being able to offer that secure benefit into retirement, I think it's the wave of the future and I think it's the way you're going to get that top talent to come to your company.

Robert Krebner: And that all ties back to that stat you gave at the top, that 8 percent are covered by a pension plan today. And like you said, what a huge advantage it must be to offer a pension plan in today's environment to attract and retain that top talent. And just like a traditional pension plan, the retirement income is meaningful and appreciated by employees. So I totally agree with that. Well, John, this was fantastic. Do you have any final words for the audience?

John Redmond: I just want to encourage any company HR out there looking, and you're really looking at your workforce and saying, "Hey, why can't I get that really experienced individual? What is it about my benefits that can't draw them over?" It's really not all about salary, it's really about providing that full benefit package. And I think a defined benefit plan, a retirement plan, fills that gap, fills that hole and makes your company that much more attractive for somebody to maybe come over there and work with you, really shows that you're concerned about your employees. And I think that a Variable Annuity Pension plan, one where the costs are quite predictable and manages all those risks for why maybe your corporation got rid of their defined benefit plan 20 years ago, I think it's something that people should take a fresh look at.

Robert Krebner: Well, John, thank you again so much for taking this time today to share this information. After speaking with you, I truly believe that VAPPs are a big part of the future landscape for retirement plans. And honestly, I can't believe they're not as popular as they could be. I mean, I think they might be the best kept secret in the industry, but they certainly shouldn't be. So I don't know, who knows, they might just be the next big thing that steps in and saves the day when it comes to addressing that retirement income gap for Americans.

So we could go on and on about this topic and we certainly will continue the conversation around retirement security and future episodes, but that is it for us today. We are going to wrap there. From John and myself and everyone at Segal, thank you as always for tuning into the Retirement Plan Insider podcast. For more episodes, check out our website at www.segalco.com, and don't forget to tune into next quarter's episode. Goodbye everyone.