Why use a ReDefined Benefit strategy?

June 28, 2012

In this article we provide a summary of why we think employers should consider a ReDefined Benefit (ReDB®) design, rather than a 401(k) or other defined contribution (DC) plan, as a core retirement plan for employers.

1. ReDB® is not TDB

Traditional defined benefit (TDB) plans pose serious difficulties for many employers, as we discuss in our article Plain Talk About Risk – To the Company. ReDB® plans don’t. Like DC plans, ReDB® plans produce stable, predictable costs to employers and transparent, account-based benefits to employees. Although they are technically DB plans, they address DB volatility concerns by carefully aligning plan liabilities with underlying assets.

That may not sound like a big deal, but this feature of a ReDB® plan has to be kept in mind as we discuss its other virtues, which can accomplish important financial and HR management objectives that DC plans can’t.

2. ReDB® plans produce better investment outcomes than DC alternatives

401(k) and other DC plans — because they are constructed based on a retail, mutual fund model — suffer from a persistent set of problems: (1) retail pricing of investment services (even for so-called ‘institutional spokes’); (2) limited, generic investment options, which typically preclude nontraditional asset classes and sophisticated investment strategies; and (3) poor investment decisions by many participants. The result – DC asset _under_performance and widely disparate outcomes for participants.

In a ReDB® plan, investment responsibility is retained at the company level, allowing employers to capitalize on company ‘institutional’ expertise, buying power, and investment discipline to the benefit of employees.

Also, as we discuss in our article Freezing Your Plan Pension May Not Be The Best Option, employers that have frozen their DB plan and converted to a DC plan face a new and costly risk: overfunding of the DB plan. Broad “de-risking” strategies for DB plans try to manage this risk using a progressively more conservative asset allocation ‘glide path’ that focuses on risk instead of return. Bottom line: higher costs.A ReDB® strategy does not require the company to freeze its DB plan; ongoing accruals are provided based on a ReDB® design. As a result, any surplus can be used to defray the cash cost of new benefit accruals, and assets can continue to be invested with an objective of prudently seeking return.

3. ReDB® plans allow for implementation of a rational risk and reward sharing strategy

What really sets a ReDB® plan apart is its unrivalled ability to share risks and rewards between employers and employees in novel and useful ways.

We understand that some employers with fresh experience sponsoring a TDB plan, will be understandably wary of taking on any retirement-related risks. In those cases, a ReDB® plan can operate almost exactly like a DC plan, with all investment experience (subject to a preservation of capital minimum) passed through to employees by, for example, defining ‘interest credits’ as equal to the return on plan assets.

But employers can do more under a ReDB® plan – by, for example, guaranteeing a cumulative return on participant accounts of up to 3%. Employees will readily understand and appreciate the value of such a guarantee, particularly in today’s investment climate.

But employers can do more under a ReDB® plan by, for example, guaranteeing a cumulative return on participant accounts of up to 3%. Employees will readily understand and appreciate the value of such a guarantee, particularly in today’s investment climate.

The risks of such a guarantee are transparent, easy to understand, and largely manageable – very different from risks faced by TDB sponsors. In fact, this (3% cumulative guarantee) risk is much lower than the risk cash balance sponsors face by guaranteeing a seemingly conservative “bond-based yield” for interest credits. For 2012, the yield on the 10-year Treasury is about 2%, as low as it’s ever been. But what if interest rates go up? In our view, as we discuss in or article Plain Talk About Cash Balance Plans, the risks associated with this type of design are significantly underappreciated.

In the financial world, guarantees always come with a price, usually in the form of ‘limited upside.’ And ReDB® plans allow for just this sort of provision, allowing the employer to cap or share in investment returns above some threshold of the employer’s choosing.

This “sharing” of investment risks and rewards, unique to ReDB® plans, also aligns employee and employer interests with respect to investments. In a DC environment, regardless of who is making investment decisions, employers have no “skin in the game” – i.e. no direct financial interest in the performance of plan assets. “Skin in the game” may be a big part of the explanation for superior DB investment performance, and this feature can be preserved under a ReDB® plan.

Finally, the ability to share risks allows employers, by design, to minimize the risk of large losses to employees that are an understandable source of anxiety in DC plans and an increasing motivation for lawsuits.

4. ReDB® plans allow for efficient management of longevity risk

‘Longevity risk’ is a hot topic right now and a major issue for many retirees and those approaching retirement. DC plans face a variety of technical hurdles to implementing annuity options to address this risk. The IRS recently released guidance on this issue, as we discuss in our article Administration provides guidance on annuities.

ReDB® plans, like DB plans generally, provide a natural risk pool among the employee population that allows employers to provide annuity options within the plan, which are generally easier to administer and more attractively priced to employees than their DC counterparts.

5. ReDB® plans are more inclusive than 401(k) plans

Many employers have adopted a “401(k) plus match” as their sole retirement plan. Experience suggests that, even under an auto-pilot design, 10%-20% of employees will choose not to participate in these plans, leaving them with no benefit. ReDB® plans provide benefits for all covered employees, delivering more comprehensive protection to employees.

6. ReDB® plans are more tax efficient than DC plans

Many employees under 401(k) plans are constrained from deferring as much for retirement as they would like. ReDB® plans allow for higher benefits than comparable DC plans. This means greater tax efficiency and a greater share of compensation dollars ending up in employees’ pockets.

The future of retirement plan design is in flux. Many employers have moved away from TDB plans due to intolerable cost volatility. We believe employers, in the process of “de-risking” their retirement plans, may be creating a new set of problems where they don’t have to. The ReDB® design, uniquely, allows employers the flexibility to address TDB risks while continuing to provide better retirement benefits than DC alternatives.