Of DC plan benefits adequacy and employer contributions

In the context of a defined benefit to DC transition, opting for this approach has allowed many employers not only to get away from some of the now well-known DB-related risks, but also to reduce their pension funding costs. For instance, a DB plan which maybe had an employer’s share of its “normal cost” (i.e., excluding any special funding or deficit-related contributions) of, say, 7.5% of salary and transforms into a DC plan with the median 5% employer contribution rate would reduce going-concern contributions by 2.5% of pay.

If you now consider a DC contribution formula which would include a matching mechanism (say, 3% base employer contribution rate with an extra 50% matching on employee contributions up to an extra 2%, totalling a potential 5%), the savings may be even greater. It is widely known that when given the choice to contribute less than the maximum, most employees do (particularly younger ones). So the actual overall new employer contributions in this second example may then be closer to 4%.

Obviously, all things being equal, lower employer contributions can only mean lower pensions come retirement—unless employees make up for the difference, something we know does not happen.

Contribution setting 2.0
Increasingly, we are seeing employers wanting to go beyond this simple copycat approach and think of plan design in new ways. One consists of determining target income replacement ratios at retirement. Some sophisticated tools are now brought to the table (for instance, taking into account the volatility of future rates of returns as well as retiree longevity) that allow plan sponsors to model replacement ratios for various groups of employees. This in turn permits some fine-tuning of contribution formulas, possibly by employee category, by level of income or by a combination of age and service.

The outcome of such an approach may lead to higher employer contribution rates, but not always. Finer analysis oftentimes shows that lower income earners may not need contribution rates as high as once thought when public plans and programs are taken into consideration. This approach therefore allows for a better fit as to where employer contributions are going, optimizing participant retirement income given the plan sponsor’s financial involvement.

When this is done in the context of a DB to DC transition, the results of such replacement ratio analysis can also be used to communicate with plan members and explain the impact of the change. By providing more meaningful information on expected retirement income, the employer can reduce uncertainty, better manage employee expectations and have a positive impact on their perception of the DC plan.

Don’t shoot at DC plans
I have read a lot recently about how DC plans may not provide future retirees with adequate income. One has to look, however, at what the actual goal of the plan is. Is it to replicate what a DB plan as we normally think of provides in terms of pension income? Possibly, but likely not. In that case, a DC plan sponsor needs to ensure that participants’ expectations of the plan outcomes are well managed and communicated—particularly in the context of a DB to DC transition. Otherwise, there are probably troubles ahead.