In prior articles in this series, I have revisited the design of hybrid pension plans—plans that deliver the better of a defined benefit(DB)promise and a defined contribution(DC)account balance. In this article, I will focus on the question of whether the funding of such a plan might produce very volatile employer contributions, and if so, how this could be managed.

The specific design under consideration is the following:

  • DC component: 5% of earnings contributed by both the employer and the employee for a total contribution of 10%
  • DB component: 0.8% of final three-year average earnings for each year of employment, with no inflation protection

From a funding perspective, this design can be considered as a very stable DC plan requiring a contribution of 5% each of covered payroll from both the employer and the participant, plus a potentially quite volatile DB plan that is the “tip of the iceberg”—exposed when the DB benefit is more valuable than the DC account balance.

In the previous article in this series, the plan design was developed using reasonable(but conservative)assumptions. On that basis, the starting point was that a 9% DC contribution could provide a 1% of final average earnings DB benefit for an employee retiring at age 65 with 35 years of service. We then altered the DB/DC relationship a little bit to increase the total DC contribution to 10% and to reduce the DB benefit to 0.8%. The purpose of altering the relationship was to make sure that the DB component was truly a “safety net.”

It turns out that this “safety net” design works as intended. For a 50-year-old with 20 years of service, the expected DC account balance is roughly twice the DB liability. The expected relationship for a 60-year-old has the DC account balance about one-third larger than the DB liability.

With this design, the DB excess liability will be positive only if there are material early retirement subsidies built into the design and poor experience emerges. Whether subsidies should be built into the design will be affected by the employer’s manpower planning strategies. As the baby boom generation starts to retire from the workforce, there will be a potential for labour shortages. In this environment, very few employers will want to encourage early retirement as a permanent feature of their pension plan.

What does this all mean? With this plan design, the DB benefit is truly a safety net and is unlikely to cause material swings in employer contributions to the hybrid plan. However, it is important for every sponsor of every DB plan to assess contribution volatility and their ability to withstand it.

In a perfect world, an employer concerned about contribution volatility would not contribute at minimum statutory levels, but instead would contribute larger amounts in the good times to smooth out the swings in contributions. As should be clear to all, however, we do not live in a perfect world. Employers are wary of contributing more than minimum amounts when they may lose control of part of that contribution in the event of a partial or full plan wind-up. This does not mean that the employer just has to live with the volatility. As a cash budgeting technique, they could make a provision for contributions at levels higher than the statutory minimum and draw down on this provision as required.

Each plan sponsor needs to address a number of issues relating to the funding of their pension plan. The key points to remember are that the volatility of contributions must be assessed, an adequate provision should be made if there is a need to cushion the effect of the volatility, and the rationale for this provision should be documented. This is sound governance for any DB plan.

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