The economy has changed to be generally favorable to defined benefit (DB) plans—leading at least one company (IBM) to make changes. Is it time to revisit the goals and strategies of a DB plan?
The current economy and stock market have created a positive environment for defined benefit (DB) plans. Interest rates have inched up while equities have kept their footing, and the funding status of many DB plans has markedly improved. Changes in the economy like this may have big impacts on some DB plans. While economic factors alone didn’t drive IBM’s recent decision, it’s still important to recognize that every plan sponsor has a unique set of drivers to consider as they manage their DB plan.
IBM changed its retirement benefits plan by unfreezing the cash balance DB plan and redirecting the contributions it had historically made to the defined contribution (DC) plan into its cash balance DB plan.
It’s an interesting move by a well-respected company and a world leader in supercomputing and artificial intelligence (and father of Jeopardy champion, Watson). Surely there were many considerations and computations behind IBM’s decision.
Fully funded defined benefit plan status? Breaking down IBM’s move
According to the most recently available IRS Form 5500 filing, IBM’s pension entered 2023 overfunded by more than $5 billion (meaning assets exceeded liabilities used to determine minimum contributions).
Meanwhile, IBM has been providing a cash 401(k) plan contribution each year (a 1% automatic contribution and a 5% matching contribution). The company reported an investment of over $900 million of total contributions to the DC 401(k) plan in 2022.
With this shift in approach, starting in 2024, the captive excess pension assets can be deployed to free up an estimated half-billion dollars of cash expense annually. Investment in employee retirement benefits can be covered by surplus assets in the DB plan rather than new cash contributions as accruals transition to the pension plan. In effect, future benefits can be funded by past contributions and investment returns.
Greatly oversimplifying, this is creating a retirement benefit funding holiday for IBM which should last about ten years ($5 billion/$0.5 billion), longer if the actual cost of accruals is less than estimated in our initial review (it could also be shorter if the cost of accruals is more). There could be other unique factors besides immediate cash savings involved in the IBM DB decision. We find that a cash balance structure can offer attractive benefits to both employers and employees that are difficult to replicate in a DC model. Many of these benefits are more broadly applicable.
Cash balance benefits for plan sponsors:
-
Sponsor time value of money: The annual valuation funding cost of a cash balance accrual is often less than the cost of an equal benefit contributed to a DC plan. This is true when assumed returns of the pension fund used to discount future payments exceed the interest crediting rate of the accounts.
For example, a $10,000 cash balance benefit for a 45-year-old employee assumed to retire at age 65 has a pension funding accrual cost of about $8,300 assuming annual interest credits of 4.4% and a discount rate of 5.4% (with no mortality or other decrements assumed). Actual savings vary with assumptions and demographics, but a conservative estimate of 10% savings of funding liability vs. cash would translate to $50 million annually in our simplified IBM example, extending its hypothetical funding holiday to 11 years.
- Workforce management: Cash balance plans offer plan sponsors a wide range of plan design flexibility that can be tailored to help meet their specific workforce objectives. That flexibility can allow them to create a benefits plan that helps recruit and retain the right talent. Interest crediting can be guaranteed and safe, or risky and variable (though the principal is always protected). If desired, pay credits can be skewed toward key employees as a remedy for relatively low IRS-defined contribution deferral limits (a popular feature for professional service firms—think “doctor/lawyer” cash balance plans). It’s also easier to offer supplemental early retirement benefits through a cash balance plan, which helps facilitate retirements at times agreeable to both employers and employees.
Cash balance benefits for employees:
- Risk sharing: IBM’s pension should provide annual 5% pay credits with guaranteed interest equal to the yield on US 10-year treasuries (about 4.2% currently
) with a minimum of 6% for the first three years and 3% thereafter. Though not necessarily eye-popping, these risk-free returns offer employees a measure of market protection not easily achieved in a DC plan. The value of these guarantees increases if future equity returns disappoint and bond yields remain high. - Efficient lifetime income: Conversions of cash balances to monthly annuity payments are regulated by IRS rules. As a result of favorable interest rate assumptions for the employee, the monthly payments from an account balance are likely to be significantly greater (10% or more) than a retail annuity purchased with an equal amount of cash.
- PBGC coverage: Unlike DC plan benefits, cash balance benefits are insured by the Pension Benefit Guaranty Corporation (PBGC) (protecting a participant’s CB benefit up to more than $7,000 per month at age 65 for 2024). Though it’s extremely unlikely an overfunded plan like IBM’s would need to use PBGC insurance, it offers comfort to employees and retirees not available in DC plans.
Considering unfreezing a DB plan or starting a new one?
Given the current environment, plan sponsors may want to revisit their comprehensive retirement benefits to see if they are getting the value they expect and determine if improvements can be made. The unusual, significant cash benefit to IBM makes it unlikely that its pension decision represents the first shot in a full-blown DB revolution. Most retirement plan decisions pivot heavily on cost and the financial incentive for many may not be compelling enough to act.
There are advantages of cash balance plans that could be universally appealing, and sponsoring DB plans has become less daunting in a higher interest rate environment. A well-designed, well-managed cash balance plan may hold minimal risk to sponsors while diversifying risk and delivering lifetime benefits to employees.
The calculations and implications can be complex. Reach out to your Principal® representative for a fresh look at your retirement benefits offering.
