Variable Annuity Plans have gained increasing popularity among the sponsors of Defined Benefit plans in recent years. The appeal is clear: the plans hold the promise of lifetime benefit guarantees for retirees but without the risk of escalating contribution requirements for sponsors due to the volatility of investment returns. As noted in the recent Bolton Whitepaper on the topic, the plan and their actuary must understand the intricacies of the program and how to properly measure returns (both actual and expected) or both the members and sponsors could find unpleasant surprises in their future.
What are Variable Annuity Plans?
Variable Annuity Plans come in many forms and designs. Often, the basic benefit formula accumulates benefits over the course of a participant’s career and adjusts past accruals for experience that differs from a baseline assumption. One of the primary approaches is to index the benefits being earned by members to investment returns that either fall below or exceed a preset “hurdle rate”. This approach essentially locks in the sponsor’s cost (and keeps the plan fully funded) as if the investment return always matches this hurdle rate. At the same time the member’s benefit can escalate in the future if investment returns exceed that hurdle rate (or decline in years the investment returns fall below the hurdle rate). In some cases, plans impose “caps” (a limit on how much of an increase can be applied to a member’s benefit in a year) and/or “floors” (a limit on how much of a decrease can be applied to member’s benefit in a year) to limit the volatility in member benefit adjustments year to year.
What are the Complications?
Whenever new program designs are created, there are often nuances to how the plans operate that need to be understood and applied before the promised benefits of the new design can be realized by sponsors and members. This was true years ago with Cash Balance plans and Pension Equity Plans (both Defined Benefit plan designs) and Age-weighted Profit Sharing plans or Target Benefit plans (both Defined Contribution plan designs) and is true with the newer Variable Annuity Plan designs.
Variable Annuity Plans, especially those with caps and/or floors, pose similar challenges in terms of how contribution levels are set and when and how member benefits are adjusted each year. As pointed out in the Bolton Whitepaper, the presence of caps and/or floors can create asymmetries that, if not handled properly, can lead to unintended sponsor contribution volatility and potentially discrediting of the program to members and collective bargaining groups. The paper discusses the use of stochastic simulations to value these plans and the funding levels for both “pure” Variable Annuity Plans (where all investment risk is passed to the participant) and those with caps and/or floors that limit the annual adjustments to participant benefits. Key takeaways include the time horizon for any stochastic trials, and the differences created by the choice of whether to use arithmetic mean or median results.
Adding floors or caps to a Variable Annuity benefit adds complexity to the valuation process compared to a traditional fixed benefit or a pure Variable Annuity benefit. Not only are there arithmetic mean and geometric median returns that can be used as a discount rate, there are also average and median expected benefit increases. Mismatching these two creates a tension in the valuation which could, in some cases (median discount rate and mean (average) benefit increases), be viewed as a margin of conservatism while in others (mean (average) discount rates and median benefit increases) cause systematic underfunding.
Conclusion
Variable Annuity Plans have the potential to provide a “win-win” for plan sponsors and members. Sponsors get relief from contribution and funded status volatility while members retain long term income guarantees and benefit from professional long-term investment expertise and longevity pooling. However, as these plans evolve and new features and wrinkles are added, the risk of the actuary “misvaluing” the benefits and their costs also rises. The Bolton Whitepaper provides a solid foundation for those looking to avoid those pitfalls and help the plans meet their upside promise.
