Two types of retirement plan designs that have been in the spotlight recently are cash balance pension plans and Variable Annuity Pension Plans (VAPPs). Neither plan design is new, but legislation in recent years has made them more viable options for the average employer. In this article we explore these two options for plan sponsors contemplating a potential change in retirement plan design, even those who only currently have a 401(k) plan.

What are cash balance pension plans?

Cash balance plans have been around since the 1980s, and they are a popular option for small business owners. In the large plan space, IBM made headlines in late 2023 with the announcement that it was reopening its frozen traditional pension plan and replacing its previous 401(k) retirement benefit with a cash balance benefit in the reopened plan. IBM’s decision has prompted a lot of discussion in the retirement industry about the possibility of other corporate plan sponsors reopening their own frozen pension plans.

A cash balance plan is a defined benefit (DB) plan that has several characteristics of a defined contribution (DC) plan. It’s often referred to as a hybrid plan, blending the traits of both DB and DC plans. A cash balance plan holds assets in a pooled account, and each participant’s benefit is communicated in terms of a hypothetical account balance. The balance grows through two main parts: a pay credit and an interest credit. The pay credit can be a dollar amount per year or a percentage of the participant’s annual salary. The interest credit can be a fixed rate or a variable rate linked to an index. The specific details of a plan’s interest credit and pay credit are laid out in the plan document and must meet various legal requirements, such as not discriminating in favor of highly compensated employees.

Cash balance plans must offer annuity (lifetime income) options to participants at retirement, but they typically allow the choice of a lump sum as well, giving participants flexibility with payment options.

Why a plan sponsor might choose a cash balance plan

One reason a cash balance design might be appealing is that it can look and feel like a 401(k) plan design, which is already familiar to a lot of plan sponsors and their employees. Communicating the value of the benefit can be straightforward as participants see their cash balance accounts grow.

Employers may be able to achieve certain objectives with the cash balance design. Take pay credits as an example. A flat pay credit (either flat dollar amount or flat percentage of pay) can be used for simplicity in communication and to make satisfying nondiscrimination testing requirements easier. Tiered pay credits can be used to give greater contributions to certain participants, such as those who have more service with the company. Benefit formulas must meet regulatory requirements like the aforementioned nondiscrimination testing, but there are options to suit a variety of employer goals.

The contribution limits for a cash balance plan are higher than those for a 401(k) plan, so greater tax-deferred contributions can be made. If an employer offers both a cash balance plan and a 401(k) plan, the contribution limits are separate for the two plans, resulting in even greater tax deferral.

There are also options for the employer in terms of who bears the investment risk in a cash balance plan. If the interest crediting rate is set up as a fixed rate, the participant is protected from investment risk because their account is guaranteed to grow at the fixed rate each year. An alternative is a market-based cash balance plan where the interest crediting rate is linked to the plan’s asset return; in this case, much of the investment risk is transferred to the participant.

A cash balance plan has some advantages to participants as well. Participation in the plan typically doesn’t require employees to contribute part of their salary, and participants must be vested in their cash balance benefits no later than after three years of service, which is a faster vesting schedule than is required for traditional DB and 401(k) plans. Another advantage for participants is that a lump sum option at termination of employment makes the benefit portable, but participants have the ability to choose a lifetime pension income if that’s what they prefer.

Plan assets are combined and professionally managed, so the participant isn’t responsible for making investment choices. Whether this is an advantage depends on who you ask. Some participants may see this as a negative if they prefer to manage their own investments and believe they could achieve higher investment returns in a 401(k) plan. Other participants may appreciate a guaranteed return (if the interest crediting rate is fixed) and not having to make investment decisions themselves.

Like traditional DB plans, and unlike 401(k) plans, cash balance benefits are typically covered by the Pension Benefit Guaranty Corporation (PBGC). This federal insurance protects participants’ benefits up to certain limits. Note that annual premiums must be paid by plans that are covered by the PBGC insurance.

Plan sponsors should also be aware that cash balance plans are subject to annual minimum funding requirements that are calculated under IRS rules, so employers don’t always get to choose how much to contribute to the plan in any given year.

What are Variable Annuity Pension Plans?

VAPPs have been around since the 1950s but interest has increased in recent years due to additional regulatory guidance.

In a basic VAPP, the participant earns benefits for each year of service with the employer. The benefit formula is typically a flat dollar or career average accrual. The benefits earned can move up or down each year based on the plan’s actual asset return, even after retirement. A target return rate is established in the plan and, if the actual return equals the target, then benefits do not change. Benefits increase if the actual asset return is greater than the target rate, and benefits decrease if the actual asset return is less than the target rate. The result is that plan assets and liabilities move up and down together and thus the plan stays fully funded regardless of current market conditions.

A disadvantage to the basic VAPP is that benefits decrease in years where asset return is less than the target. The Milliman Sustainable Income Plan (SIP) is a variation on the VAPP design that tackles this benefit volatility. In addition to having the regular VAPP features, including contribution and funded status stability, the SIP also includes downside protection for participants in retirement. The SIP does this by using a stabilization reserve that builds up excess assets in years of good asset return, to help cover participants’ benefits in future years when returns are less than the target. Thus, the SIP significantly reduces the chance that benefits would decline in down markets.

Why a plan sponsor might choose a VAPP

One of the most attractive features of a VAPP is that it stays fully funded in all market conditions. This removes the balance sheet volatility that is associated with many traditional DB plans. The contributions are also more stable and predictable, as the employer funds the benefits earned plus plan expenses but doesn’t have to contribute additional amounts to make up for a funding shortfall.

A VAPP provides a lifetime benefit for participants in retirement and can include inflation protection. Participants also benefit from the professional management of investments in the plan and don’t have to make individual investment decisions themselves. (As with a cash balance plan, some participants may not see this as an advantage if they prefer to manage their own investments.)

Participants have PBGC protection for their benefits and the plan pays lower PBGC premiums due to being fully funded. (One part of the PBGC insurance premium is a flat rate, based on participant head count, while another part is a variable rate based on the underfunded amount of the plan’s liabilities compared to its assets. A fully funded plan does not have to pay the variable rate portion.)

To help meet their objectives, plan sponsors have design options when setting up a VAPP, such as using the stabilization reserve mentioned above to protect participants’ benefits from decreasing in retirement. A VAPP can also have a floor and/or ceiling on the amount of asset return to consider when adjusting benefits, to provide more benefit stability.

Plan sponsors who implement a VAPP should note that participants may need initial education about the plan, as well as ongoing communication about benefit adjustments. A robust communication campaign in the beginning stages can help facilitate a successful transition to a VAPP.

Which pension plan design to choose?

When contemplating a new plan design, plan sponsors should first focus on the objectives they are trying to achieve as an organization. Particular goals may include increasing retirement income security for participants, reducing balance sheet volatility, attracting and retaining employees, or achieving more stable contribution patterns, just to name a few. Cash balance plans and VAPPs have both advantages and disadvantages, like any retirement plan, but one of these plans could be the design that fits the needs and goals of your company.

For more information on cash balance pension plans or VAPPs, or for assistance with finding the right retirement plan design for your organization, please contact your Milliman consultant.