The big thaw: Why now is the time to consider unfreezing your defined benefit plan

Defined benefit (DB) plans were once considered the gold standard for employee benefits. However, since their glory days, the percentage of employers offering them to new hires has shrunk considerably.

At the turn of the 21st century, asset losses coupled with decreased interest rates led many plan sponsors to freeze their DB plans; that is, closing the pension plan to new hires and/or stopping future benefit accruals for current plan participants. Today, some plan sponsors with frozen plans are engaging in costly risk-transfer transactions or looking for a way to exit plans altogether.

However, freezing a pension plan and exiting the DB space are not foregone conclusions. They are the result of specific market factors and management practices. Rather than a burden, DB plans can serve as a way for employers to differentiate themselves. DB plans aren’t inherently flawed—in fact, they can generate significant value in the right set of circumstances and when properly administered.

Today presents such an opportunity for many organizations with frozen DB plans. The 2022 Milliman Corporate Pension Funding Study shows a rise in the aggregate funded percentage of the largest U.S.-sponsored DB plans from 88.1% to 96.3% at the end of 2021. Despite asset declines in 2022, funded status gains have continued due to sharp rises in discount rates, pushing many plans into surplus funding territory. Because of economic and regulatory changes, we have come full circle in such a way that unfreezing DB plans and utilizing their surplus funding makes sense in many cases.

Benefits of unfreezing your DB plan

There are two main reasons to consider unfreezing your plan. First, in a hiring environment transformed by the “Great Reshuffle,” many companies face a significant talent shortage. Anything that makes you stand out from the competition when it comes to hiring is an advantage. Communication and awareness are vital components of an organization’s employee benefits strategy.

Looking at national savings rates and average retirement account balances, it is no surprise that a majority of employees are concerned about paying for retirement. The fears of many aging participants have certainly come to light this year as investment markets are in bear market territory. Unlike a typical defined contribution (DC) plan, a DB plan offers guaranteed lifetime income, which can be a powerful enticement to candidates and a way to build loyalty. In this hiring climate, when corporations are doing everything they can to attract and retain high-level talent, including getting employees to return back to work after the onset of the COVID-19 pandemic, a DB plan can make the difference in someone choosing one company over another.

Additionally, well-managed plans offer potential financial benefits. Starting with plan design, future DB plan accruals can be based on hybrid plan designs that mimic DC plan accruals, all the while costing less as a percentage of pay. Furthermore, surplus funding levels can be preserved using modern investment strategies that match pension assets with plan liabilities.

At the same time, many companies are understandably skeptical about the upsides of DB plans after spending so long keeping frozen plans on life support. If you’ve primarily been concerned with how to exit a plan as quickly as possible, it may feel odd to consider how to revive it.

The simple explanation is that a lot has changed since 2001. Let’s look at a few of the reasons that now is a great time to reconsider the place of DB plans in your employee benefits strategy.

Landmark regulatory relief

The minimum cash funding requirements of DB plans are governed by IRS regulations. Recently, two significant pieces of legislation related to pandemic relief provided a major boost in this regard.

First, the American Rescue Plan Act of 2021 (ARPA) was passed in March 2021. ARPA provided funding relief by significantly reducing minimum contributions levels relative to the prior law. ARPA’s retroactive start date provisions allowed many sponsors to reconstitute prior year valuation results so as to establish credit balances to offset future contribution requirements. Interest rate smoothing provisions (first introduced in the 2012 Moving Ahead for Progress in the 21st Century Act) were also extended under ARPA all the way to 2030, providing significant future funding relief for plan sponsors.

These provisions allow companies to use a 25-year average of corporate bond interest rates coupled with a 5% floor interest rate to calculate liabilities, instead of current historically low interest rates. The result is a significant reduction in minimum funding requirements, including to $0 for many plan sponsors with fully funded frozen plans. Defined contribution plans on the other hand must be funded with cash by definition.

Then, in November 2021, the Infrastructure Investment and Jobs Act (IIJA) was passed, which provided further DB relief and extended the interest rate smoothing provisions under ARPA to 2035. Together, these acts make it much more likely for plans to maintain funded status or even run into surplus positions from a minimum funding perspective.

Rising interest rates, balance sheet surpluses, and pension income

Interest rates have been on the upswing, resulting in further improvements to the funded status of DB plans. Just in the first five months of 2022, interest rates moved up over 150 basis points, which has lowered DB plan liabilities by about 17%. Pension plan assets have fallen by 9% during that same period, resulting in accounting surpluses on the balance sheet of plan sponsors. Also, as reported in the 2022 Milliman Corporate Pension Funding Study, the plans of the largest 100 U.S. publicly traded companies reported aggregate pension income during the 2021 fiscal year. Pension income is the negative of pension expense and serves to boost company earnings. The 2022 Milliman Corporate Pension Funding Study observed that the last time the pension plans of the Milliman 100 companies had aggregate pension income on the order of $20 billion was prior to the turn of the century.

Higher interest rates result in lower net present values of DB plan liabilities, improving balance sheets. If this trend continues, the climate for DB plans will grow even more favorable over time as the present surplus funding can be used to pay for the future benefit accruals of new plan entrants resulting in a net-zero additional spend in the DB plan and capturing a savings from a reduction in the retirement budget reflecting cutbacks on DC plan spending.

Hybrid plan designs

Older DB plans were typically based on final average pay designs for the plan participants. Under such a plan design, benefit accruals are highly leveraged to include pay raises and service increments and can result in very costly pension benefits, especially for long-tenured employees. This means employer contribution costs rise rapidly over time, a pattern that can be even worse to deal with during inflationary times, as we presently are experiencing.

Newer plan designs such as cash balance plans or variable annuity plans feature a more balanced cost-sharing relationship between the employer and employee. Typically, each year’s accrual is independent of past accruals and can be indexed to investment returns. Employers don’t necessarily pay more for longer-serving employees, and they can often match accruals to the investment climate, thereby maintaining a plan’s fully funded status.

Modern investment approaches

In the past, DB plan managers typically focused on maximizing asset returns, weighting investments heavily toward stocks. This worked well in an era of unprecedented market expansion such as the mid- to late-1990s. However, when the markets posted negative returns during 2001, the result was widespread underfunding and the freezing of plans.

Today, a more prevalent investment approach called liability-driven investing (LDI) focuses on using fixed-income instruments with durations matched to plan liabilities. Investments and liabilities move in tandem, resulting in more consistent funded statuses from year to year. The goal is to achieve and maintain surpluses and minimize volatility. LDI has been proven to effectively manage portfolio risk and funded ratios without the volatility of purely return-seeking investment strategy. This maintains the funded status of the plan more consistently while opening the possibility of interest rate arbitrage, depending on how plan accruals are designed.

Explore your options

Every plan is different, and each sponsor has its own approach to employee benefits. Not every plan will be in a position that makes it sensible to unfreeze. However, it is prudent for plan sponsors to consider all their options as a part of their retirement benefits and risk management strategies. Regulatory changes, rising interest rates, balance sheet surplus, pension income, and modern plan designs and investment approaches make DB plans not only viable but, in many cases, highly valuable.