Despite the proliferation of 403(b) and 401(k) plans, defined benefit plans remain an important part of the healthcare sector’s culture. They provide retirement security for employees and are still a valuable recruiting tool for hospitals. Over the past two decades, many hospitals converted these plans from traditional programs with an age/service formula to a cash balance design that may quite possibly represent the last stand for DB plans.
Cash balance plans are true hybrids: to employees, they look a lot like defined contribution plans on the surface, but behind the scenes they remain subject to all of the complex rules governing traditional defined benefit plans. And in fact, they must jump through additional hoops that don’t apply to plain vanilla DBs. By the end of 2016 (with some leeway for certain collectively bargained plans), sponsors of cash balance plans must modify any non-compliant features in their plans. These modifications may require negotiations with the unions and that, in turn, makes this process extremely time-sensitive.
To recap, since the 1980’s, nonprofit healthcare systems have been shifting steadily to defined contribution retirement plans and deemphasizing DBs. The trend moved from traditional profit-sharing plans with fixed employer contribution to more nimble 403(b) and 401(k). Many factors account for the precipitous drop in the number of surviving defined-benefit plans. Employers struggle to maintain minimum funding levels prescribed by federal law. PGBC premiums levels continue to rise. The flat per-participant rate in 2016 is $64, increasing to $69 in 2017, $74 in 2018 and $80 in 2019. For each $1,000 of unfunded vested benefits, plan sponsors pay an additional premium. The brunt of volatile investment returns falls on plan sponsors while their obligation to pay pensions remains constant. Longer life expectancies further increase the costs of providing pension benefits. The current accounting standards require employers to carry pension plan liabilities on their books. Extreme complexity also plagues pension plans. Most nonprofit hospital plans have evolved over time, undergone many iterations and merged with other plans, resulting in multiple grandfathered and active formulas. These plans require expensive actuarial services and extensive administration. Convoluted benefit formulas can sometimes make it difficult for employees to fully appreciate the benefits they earn.
To address pension plans’ volatility and expense, perceived lack of employee appreciation, and accounting burdens, plan sponsors resort to various risk-mitigation techniques. These include liability-driven investment, de-risking through lump-sum windows or transfers of liabilities to annuity issuers, benefit freezes, or the adoption of hybrid plan designs.
Despite the general decline, defined benefit plans retain their hold in the nonprofit healthcare sector. Moody’s Investors Service indicates that 72% of the 460 nonprofit hospitals it rates still sponsor defined benefit plans. Some employees continue to value these plans and often make their career decisions taking into account an employer’s commitment to continue an existing pension plan.
Although very few large employers establish new defined benefit plans nowadays, cash balance plans have gained popularity among professional employers, such as physician practices. A cash balance plan provides benefit accumulation more evenly throughout an employee’s career. The plan’s costs are more predictable, and the risk of investment losses is shared by the sponsor and plan participants.
In a typical cash balance plan, a hypothetical recordkeeping account is established for a participant. Each year, the account grows with pay-based credits and interest credits. Interest credits are often tied to a bond index. At retirement, the participant may take the value accumulated in the hypothetical account as a lump sum or as an annuity based on the account’s value.
Cash balance plans stirred quite a bit of controversy in their infancy. They were challenged as age-discriminatory because they seemingly favor younger employees by offering a longer period for interest credits to accumulate. As a result of legal challenges, cash balance plans with unusually high interest crediting rates had to pay out lump sums that far exceeded the value accumulated in the hypothetical accounts. This was a function of the high interest crediting rate and low discount rates prescribed for use in calculating minimum lump sums. The future of these plans does look brighter, however. The cash balance conundrum was resolved by legislative fiat. The Pension Protection Act of 2006 legitimized these plans and prescribed a set of standards they must follow to assure they are not age-discriminatory and do not shortchange participants by undervaluing lump sums. A major part of the Pension Protection Act and the IRS regulations is the ceiling on interest crediting rates. These rates must not exceed the market rate of return. The regulations establish the universe of acceptable interest rates. All plans must have an acceptable rate to continue in existence.
Last year, the IRS extended the deadline for cash balance plans with non-compliant rates of interest to get their act together. Generally, cash balance plan sponsors have until the end of 2016 to amend their plans to conform interest crediting rates to the rules and incorporate other requirements of the final IRS regulations. Certain collectively-bargained plans (i.e., generally those with a substantial percentage of participants whose benefit levels are set by a collective bargaining agreement) may have additional time to bring their provisions into compliance with the regulations (which in all instances will not extend beyond 2018). Thus, the time is running short for amending the plans. Unfortunately, for some plans, this means a potential reduction in the rate of future benefit accruals. While plan sponsors must comply with the regulations, they often cannot unilaterally change the interest rate without negotiating with the unions where plans cover unionized workforces. Thus, plan sponsors might be finding themselves between the proverbial Scylla and Charybdis. On the one hand, they face disqualification of the plan, with draconian tax consequences. On the other hand, they may run afoul of their obligations under the labor laws. In view of these challenges, hospital plan sponsors must start a conversation immediately with their unions and work with their legal advisors and actuaries to meet the looming December 31, 2016 deadline.