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    Document Summary
    - Report Published -

    House Document No. 12
    PUBLICATION YEAR 2015

    Document Title
    Cash Balance Retirement Plans

    Author
    Virginia Retirement System

    Enabling Authority
    Chapter 511 Enactment Clause 1. (Regular Session, 2015)

    Executive Summary
    Cash Balance Plans Not Prevalent in Public Sector

    The 2015 General Assembly tasked VRS with reviewing cash balance retirement plans implemented in other statewide retirement systems, analyzing the impacts of cash balance plan designs, and recommending a funding structure for a cash balance plan. Currently three states, Kansas, Kentucky, and Nebraska, administer a cash balance plan as the primary retirement plan for new members. A few other states offer cash balance plans, but these other state plans do not serve as the primary retirement plans for the respective states’ employees.

    Cash Balance Plan Designs Adopted by Other States Provide Lower Retirement Benefits Than Current VRS Plans

    Generally, the cash balance plan designs used in other states result in a lesser retirement benefit when compared to those currently administered by VRS. However, the level of benefits provided under any given cash balance plan depends heavily on the design features (e.g., the amount of pay credit and interest credit guaranteed to a member). Therefore, the lesser benefit found in other states is not necessarily indicative of cash balance plans as a whole, but rather the design features selected in those particular states. In addition, benefits accrue differently in a cash balance versus a traditional defined benefit plan. This accrual results in different benefit levels being provided under the two plan structures based on the member’s career stage.

    Cash Balance Plans Reward Employees Differently Than Traditional Defined Benefit Plans

    Whereas traditional defined benefit plans often back load benefits, which provides an incentive for participants to work longer by providing higher accruals to long-term employees, cash balance plans often front-load benefits, which provides more valuable accruals to newer short-term employees with less provided to long-term employees.

    Depending on the plan design, specifically the interest crediting rate, and the annuity conversion provisions of the plan, a cash balance account will often fluctuate depending on the economic conditions that exist during a member’s career. Since members would potentially be converting a lump sum of money into a lifetime annuity at retirement, members’ benefits could also vary depending on the conversion rates adopted by the plan.

    Cash Balance Plans Distribute Risk Differently Than Current VRS Plan Designs

    While both cash balance and traditional defined benefit plans are defined by the IRS as defined benefit plans, there are several differences. Traditional defined benefit plans such as VRS Plan 1 and Plan 2 were designed such that all of the financial risk will be borne by the employers. With the advent of the Hybrid Retirement Plan, approximately 30% of a hybrid plan member’s benefit was moved to a defined contribution plan. As a result, hybrid plan members now bear all the risk for 30% of their benefit.

    How cash balance plans compare with traditional defined benefit pensions depends on their design, in particular whether they have fixed or variable interest credits. In general, cash balance plans with fixed interest credits are more like traditional defined benefit pensions in that they provide participants with relatively secure benefits but expose employers to investment risk. Cash balance plans with variable interest credits tied to pension fund returns resemble defined contribution plans to the extent that they shift much of the investment risk onto participants, though the IRS requires that cash balance plans must at a minimum offer a zero percent floor on investment returns.

    Therefore, with cash balance plans the employer will still bear many of the same risks associated with defined benefit plans, although there are some differences. Cash balance plans typically do not provide inflation protection to retirees. If a retiree wants a cost-of-living adjustment in retirement, he or she must pay for it through a reduced benefit during conversion to an annuity. Secondly, due to annuity conversion at retirement, the member takes on more longevity risk than in a traditional defined benefit plan design. Cash balance plans also introduce portability risk to the fund. If more members cash out their accounts at termination, this could impact the fund’s investment horizon by introducing potential cash flow liquidity and long-term rate of return issues.

    Administrative Issues, Costs, and Timeline

    Adding a new tier of benefits increases administrative complexity, which in turn results in corresponding additional costs to the plan. VRS estimates that implementing a cash balance plan would cost approximately $12 to $13 million. These costs are described later in more detail, but are an important factor to consider. In addition to the cost of implementation and maintenance of a new plan, VRS estimates that the earliest such a plan could be implemented is January of 2019. The agency’s major information technology initiative (Modernization Program), which has been underway since 2009 and has been previously put on hold or delayed in order to implement various components of pension reform, would incur an additional 18-month delay. Implementing a new plan will not only impact VRS, but also all of VRS’ participating employers.

    Funding Issues

    When considering the implementation of a new plan design, it is important to not only consider what benefits will be offered going forward, but also how to deal with the existing unfunded liabilities facing the state and participating employers. Decision makers have increased focus on plan funding requirements and to that end have codified a plan ( 51.1-145 of the Code of Virginia) to move to fully funding the board certified rates by Fiscal Year 2019. In addition, during the 2015 legislative session, the Governor and General Assembly infused additional funding into both the state and teacher plans.

    Despite this demonstrated commitment and its positive impact on the plan, nearly two-thirds of the current employer contribution rates are made up of amortization payments to pay down the legacy unfunded liability associated with Plan 1 and Plan 2 members. As a result, regardless of the plan design used for future employees, the employer contribution rates will still mostly be made up of amortization payments to pay down the unfunded liability associated with prior benefits. Under the current funding policy, this legacy liability is scheduled to be funded over the next 28 years. With the exception of making changes to benefits for current or prior members, progress in paying down the legacy liability can generally be achieved only through direct contributions or excess fund returns above the actuarially assumed 7% long-term investment rate of return.

    Potential Adjustments to Current Hybrid Design

    In lieu of developing a new retirement plan, consideration may be given to making several changes to the Hybrid Retirement Plan. Based on the percentage of the benefit that a VRS Plan 1 or VRS Plan 2 employee is currently paying, a change to the allocation of the member contribution between the defined benefit and defined contribution components of the Hybrid Retirement Plan may be worth exploring. Adding auto-enrollment in voluntary contributions and enhancing the auto-escalation feature would likely encourage greater savings in the defined contribution component of the hybrid plan. These potential changes result in a relatively modest impact on employer costs, but could provide more favorable outcomes for hybrid members. The estimated implementation cost of these potential changes ranges from approximately $35,000 to $75,000, and they could be implemented within a fairly short time frame without delaying the Modernization Program.