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October 2022 / RETIREMENT INSIGHTS

The Importance of Defined Benefit Plan Design

Defined benefit plans don’t all impact glide paths the same way.

Key Insights

  • It is an oversimplification to assume that all defined benefit (DB) plans impact glide path design for an accompanying defined contribution (DC) plan the same way.
  • Accrual formulas and forms of payment within a DB plan are the features that seem to have the greatest potential impact on an accompanying DC glide path.
  • Using scenario analysis, we evaluated several common DB plan designs to show how each one affected the equity level and slope of a hypothetical glide path.

There are considerations that DC plan sponsors face when they want to optimize outcomes holistically across their retirement benefit offerings, including their defined benefit plan. DB plans encompass more structures than the common perception of a fixed dollar pension payable for life.

In this fifth installment of our Making the Benefit Connection series, we expand the notion of defined benefits to cover more of the category space. To this end, we used our proprietary models to construct a collection of hypothetical DC glide paths designed to be optimal complements for DB plans featuring varying benefit levels and payment patterns.

We used scenario analysis to compare these complementary glide paths across several features, including their shape and our full suite of metrics. This allowed us to explore the impact that the specific structure of a sponsor’s DB benefits can have on the characteristics of an accompanying DC glide path.1

Our results highlight the fact that it is a critical oversimplification to assume that different DB plan structures will influence the glide path for a companion DC plan in essentially the same way. In reality, the type of plan and its structural features—such as the form of payment, the accrual formula, and the inclusion or absence of cost-of-living indexing—can have a major impact on the level and slope of equity exposure in the glide path design.

Representative Plan Designs and Considerations

Up to this point in our series, we have assumed that defined benefit plans adhere to a structure like that of a fixed annuity. More specifically, we’ve assumed that payments are derived via a benefit formula incorporating tenure and salary:

Normal retirement benefit at normal retirement date = 1% x average of final five years of pay x years of service.

Traditionally, this type of final average pay (FAP) plan was common in corporate plans. Many sponsors understand that they can, for example, provide richer benefits by offering a replacement multiplier greater than 1% or provide lower-valued benefits (the more common trend recently) by considering the career salary average rather than the final five years, by capping the years of tenure used in the benefit calculation, or simply by reducing the multiplier.

Other changes have had more profound impacts. For example, like Social Security benefits, a defined benefit can include a cost-of-living adjustment (COLA) to attempt to maintain the real value of the payout over time. This is a more common feature in public pension plans. Historically, equity has often been considered a hedge against inflation in DC plans. But if an inflation hedge is built directly into the in-plan source of guaranteed income, DC plan participants may not need as much equity in their glide paths to perform this function, allowing sponsors to try to reduce balance variability by lowering the allocation to equity.

Cash balance (CB) plans, which often offer participants lump-sum options at retirement, have an entirely different benefit accrual and payout structure than their FAP counterparts. During employment, the plan sponsor issues credits to the employee, who accumulates a notional account balance.

There are two types of credits common to these plans: pay credits determined by a predefined formula, and interest credits, which often have an annually changing yield or investment return that determines the size of the credit.

Since the balance in a CB plan often acts like an allocation to low-risk fixed income assets during the benefit accrual phase, a participant’s remaining wealth held in a DC plan potentially could be invested in assets with a higher growth orientation than would be the case for a participant with an FAP plan.

Since most employees do take lump-sum benefits when offered, our analysis assumed that once a cash balance benefit had been paid, it was invested and allocated according to the accompanying DC glide path.2 Further details of the assumptions behind our cash balance plan example can be found in the appendix.

Different DB Plan Structures May Have Different Impacts

(Fig. 1) Glide paths for a hypothetical DC plan only vs. DC plan + various DB types

Different DB Plan Structures May Have Different Impacts

Source: T. Rowe Price.
For illustrative purposes only. Not representative of an actual investment or T. Rowe Price product. This analysis contains information derived from a Monte Carlo simulation. See Appendix and Additional Disclosures for important information.

Glide Path Comparison

Figure 1 shows the plots of the optimal hypothetical glide paths calculated by our model for the baseline case of a standalone DC plan, and for the same DC plan design accompanied by examples of three different DB designs:

  1. fixed yearly benefits based on a final average pay formula;
  2. the same FAP plan with a COLA indexed to the U.S. Consumer Price Index with a 0% floor;
  3. a CB plan.

Figure 2 shows the relative differences in equity allocation at various points along these glide paths with respect to the baseline case of a hypothetical optimal glide path without an accompanying DB plan.

Optimal Equity Levels Can Vary Widely

(Fig. 2) Percentage point changes in glide path equity relative to a DC plan only baseline

Optimal Equity Levels Can Vary Widely

Source: T. Rowe Price.
For illustrative purposes only. Not representative of an actual investment or T. Rowe Price product. This analysis contains information derived from a Monte Carlo simulation. This is not intended to be investment advice or a recommendation to take any particular investment action. See Appendix and Additional Disclosures for important information.

In our simulations, the CB plan indeed acted like a low-risk asset, resulting in higher optimal equity levels in the glide path for the accompanying DC plan during working years compared with the FAP plan and significantly higher equity exposure during retirement. This is because the lump-sum infusion of cash from the CB benefit had to continue to work hard during retirement to maintain preretirement consumption levels in the absence of guaranteed payments. In fact, in our simulations, the glide path for a DC plan accompanied by a CB plan that paid out in lump sums looked quite similar to the glide path for DC participants who did not have access to a DB plan after retirement.

Our assumed FAP plan with a COLA was, by explicit design, richer than a non-indexed FAP plan (whereas our CB plan was designed to be roughly cost and benefit equivalent to the non-indexed FAP plan). For the FAP plan with COLA, as for the non-indexed FAP, the resulting lower-equity glide path was an example of what we call the wealth effect. In short, since wealth is one source of utility in our model, having the added wealth from a DB plan led our model to decide that there was less need for utility from DC plan-supported consumption, allowing the DC plan to reduce risk and still achieve a good outcome, in our view.

However, the optimal glide path for an FAP plan with a COLA was even steeper during the working years because not as much real growth was needed from equities, thanks to the inflation hedge provided by the indexed DB benefit. Consequently, under our assumed preferences, the model lowered glide path equity levels in an effort to reduce risk and maintain utility from wealth. Meanwhile, the DB pension payments, in addition to Social Security benefits, provided consumption-based utility.

Consumption Comparison

Consumption during retirement is not limited to the sum of Social Security and pension payments, but having both sources of income—each including its own method of real income replacement—can significantly reduce withdrawals from savings, represented here by the DC plan.

Figure 3 shows the median level of total consumption supported by each plan. Understanding the sources of consumption (shown here as median results from a broader Monte Carlo simulation) helped inform why the glide path shapes in Figure 3 differed, particularly after retirement. Figure 4 shows the sources of the consumption totals.

FAP Plans May Support Higher Retirement Consumption

(Fig. 3) Median consumption support from a hypothetical DC plan only vs. DC plan + various DB structures

FAP Plans May Support Higher Retirement Consumption

Source: T. Rowe Price.
Results shown are hypothetical and for illustrative purposes only. This does not represent the results of an actual investment or T. Rowe Price product. Actual outcomes may differ materially. This analysis contains information derived from a Monte Carlo simulation. See Appendix and Additional Disclosure for important information on the analysis.

Notice that the consumption levels supported by the CB plan dropped most quickly after age 90, when they started to diverge noticeably from those provided by the non-indexed FAP plan. This is because the dwindling balance in the CB plan could not keep pace with the continued guaranteed payments in the FAP plan.

In the baseline case where there was no companion DB plan, the significantly higher equity allocation in the glide path throughout the accumulation phase provided a sufficient cushion, at the median, to meet consumption needs. In the simulations that included either a non-indexed FAP plan or an FAP with COLA, the guaranteed income streams alleviated the burden on savings, supporting consumption late into life.

IMPORTANT INFORMATION

This material is being furnished for general informational and/or marketing purposes only. The material does not constitute or undertake to give advice of any nature, including fiduciary investment advice, nor is it intended to serve as the primary basis for an investment decision. Prospective investors are recommended to seek independent legal, financial and tax advice before making any investment decision. T. Rowe Price group of companies including T. Rowe Price Associates, Inc. and/or its affiliates receive revenue from T. Rowe Price investment products and services. Past performance is not a reliable indicator of future performance. The value of an investment and any income from it can go down as well as up. Investors may get back less than the amount invested.

The material does not constitute a distribution, an offer, an invitation, a personal or general recommendation or solicitation to sell or buy any securities in any jurisdiction or to conduct any particular investment activity. The material has not been reviewed by any regulatory authority in any jurisdiction.

Information and opinions presented have been obtained or derived from sources believed to be reliable and current; however, we cannot guarantee the sources' accuracy or completeness. There is no guarantee that any forecasts made will come to pass.

The views contained herein are as of the date noted on the material and are subject to change without notice; these views may differ from those of other T. Rowe Price group companies and/or associates. Under no circumstances should the material, in whole or in part, be copied or redistributed without consent from T. Rowe Price.

The material is not intended for use by persons in jurisdictions which prohibit or restrict the distribution of the material and in certain countries the material is provided upon specific request.

It is not intended for distribution to retail investors in any jurisdiction.  

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© 2022 T. Rowe Price. All Rights Reserved. T. ROWE PRICE, INVEST WITH CONFIDENCE, and the Bighorn Sheep design are, collectively and/or apart, trademarks of T. Rowe Price Group, Inc.

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