April 2022 / RETIREMENT INSIGHTS
Mixed Benefits: Identifying a Single Glide Path for All
Closed and frozen defined benefit plans shape glide path design.
- Plan sponsors increasingly maintain mixed benefit structures because of changing defined benefit (DB) plan offerings and merger and acquisition activity.
- Differences in DB plan coverage should be considered when selecting a glide path for all participants in a defined contribution plan’s target date offering.
- We believe it is possible to identify a glide path appropriate for all participants by closely considering those without DB plan access within the workforce.
Many employers have made changes to their defined benefit plans in recent years. While some sponsors have closed plans to new hires and/or frozen benefit accruals for current employees, others have brought together plans with differing status and/or levels of employee coverage as a result of merger and acquisition activity. These actions can result in a workforce that has varying degrees of access to different sources of retirement income, typically based on tenure with the company.
When a sponsor decides to close a DB plan to new participants, most of the workforce continues to accrue DB benefits in the first few years after closure. However, the plan’s characteristics will slowly shift as more participants terminate or retire and are replaced by employees not eligible for plan coverage. These new hires typically are only enrolled in the sponsor’s defined contribution (DC) plan.
Sponsors may face a potentially difficult administrative challenge when both employee cohorts—DB plan participants and nonparticipants—are covered by the same DC plan, typically with a single target date offering as the qualified default investment alternative (QDIA).
Sponsors often ask us how DB plan benefit structures should be reflected in their glide path evaluation process. The previous installment in our Making the Benefit Connection series1 argued that, under a set of preferences we believe applicable to a broad participant population, it may be appropriate to reduce equity exposure in the glide path when DB plan coverage is available because participants may not need to absorb additional market volatility when their defined benefits provide a base level of retirement income.2 However, we believe the answer is more nuanced for most plan sponsors—particularly if their DB plan is either closed to new entrants or frozen for all participants.
In fact, our analysis shows that if any participants in the DC plan do not have access to the DB plan (i.e., if the DB plan was closed before a portion of the current workforce joined the company), then the glide path that potentially provides the highest overall utility for the entire DC plan population in our simulations often has a similar level of equity exposure as one suitable for a sponsor who offers no DB plan at all.
Optimal Glide Paths Based on DB Plan Eligibility
T. Rowe Price’s glide path assessment framework focuses on outcomes. Our primary objective is to seek to maximize investor utility derived from consumption and wealth, rather than focusing on conventional investment metrics—such as risk‑adjusted rates of return—that are more typically used in the target date industry. Using our framework, we can investigate how the existence of a closed or frozen DB plan potentially can impact the optimal shape of a target date glide path.
Figure 1 shows a range of glide paths for a hypothetical QDIA offering when differing percentages of the DC plan population also are eligible for defined benefits.3
The Optimal Equity Allocation Declines as Defined Benefit Eligibility Increases
(Fig. 1) Hypothetical glide paths based on percent of participants eligible for a DB plan
If 100% of the employees in our hypothetical example were DB plan eligible (i.e., if the plan was still open), then the lowest equity glide path shown in Figure 1 (the bottom line) potentially would produce the best aggregate retirement outcomes across the entire sample population, given our utility preference settings.
Alternatively, if 0% of all employees were DB eligible (i.e., if the employer had no DB plan at all), then the glide path with the highest equity allocation (the top line in Figure 1) potentially would be the utility‑maximizing solution. Between these two extremes are glide paths optimized for sponsors that have closed DB plans with varying proportions of eligible participants.
Note that the different glide paths are not evenly spaced, indicating that the proportion of employees who are eligible for the DB plan can have a nonlinear effect on glide path suitability. Figure 2 shows this more explicitly:
- The allocation shifts were negligible until 80%+ of the employee base was covered by the DB plan.
- If 60% or less of the employees had access to the DB plan, the change in the optimal equity allocation was less than five percentage points at each age level.
- Even if 80% of employees were DB eligible, the change in the optimal equity allocation was less than 10 percentage points at all ages. However, the shift was much more significant if 100% of the employee population were DB eligible.
Changes in Optimal Equity Exposure Are Minimal When Defined Benefit Eligibility Is Reduced
(Fig. 2) Differences in hypothetical equity allocations at various ages based on DB plan eligibility
Thus, we believe that sponsors who decide to close their DB plan to new participants would do well to also reassess their QDIA glide paths, because those without DB benefit coverage likely will have a material impact on overall glide path suitability.
Figure 3 highlights the changes in equity allocation based on the DB eligibility of the participant population at age 65—the most frequent retirement age. Here again we see that the indicated drop off in equity exposure is largest when a significant portion of all employees are eligible for the DB plan.
While DB benefit eligibility is often binary, particularly for closed plans, the reality can be a little more complex for frozen DB plans because the financial situation of each employee with access to the plan will differ based on the length and trajectory of their career prior to the plan freeze. However, at any given freeze date there are likely to be DB participants with minimal accrued benefits, while everyone subsequently hired will not have access to the plan at all.
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April 2022 / RETIREMENT INSIGHTS