4 February 2021 / RETIREMENT INSIGHTS
Making the Benefit Connection
The importance of defined benefit plans in glide path evaluation.
- Many employers have made major changes in their defined benefit plans, resulting in more varied benefit coverage across different participant groups.
- Defined benefit changes can affect defined contribution plans, particularly the evaluation of qualified default investment alternative (QDIA) glide paths.
- We intend to develop a series of papers highlighting our research on the potential impact of defined benefit plans and their features on glide path design.
Many plan sponsors face the complex process of adapting their retirement benefit structures due to closing or freezing their existing defined benefit (DB) plans or as a result of merger and acquisition activity, leading to plans with multiple benefit structures based on legacy companies. As a result, many organizations now offer a variety of benefit structures to their employees, leaving plan sponsors uncertain about how to factor these differences into decisions about their defined contribution (DC) plans—most notably, the plan’s qualified default investment alternative (QDIA).
We believe plan sponsors that have made changes to their DB plans, shifted from DB to DC plans, or merged plan populations should take these changes into account when they assess whether the underlying glide path in their QDIA solution is appropriate for their aggregate workforces and their stated retirement objectives.
One key component of DC plan structures is the selection of the QDIA and the potential impact of that decision on retirement outcomes. One of our key observations is that the traditional approaches to QDIA evaluation and selection being used today suggest that the problems associated with changing benefit structures may not be fully understood by some plan sponsors.
Our analytical work has focused on the principles that we believe should guide the glide path evaluation process and that, in our view, may help plan sponsors make more informed choices about their glide path design as a conduit for promoting income replacement during retirement.
It Is Important to Account for the DB Benefit
The evolution of benefit structures has resulted in DC plans becoming a primary retirement vehicle for many employees, which has increased the importance of the evaluation and selection of QDIAs in supporting the sponsor’s plan objectives. Typically, underlying the QDIA is an asset allocation glide path that changes over time as participants move through their preretirement and postretirement life cycles. Ideally, the glide path evaluation process should consider a sponsor’s full retirement benefit structure.
The foundational premise of our research is that the presence of a DB plan in an organization’s benefit package can materially affect outcomes for DC participants. Thus, we believe that DB structures should be considered carefully when evaluating and selecting QDIA glide paths. Just as important, this impact may vary, and trade‑offs between higher growth potential and account balance variability will need to be considered in the selection process. Critical considerations in this process include the design of the DB plan, participant income and savings behaviors, and the design of and degree of reliance on the DC plan.
A second premise of our work, but no less important, is that contrary to popular belief, there simply is no single correct “rule of thumb” for assessing a DB plan’s impact on glide path suitability. In fact, we advocate flexibility and emphasize the importance of connecting the glide path assessment back to sponsor objectives and how well funded participants are in terms of replacing their preretirement incomes.
No Easy Task but Worth the Journey
Incorporating DB plan coverage into glide path design is not a straightforward exercise:
- Some retirement analysts believe that a DB benefit provides a secure source of income, much like a high‑quality bond, and thus DC assets can be more heavily invested in equities to offset the bond‑like predictability offered by the DB plan.
- Other industry experts argue that the DB plans provide additional retirement wealth, reducing the need to emphasize growth‑seeking assets in the DC plan glide path.
Although these two views appear contradictory, both potentially can be right under certain circumstances—but context is important. This mixture of conflicting and complementary forces illustrates why generalizations about DB impact on DC plan design can oversimplify a highly nuanced subject.
The Road Map: What to Expect From Our Research
While the reliance of most organizations on DC plans is well understood, what remains a critical area of discovery is whether plan sponsors are positioning their DC plan participants in ways that will increase their potential to meet their retirement objectives. We believe this question deserves further exploration.
This paper is intended to be the first installment in a series from T. Rowe Price that will address key themes for organizations that have evolved their benefit structures. Our research effort is intended to cover a broad range of questions that we are often asked by our clients. These include:
- What impact should a DB plan have on DC glide path design?
- How should sponsors handle differences in DB plan eligibility (e.g., should they be open to all participants, frozen, closed to some participants, etc.) and benefit formulas within their participant base?
- Does the DC match formula matter?
However, these questions only scratch the surface of insights we hope to offer to plan sponsors winding their way through the complex maze of glide path suitability analysis.
Installment 2: Glide Path Evaluation Is Not an Easy Task
Glide path risk and reward should be defined in terms of the utility derived from both a participant’s retirement consumption and wealth (Figure 1), rather than simple market return and volatility metrics. Sponsors should focus on glide path suitability versus optimality (Figure 2), as preferences will vary across a participant population.
Glide Path Risk and Reward Should Be Defined in Terms of Their Impact on Potential Participant Outcomes
(Fig. 1) Key evaluation metrics
Annual consumption that can be supported, on average, postretirement, by in‑plan assets and projected sources of secure income, such as Social Security benefits or pension annuities from DB plans.
Wealth at Retirement
Average wealth at retirement expressed as a multiple of final preretirement consumption in real terms.
Measure of consumption risk, combining the probability of lower spending with the magnitude of the spending cut.
Measures average simulated maximum drawdown on a monthly basis during the years leading up to retirement or shortly after retirement.
Managing the Trade‑Off Between Consumption Replacement and Wealth Stability
(Fig. 2) A hypothetical glide path suitability envelope
To understand how DB plan coverage can impact the selection of a DC plan glide path, one must first have a framework for evaluating glide paths and retirement outcomes overall. Accordingly, the second installment in our series will explore how T. Rowe Price analyzes retirement and investment trade‑offs—specifically, as they relate to a participant’s life cycle spanning the asset accumulation and decumulation phases.
We will describe our economic utility framework and explain why we believe the level and reliability of retirement income are both crucial to estimating potential retirement outcomes.
Our framework considers sponsor preferences regarding trade‑offs between increased consumption replacement and decreased account balance variability.
Installment 3: Closed or Frozen DB Plans Present Unique Challenges
We believe that determining an appropriate glide path for all participants is possible, considering those without DB plan benefits alongside participants that have access to DB benefits.
How Glide Paths Can Change Based on Defined Benefit Eligibility
(Fig. 3) Hypothetical impacts of participant DB eligibility
Many DB plan sponsors are managing closed and/or frozen plans. Even sponsors with ongoing DB plans may be considering closing or freezing those plans in the future. These situations offer relatively unique challenges for DC glide path evaluation and selection in that some participants may have legacy DB benefits while others likely will not (Figure 3). The third installment in our series of papers will explore several questions surrounding this dynamic:
- How should a glide path be designed if it must cover both groups of DC participants—both those with and without DB plan coverage?
- Can a single DC glide path serve both cohorts well? Or should a plan sponsor focus on the potential outcomes of one specific group of participants?
- What could be the consequences for one cohort of DC participants if their DC allocations follow a glide path selected based on the characteristics of the other cohort?