A variable annuity pension plan offers a unique blend of defined-benefit predictability and investment-linked flexibility.
While these plans have been around for a long time, they have not been widely adopted until recently. The increased attention to these plans has been driven by their ability to mitigate risks and share risks between the contributing employer and the covered participants.
This article will discuss how these plans works as well as the pros and cons. Let’s get started!
Some Background
This is a type of defined benefit plan that provides plan participants with a lifetime income. Although some refer to these as hybrid plans, they are not defined as such under IRS regulations.
Unlike traditional plans with fixed payouts, these arrangements allow benefits to rise or fall based on the plan’s investment performance over time. This hybrid structure can provide participants with protection from outliving their benefits while still offering upside potential in favorable markets.
At its core, a variable annuity pension plan follows a formula defined in the plan document, but adjusts accrued benefits based on how actual returns compare to an assumed interest rate. In good years when returns exceed assumptions, the benefit will grow. In lean years, the benefit amounts may shrink. While this structure introduces more variability, it aligns plan funding more closely with investment outcomes—shared transparently among all participants.
In certain cases, if the hurdle rate is set sufficiently low, plans become subject to some hybrid plan regulations—but this is not universal. Although these plans have been in existence for years, they have only recently gained broader adoption. Their growing popularity is due to their ability to manage and share risks between the employer and participants.
In these plans, the accrued benefit fluctuates according to the plan’s investment performance. This paper explains the plan’s mechanics and weighs its advantages and disadvantages. We also examine plan design options for tuning performance and managing risk assignments. Before that, we must define a few additional terms related to variable annuity pension plans.
- Adjustment Period – typically, the benefits are adjusted annually (meaning they are recalculated or updated once each year), and for our discussion here, we will focus on an annual adjustment. Ultimately, we will discuss the impact of adjusting benefits more frequently (i.e., making updates more than once a year).
- Investment Return – this is the actual return, or earnings, generated by the assets in the pension plan for the given Adjustment Period.
- Hurdle Rate – the expected investment return for the plan, expressed as a percentage. Typically, this rate has been set between 3.0% and 6.0%. Note that if this rate is set below 5.0%, special rules—such as faster vesting (giving plan participants ownership of accrued benefits sooner)—will apply to the plan.
For this plan type, the accrued benefit will increase or decrease over time based on the investment performance of plan assets.
Why adopt this type of plan?
This type of pension plan offers several advantages. As noted, it gives employers more predictable contribution requirements. Although employees assume more investment risk, they still obtain lifelong income at a lower cost than buying an annuity from an insurer. Participants also gain partial inflation protection through future benefit increases.
If you already have a DB plan and are considering a change, this type of plan should be considered. Changing from one type of DB plan to another maintains the accrual pattern and will not significantly change the way benefits are earned. In comparison, as previously discussed, a change to a DC plan will shift the benefit value to younger participants, with mid-career individuals being impacted to a greater extent.
This plan also aids workforce management. Providing lifelong benefits helps attract and retain employees. Because participants know they have a lifetime income, they can retire with greater confidence, enabling better control over workforce demographics.
Planning Considerations and Design
When setting up this type of plan, several additional factors must be considered and modeled to ensure the plan performs as intended. It is essential to perform long-range projections when establishing a new plan to ensure that, as the plan matures, it can continue to provide the promised benefits without additional funding pressure due to the plan’s maturity.
Adjustment Period
The Adjustment Period refers to the interval between benefit adjustments, typically annual, aimed at reducing administrative expenses. Some argue that these plans are always fully funded, but while they reduce much of the investment risk, full funding cannot be guaranteed. Theoretically, adjustments could occur monthly, but in practice, this is unrealistic because asset data cannot be collected and benefit payments adjusted that quickly.
If the Adjustment Period is one year, as is common, timing can be an issue. For example, to adjust benefits on January 1 each year, you need finalized asset values as of December 31. In reality, December 31 asset values are often unavailable until mid-January, which prevents adjustments on January 1. If assets include illiquid investments, gathering this data can take even longer.
To overcome this issue, some plans use a one-year lag in adjusting the benefits. This means you calculate the actual return for the period from January 1, 2021, to December 31, 2021. You then compare against the Hurdle Rate to determine the adjustment factor. This adjustment factor would be used to adjust benefits effective January 1, 2023. By doing this, you have sufficient time to perform the calculation and administer the change in benefits.
However, the longer the lag period, the more risk you take on. In the scenario we just described, a variable plan likely had a good investment return in 2021 and a bad return in 2022. When 2023 arrives, even though the assets were down at the end of 2022, benefits are increased in 2023 due to the strong returns in 2021. The result is an increase in benefits at a time when the plan may not be able to afford it, putting pressure on the plan’s funded status.
Investment Return
Investment Return depends on the investment strategy chosen by the pension plan trustees. The plan’s level of risk will dictate long-term results. Trustees should expect the actual returns to exceed the Hurdle Rate frequently; otherwise, the benefit promise may be misleading. When structuring the investment portfolio, consider how quickly asset values can be assessed, as this directly affects participants’ benefits. Investing in real estate may be unwise, given the time and subjectivity involved in valuations.
Hurdle Rate
The hurdle rate is a key factor in determining how benefits will be impacted by actual investment returns. It is essential for the trustees to select an appropriate Hurdle Rate, which requires an understanding of how benefits change based on different rates.
When setting the Hurdle Rate, it is best to understand how the extreme ends of the spectrum will impact benefits. Note that the IRS does not allow the Hurdle Rate to be less than 3.0%. If the Hurdle Rate is less than 5.0%, the plan will be required to provide faster vesting.
If the Hurdle Rate is low, the plan will likely grant more frequent benefit increases since it is easier to surpass the target. Additionally, initial benefit accruals will be smaller; however, subsequent increases, driven by investment returns, will benefit younger participants over time.
A higher Hurdle Rate produces larger initial benefits but more frequent decreases, as outperforming the rate is more difficult. This setup favors older workers.
Is a Cash Balance or Defined Benefit Plan Right For You?
Setting the Hurdle Rate also has implications for long-term inflation protection. A key feature of variable annuity plans is the ability to offset inflation by adjusting future benefits in response to investment performance. In contrast, traditional defined benefit plans provide fixed lifetime benefits, which can potentially erode purchasing power over extended retirement periods. With prudent investment performance, variable annuity plans may offer retirees increased protection against declining real benefits.
Variable Annuity Pension Plan Options
Adjusting retiree benefits
Should the approach involve adjustments to retiree benefits or providing a fixed lifetime benefit? Retirees typically rely on fixed incomes and may face challenges if their monthly benefits decrease following a market decline. Lack of adjustments also eliminates inflation protection for these benefits.
Balancing these considerations is complex; establishing a reserve account is one solution to help mitigate risk for retirees. Notably, when benefits are locked in at retirement without future adjustments, strong investment years may prompt increased retirements as near-retirees capitalize on higher market-linked benefit calculations.
Reserve account
Reserve Account refers to additional money stored in the pension fund to protect retiree benefits from declines. The plan may target a funding ratio of 110% to 120% (or higher) to help ensure that retiree benefits do not decrease if market values decline.
When establishing a Reserve account, understand that these funds could otherwise enhance benefit accruals but are deliberately set aside. Trustees must balance offering higher, riskier initial benefits with lower benefits offering some investment protection. Be aware that protection is never absolute—even with a Reserve, significant market downturns may force benefit reductions for retirees.
If trustees open a Reserve account, stochastic modeling helps them see its protection level as the plan matures. A small reserve might suffice initially, but as retirees outnumber active workers, retiree benefit protection becomes increasingly difficult.
Cap on benefit adjustments
the plan can also provide for a Cap on increases to benefits. If this is done, the excess assets can be used to fund a Reserve account rather than relying solely on extra contributions.
Adjustment period
The frequency of adjustment periods—whether annual or more frequent—should be carefully evaluated. While more frequent adjustments can better synchronize assets and liabilities, they also elevate administrative costs. Any planned lag periods for ensuring accurate asset valuations must also be considered, as they directly affect benefit adjustment operations.
Minimum benefit
Some plans provide a minimum benefit, so retirees know they will always receive this minimum benefit, no matter what the market conditions are. This will help them understand the worst-case scenario and plan for retirement accordingly.
Other risks
While the Variable Annuity plan mitigates investment risk, other risks remain. Demographic changes may affect costs and should be reviewed annually with trustees.
Mortality is a pooled risk in DB plans and is reasonably well managed. Actuarial valuation systems have been enhanced to incorporate future mortality improvements, resulting in a significantly reduced underlying mortality risk.
| Aspect | What It Means | Why It Matters | Watch-Outs / Notes |
|---|---|---|---|
| Plan Type | A defined benefit plan with benefits tied to investment performance. | Combines DB longevity protection with market-linked outcomes. | Still a DB plan for funding and compliance purposes. |
| Benefit Formula | Base pension earned via a DB formula (service × pay × factor). | Creates a predictable “target” before market adjustments. | Plan document defines accruals and adjustment mechanics. |
| Assumed Interest Rate (AIR) | A long-term return assumption used as the “hurdle rate.” | Performance vs. AIR determines up or down adjustments. | If returns > AIR, benefits rise; if below, benefits may fall. |
| Investment Linkage | Assets are unitized; benefits vary with unit values. | Participants share investment upside and downside. | Requires prudent investment policy and diversification. |
| Adjustments | Benefits are periodically adjusted based on actual returns. | Improves long-term funding stability versus fixed COLAs. | Frequency and caps/floors should be specified in the plan. |
| Funding & Actuarial | Contributions set by an actuary using DB funding rules. | Aligns contributions with economic experience over time. | Minimum funding standards and PBGC rules may apply. |
| Risk Sharing | Market risk is shared within the plan community. | Reduces employer volatility relative to traditional DB. | Participants must understand benefit variability. |
| Retirement Payout | Benefit is annuitized; payment level can continue to vary. | Provides lifetime income with potential growth. | Some designs stabilize in-payment adjustments. |
| Communications | Clear disclosure of AIR, unit values, and adjustments. | Builds participant trust and informed expectations. | Provide examples showing good and bad markets. |
Compliance and Regulatory Risks
If you work with public sector or multi-employer plans, the funding rules are clear, and you simply value the plan using the hurdle rate as the valuation rate.
If you work with single-employer pension plans, there is no clarity as to how these plans should be valued. Mathematically, it makes sense to value the plan using the hurdle rate as you would with other plans. However, in the single-employer world, the IRS and PBGC require the liability to be valued using interest rates they produce, and there is no clarity on how this should be done with variable benefits.
In the absence of regulatory clarity, a plan could be established and valued using prevailing practices, giving sponsors confidence in its funded status. Should regulatory agencies subsequently issue specific guidance, the liability assessed under new rules may exceed previous estimates, potentially resulting in unexpected increases in cash funding requirements and associated premiums.
Final Thoughts
This discussion has illustrated the mechanics of the plan and its role in mitigating investment risk. Features such as Caps, Reserves, and minimum benefit guarantees can be structured to balance risk allocation between participants and employers.
It is important to note that, contrary to some statements, these plans do not eliminate investment risk or guarantee perpetual full funding. While theoretically possible, such outcomes are not operationally feasible.
