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The Adjustable Pension Plan

The Adjustable Pension Plan*
Richard Hudson, FSA, FCA, EA, Principal Consulting Actuary

The Adjustable Pension Plan (APP) is designed to mitigate the various risks that have caused many pension plans to shutdown over the past decades.  Americans need a secure way to provide lifetime income during retirement and the current defined contribution plans will not provide a safe level income stream throughout the retirement years.  This plan creates a partnership with the employers and employees by sharing the investment risk of the pension plan and moving towards a lower risk investment pool.

The basic plan design provides a flat dollar or career average pay formula for the participants.  This benefit is developed after determining what level of contributions are available to fund the plan.  This information is used to determine the cost of the plan and develop the ultimate benefit level that can be sustained by the employer’s contribution level.  The costs are developed using very conservative assumptions to provide more certainty that the benefits promised can be delivered.  This benefit is the floor benefit and will provide a minimum level of benefit to the participants.  The adjustable benefit will be tied to overall investment performance of the fund.  The participant gets the greater of the floor benefit or adjustable benefit.

The APP considers the following risks that are inherent in typical defined benefit plans today:

  • Investment Risk
  • Maturity Risk
  • Mortality Risk
  • Inflation Risk

The Adjustable Pension Plan addresses the investment risk by sharing the risk between the employers and employees.  The adjustable component of the benefit is tied to overall investment performance of the pension plan.  When investments are strong, the adjustable benefit increases.  When investments are weak, the adjustable benefit decreases.  The participant’s adjustable portion of the benefit is at risk of declining value and provides a layer of protection before the employer is subjected to additional funding requirements.

Maturity Risk is a risk associated with a pension plan maturing and the liability associated with retired lives increasing to levels much greater than the liability associated with the active workforce.  This has caused significant financial strain on industries like auto manufacturing and steel industries.  The APP deals with this risk by immunizing the assets that support the retired life liability so there is no equity risk exposure on these assets.

Mortality Risk is a substantial risk for participants in a defined contribution plan as they need to manage their money during retirement and hope they do not outlive their retirement savings.  In a defined benefit plan like the APP, the mortality risk is pooled and poses much less risk to the plan and the participants.

Inflation Risk is another risk that has caused many problems in pension plans.  Typical plan designs would provide a benefit on final average compensation or increase benefits during good economic times.  These issues have created guaranteed benefit improvements to participants and subjected employers to the risk of supporting higher levels of benefits.  The APP will adjust benefits up when the investments can support the change and will adjust benefits down when the investments slide.

The studies we have performed show the Adjustable Pension Plan is a sustainable model for providing secure retirement income for life and has a high probability of delivering a benefit higher than the promised floor benefit.  It provides a risk sharing element to create a partnership between the interested parties and considers the risks that have hurt many retirement plans during the past decades.

*To see slides summarizing the Adjustable Pension Plan, click here.