Although variable annuity pension plan (VAPP) designs have been permissible for decades, they have not yet seen widespread adoption—particularly in the Taft-Hartley multiemployer plan space.
Recently, however, we have seen a trend of employers and unions (or existing multiemployer plan boards of trustees) agreeing to set up VAPPs as an alternative to the traditional multiemployer defined benefit plan design (hereafter, “Traditional DB Plan”).This post provides a brief overview of VAPPs and explains the circumstances under which they may be preferable to a Traditional DB Plan.
VAPP Overview
A VAPP is most easily understood in contrast to a Traditional DB Plan.
Under a Traditional DB Plan, a participant will earn the right to a fixed annual benefit, which is ordinarily payable monthly beginning on the participant’s retirement and ending on the participant’s death. The amount of the participant’s benefit is calculated using a formula described in the plan document and is not affected by the pension plan’s investment performance. In a Traditional DB Plan, the contributing employers bear the entire burden of plan investment losses, assuming the plan remains solvent and benefits are not able to be reduced under applicable law.
Under a VAPP, a participant will earn the right to an annual benefit, which is ordinarily payable monthly beginning on the participant’s retirement and ending on the participant’s death. The amount of the participant’s benefit accrual is calculated using a formula described in the plan document.
Unlike a Traditional DB Plan, however, a VAPP participant’s benefit will adjust over time based on the pension plan’s investment performance. In a VAPP, the participant’s benefit will generally increase if the plan’s investment returns are higher than a specified “hurdle rate” and will generally decrease if the plan’s investment returns are lower than the hurdle rate.
Because each participant’s benefit will adjust based on investment performance, VAPPs generally have a more stable funded status and employer contribution formula than Traditional DB Plans and, if designed properly, will not generate any withdrawal liability for employers.
Old Dog with New Tricks: Increased Flexibility Drives Increase in VAPP Adoption
Since VAPPs were introduced in 1953, their appeal has been limited by the lack of design options and the volatility that participants experience in the event of negative investment performance.
In 2014, the IRS issued regulations providing additional flexibility for VAPP designs. The regulations allow designs—such as the “cap and shore” design described below—that provide a less volatile benefit to participants while continuing to offer better funding stability as compared to Traditional DB Plans.
In addition to this added flexibility, VAPPs are growing in popularity due to circumstance. Broadly speaking, there is a shrinking population of contributing employers to multiemployer pension plans, and many employers are wary of agreeing to contribute to multiemployer pension plans due to the potential for withdrawal liability. VAPPs allow the bargaining parties to provide participants with a lifelong annuity benefit while minimizing the potential for withdrawal liability to employers.
Typical VAPP Designs
Generally, a VAPP will provide a “basic benefit” that is fully funded at the outset. The amount of the basic benefit will increase or decrease depending on the performance of the plan’s investments relative to the specified investment return hurdle rate (e.g., 5%).
For example, if a participant earns a basic benefit equivalent to $100 a month in Year 1 and the plan’s investments returned 10% throughout the year, the participant’s accrued benefit in Year 2 would be equivalent to $104.76 a month (100 x (1.10 / 1.05)). If in Year 2 the VAPP’s investments lose 10%, the participant’s accrued benefit in Year 3 would be equivalent to $89.79 a month ($104.76 x (.90 / 1.05)).
To avoid a high level of volatility in the benefit amount, some VAPPs use a “stabilization reserve” to minimize reductions to the participant’s accrued benefit during years where the plan has investment losses. For example, the stabilization reserve may be used to offset the effect that investment losses would otherwise have on the accrued benefits of participants in pay status (i.e., retirees).
Another approach VAPPs use to mitigate volatility is the “cap & shore” design under which, in addition to the hurdle rate, the VAPP adopts both a “cap” and “shore” rate. If the investment returns exceed the “cap” rate, the overage is placed in the stabilization reserve. If the investment returns are lower than the “shore” rate, the stabilization reserve will be used to limit the reduction in the participants’ accrued benefit to the shore rate. If the stabilization reserve is exhausted, the shore rate is ordinarily disregarded until the stabilization reserve is replenished.
Imagine a VAPP where the hurdle rate is 5%, the cap rate is 10%, and the shore rate is 0%. If a participant earned a basic benefit equivalent to $100 a month in Year 1 and the plan’s assets returned 15% throughout the year, the increase in the participant’s accrued benefit would be limited to 10% (the cap rate), and the participant’s accrued benefit in Year 2 would be equivalent to $104.76 a month (100 x (1.10 / 1.05)). The excess investment returns would be placed in the stabilization reserve. If in Year 2 the plan’s assets lose 10%, the loss would be limited to 0%, and in Year 3 the participant’s accrued benefit would be equivalent to $99.77 ($104.76 x (1.0 / 1.05)).
When Should Bargaining Parties Consider Adopting a VAPP?
With this understanding of how VAPPs work, it is easy to imagine situations where the bargaining parties may consider adopting a VAPP design.
For example, where there is not already a multiemployer pension plan in place, the bargaining parties may prefer to adopt a VAPP in lieu of a Traditional DB Plan because participating employers may be less hesitant to bargain into a VAPP given the very low risk for withdrawal liability.
Similarly, where a participating employer is withdrawing from a multiemployer pension plan, the participating employer may consider bargaining into a multiemployer VAPP as an alternative to future Traditional DB Plan participation, allowing the employer to continue to provide their unionized workforce with a pension benefit.
Finally, existing fully funded multiemployer pension plans may consider providing for VAPP accruals in addition to—or in lieu of—Traditional DB Plan accruals to help secure the plan’s funded status and encourage employers to stay in the plan as opposed to withdrawing.
How We Can Help
If you are in any of the situations described above, or are considering bargaining into a VAPP or withdrawing from a multiemployer pension plan, we stand ready to assist you. Please feel free to reach out to the authors of this post or your primary Morgan Lewis contact for assistance.