A New Look at Designing ERISA Retirement Plans

By Mark Shemtob

Over the past few decades, private-sector employers have steadily shifted away from traditional defined benefit (DB) plans that offered guaranteed lifetime income, favoring instead defined contribution (DC) plans focused on asset accumulation. While this shift has reduced employer liabilities, it has left many retirees struggling to convert their savings into reliable lifetime income. Surveys show that retirees value lifetime income options, yet efforts to integrate insured income products into DC plans have seen limited success. As workforce demographics and retirement expectations evolve, it’s clear that new retirement plan designs are needed-ones that balance lifetime income predictability for retirees with manageable risk for employers.

For a retirement plan covered under the Employee Retirement Income Security Act (ERISA) to be considered tax qualified,^[1] it must meet many requirements. One such requirement is that the plan be classified as either a DB plan or a DC plan. Although certain plan designs are referred to as hybrid plans due to their features of both DB and DC structures (i.e. cash balance, age weighted, target benefit), a DB-DC classification^[2] is necessary for several reasons, including the Pension Benefit Guaranty Corporation (PBGC) insurance coverage and the associated premiums; the Accounting Standards Codification financial disclosure requirements; maintenance of an Employee Retirement Income Security Act (ERISA) funding standard account to ensure sufficient funding; and plan termination rules, among others. Most of these are discussed later in the paper.

However, the ERISA DB-DC classification requirement can limit other innovative plan design possibilities, particularly when a plan doesn’t fit into either classification. Examples include Collective Defined Contribution Plans,^[3] variable annuity plans with mortality experience benefit adjustments,^[4] and plans based on modern tontine structures.^[5]

The Classification Issue

DB plans require that a guaranteed retirement benefit be provided usually based upon a plan benefit formula and each participant’s compensation and years of service. Actuarial assumptions and a funding method are employed to determine the minimum contributions needed to fund the benefits based on the Internal Revenue Code and associated regulations. The funding is the responsibility of the employer.^[6] Because the assumptions used are unlikely to ever totally match the actual experience of the plan (mostly investment return and mortality incidence), the funding level required will vary.^[7] A primary reason for employer abandonment of DB plans governed by ERISA has been the uncertainty in unfunded liabilities and required contributions.

On the other hand, DC plans provide for an uncertain benefit in the form of an account balance calculated based on the accumulated contributions and investment earnings over the years that the participant is covered by the plan. These plans are funded by either the employee, employer, or both. Neither the employer or employee has as an obligation after the funds are contributed to increase the amounts regardless of the plan’s investment experience if it is poor. This lack of potential liability makes DC plans more attractive to employers than DB plans. However, under ERISA, DC plans cannot directly^[8] offer periodic benefit payments that use longevity sharing among retirees. This is an important element in providing lifetime income to retirees on a cost-effective basis.

Since not all plan designs can fit into either the DB or DC structure, more innovative plan designs would be available if ERISA was modified to eliminate the DB-DC classification in favor of a single retirement plan type, neither DB nor DC.

Primary Features Applicable to Plans

There are many plan designs that would be possible if the DB-DC classification was eliminated. The plans, however, would need to specify many requirements. The following are some primary ones.

How will the plan benefits be determined? There are many options available. Benefits could be fixed or variable based on a simple or complex formula. The plan would also need to specify how variable benefits, when applicable, would be determined and adjusted.
Who will fund the plan? Contributions could be funded by the employer and/or the plan participants and could be pre-tax or post-tax regardless of the benefit structure of the plan. Currently, only DC 401(k) plans allow for pre-tax employee contributions, which provides an incentive for employers to use DC plans.
How will the contribution amounts be determined? This feature would depend on the plan benefits provided. A plan that provides fixed benefits, similar to a current DB plan, would likely have minimum contribution requirements subject to legislation and regulations designed to ensure that plan assets are sufficient to pay the fixed benefits. However, in the case of plans in which benefits are variable, such funding requirements would not be applicable. Instead, the plan would specify the level of contributions from each, and those could be fixed or variable.
When and in what form will benefits be payable? Each plan would specify the optional forms of payouts available and when payments may commence. It should, however, be required that all plans provide for some income options, whether variable or fixed, or whether paid directly from the plan or through insured annuity purchases. In addition, annuity options that provide survivor benefits to spouses would be required for all plans. This is not the case for most DC plans^[9] under ERISA currently.
How will plan assets be invested? This would be subject to the type of plan benefits being provided. To the extent that benefits are guaranteed at some meaningful level, it would likely be the employer that would control the investments since the liability attributable to insufficient assets would fall on the employer. However, where the benefits are variable, plan participants would likely be given control of investing among choices selected by the employer.

Possible New Plan Designs

As noted above, eliminating the DB-DC classification would permit many new plan designs to be available.^[10] Below are descriptions of several example plan designs currently not available under ERISA. These include a brief description of the plan provisions detailed previously.

Plan 1: Enhanced Variable Annuity Plan

Monthly benefits payable at retirement age based upon a formula related to years of service and compensation. Upon retirement, a lump sum (actuarially equivalent to the monthly benefit) is transferred to a separate trust account under the plan for retirees only. The benefits are payable from this account. The benefit payable is subject to change based upon actual investment and mortality experience (within this retiree pool) that differs from what is assumed.
Employers fund the plan.
Contribution amounts are subject to rules that ensure adequate funding of benefits for every participant at the time of retirement when the lump sum is transferred to the retiree trust. No further contributions are required on account of retirees because benefits are subject to change on account of experience.
Upon retirement (normal or early), optional annuity
forms are payable. Lump sums may also be available but are not required.
Investments will be managed by the employer. However, separate trusts exist for pre-retirees and retirees.

Plan 2: Variable Payout Lifetime Annuity Plan

Benefits are initially determined based on the participant’s account balance and converted to a lifetime income amount using actuarial assumptions at payout age. Benefit levels are subsequently adjusted to account for the investment and mortality experience of the plan which differs from those assumed.
Both employees and employers fund the plan with pre-tax contributions.
Employee contribution amounts are based on participant election (may use defaults). Employer contribution amounts could be fixed or discretionary based on compensation and/or a matching formula.
Upon retirement (early or normal), optional annuity forms are available. Lump-sum distributions equal to the account balance may be permitted as well as the purchase of insured fixed-income annuities if a guaranteed (as opposed to variable) benefit is desirable.
Investments are directed by participants before retirement, based on options selected by the employer. Upon retirement, investments are managed by the employer in a separate account designated for retirees only.

Plan 3: Aspirational Target Benefit Pension Plan

Aspirational benefit is determined based upon a formula using service and compensation similar to a traditional DB plan. Benefit levels are subsequently subject to adjustments based on plan experience. Adjustments will likely vary based on whether the participant is a pre-retiree or a retiree.
The plan will be funded through fixed employer and employee contributions, which can be equal or different. Contributions would be made on a pre-tax basis.
Contributions (both employer and employee) will be determined at the employee’s plan entry, based on actuarial assumptions.^[11] These contributions are calculated to be sufficient to fund the aspirational retirement benefit at normal retirement age. Contributions would be adjusted only if the plan is amended to change the aspirational benefit formula or to account for changes in compensation. Contributions would not increase solely due to plan experience.
Upon retirement (early or normal), optional annuity forms are payable.
Investments will be managed by the employer.

The above three examples are illustrative. The first example represents a plan design similar to those in use today but incorporates mortality experience adjustments among retirees. The second represents a modern tontine structure type plan similar to what is now available in Canada. The third is a type of collective defined contribution plan.

Other Considerations

ERISA plans are currently subject to many rules and regulations. While most of these will still apply, modifications will likely be required to accommodate new plan designs. Here are some key considerations.

PBGC coverage: Most qualified DB plans are currently covered by the PBGC, which insures vested accrued benefits (up to a limit) should a plan terminate with insufficient assets to cover the insured benefits. Plans that provide for some level of fixed benefits would likely be required to be covered by (and pay premiums to) the PBGC. The level of the benefits to be guaranteed should impact the premium amounts, thus requiring different premium structures based on benefit designs. Plans that do not guarantee fixed benefits would be exempt from the PBGC, similar to current DC plans.
Accounting standard rules: Currently, DB plans are subject to disclosure in most employer financial statements.^[12] This is required for the possibility that plan assets may be insufficient to cover expected guaranteed benefits and the employer could be exposed to additional liability. Such a requirement should remain in place to the extent that the guaranteed benefit entitlements could exceed plan assets. Plans that do not guarantee any benefits (those that are fully variable) would be exempt from these requirements.
Minimum funding requirements: For plans that guarantee some benefit level, there should be a requirement that plan assets are sufficient to cover benefits. This is accomplished through a set of minimum contribution requirements, as currently applicable to DB plans.^[13] The actual required minimum contributions would be subject to different rules than currently applicable depending on the plan benefit structure. Such a contribution requirement would generally not apply when benefits are not guaranteed in any form.
Actuarial assumptions: Depending upon the type of plan, there will be a need to use actuarial assumptions. This could apply to the funding of the plan if there are minimum funding requirements, in converting account balances to annuities, or measuring the need to modify benefits due to plan experience. There may be additional requirements for actuarial assumptions. The primary assumptions would be a rate of return on plan assets (present and/or future contributions) and life expectancies. The employer would serve as a fiduciary and be required to act in the best interests of the plan participants when selecting assumptions. However, it would be best to have government regulations that define a range of reasonable assumptions.
Other methodologies: Plans with variable benefits would require a method for benefit adjustment to account for experience that differs from what was assumed. Such a method would provide for frequency of change as well as the extent that any experience should be immediately recognized or deferred. It would likely be appropriate for regulators to provide rules governing acceptable methods.
Employer pooling: Some variable benefit plan designs will function effectively only if there is a large enough scale and new participants are continually entering the plan. Unfortunately, many plans may lack sufficient critical mass. Therefore, it would be best to have individual employers band together to create multiple-employer plans. There is currently some allowance for this under the law;^[14] however, there are also restrictions. Pooling of employers within plans should be further encouraged by legislation and regulations.
Non-discrimination: Currently, qualified plans funded with tax-favored contributions are subject to limitations. The purpose is to limit the benefits available to highly compensated employees^[15] in comparison to non-highly compensated employees. There are a variety of rules based upon the plan types, and these rules can be complex depending upon the plan type and employee demographics. Nondiscrimination requirements should continue, though they will likely need to take a different form to accommodate new design plans that differ from those currently available.
Reporting requirements: As is the case currently, ERISA plans are subject to reporting requirements with government agencies. The primary reporting requirement is through the Form 5500^[16] and attachments series. In addition, plans with more than 100 participants are required to undergo an annual audit. These reporting requirements should remain in place, though the information collected will need to be changed to better report on the actual plan features.

Conclusion

Changes are necessary to allow retirement plan designs to better address the current needs and preferences of both employers and employees, and as discussed above, eliminating the DB-DC classification would permit many new plan designs to be available.

MARK SHEMTOB, MAAA, FSA, EA, provides consulting on retirement income security at both the individual and the institutional levels.

Endnotes

Contributions are tax deductible employer (and employee under a 401k arrangement) and the trust is exempt from paying taxes.
A discussion of the differences can be found on the Department of Labor website.
Collective Defined Contribution Plans; American Academy of Actuaries; September 2024.
Currently these plans can have benefits adjusted based on investment performance but not based on mortality experience of the retiree group.
“Annuities Versus Tontines in the 21st Century”; Society of Actuaries; March 2018.
DB plans could have required employee contributions, but this is a rare feature.
The funding method is prescribed by law and does not necessarily insure adequate funding of all liabilities.
Plans can offer retirees the option to have an insured annuity purchase with their account balance.
This includes 401(k) plans which are the most popular type of plan being used.
All current plan designs would also be available.
Similar to how a target benefit DC plan works.
FASB Accounting Standards Codification.
26 U.S. Code § 412-Minimum funding standards; Cornell Law School.
Employers can join Pooled Employer Plans which are DC plans.
Highly compensated employee is defined under the Internal Revenue Code based upon compensation, ownership, and officer status.
Form 5500 Series; Department of Labor.