The White House Council of Economic Advisors in a recent report, “Supporting Retirement for American Families,” expressed concern that the shift to defined contribution plans from traditional defined benefit plans diminished the prevalence of lifetime income benefits and increased the risk that retirees will outlive their assets.
Unfortunately that report, as well as proposed Internal Revenue Service guidance issued in February to address this “longevity risk,” fail to see that a cash balance plan is a natural and cost-efficient vehicle to address this problem.
The centerpiece of the IRS guidance would allow a DC plan participant to have a portion of his or her account applied to purchase a “qualified lifetime annuity contract” — an annuity contract under which payments do not start until as late as age 85.
These QLACs have the potential to be the “missing piece” to the longevity risk problem in DC plans, because they allow participants to manage and draw down the remainder of their accounts during a defined “pre-annuity” period, with guaranteed income kicking in if they survive beyond the deferral age.
QLACs are inexpensive compared with immediate annuities, typically costing only 10% to 20% as much for the same annuity amount, because the payments don't begin for many years. While that might seem like a fair price for this protection, it might not be such a good deal given that the DC plan will have to buy these annuities at retail prices from an insurance company.
The bad news is that the IRS guidance does not extend to DB plans, such as cash balance plans, which could have the unintended consequence of pushing even more employers out of the DB system, exacerbating the longevity risk issues the administration is concerned about.
At the very least, the ability to provide deeply deferred annuities should be extended to cash balance plans, which, like DC plans, express benefits as account balances and typically pay benefits as lump sums. Allowing a cash balance plan to pay a lump sum with an annuity “kicker” (covering, say, post-85 years) would provide the outcome that the administration is seeking at essentially wholesale prices. More favorable pricing means greater employee interest and uptake.
Since the mid-1980s, employers have adopted cash balance plans as an alternative to freezing DB plans and shifting all retirement risks to employees. Growth of cash balance plans has been stymied, however, by the IRS and Treasury Department treatment of them, which has ranged from benign neglect to blatant disfavor. Limited formal guidance and behind-the-scenes roadblocks led members of Congress from both parties (and even the courts) to criticize IRS rules for cash balance plans as being unintuitive, complex and seeming to serve no particular purpose other than to restrict positive innovation in this area.
Congress intervened in the 2006 Pension Protection Act, providing guidance for cash balance plans and a straightforward road map for further innovation. Yet, more than five years later, we still don't have final rules from Treasury/IRS on key issues and the IRS continues to raise hypertechnical issues in determination letter reviews and audits.
All of this suggests that the Treasury and IRS still are disinclined to find ways to make cash balance plans work. That is troubling because these plans hold great promise for delivering better retirement outcomes. Compared to DC plans, cash balance plans facilitate better investment decisions, allow for rational risk-sharing between employees and employers, and more efficiently accommodate annuity options and longevity risk pooling at the employer level.
It is time for the Treasury/IRS to remove the roadblocks and begin facilitating the use of cash balance plans to address critical retirement policy issues. And the clock is ticking. n
Brian C. Donohue and Larry Sher are partners in Chicago and Morristown, N.J., respectively, at October Three LLC, an actuarial, consulting and technology firm.