Case Studies

Problem : Smoothing Funding for Tax Exempt Plan Sponsors:

Several of our tax exempt clients subject to ERISA and the new Pension Protection Act (PPA) rules, had the practice of contributing the entire “budgeted” contribution, even if it was in excess of the minimum.


In fact for many of these clients, determination of the “budgeted” contribution was crucial, and increases beyond the budgeted amount would impose political and financial burdens upon management. Prior to PPA, the range of ERISA contributions permitted under various funding methods and actuarial assumptions accommodated most plan sponsor funding protocols and any excess contributions were simply recorded and remained available as a credit balance to offset future minimum funding requirements. PPA introduced more rigid funding methods and mandated assumptions. In addition PPA imposed many restrictions on the ability of plan sponsors to use their accumulated credit balances, including rules which could force the forfeiture of the credit balance. Clients whose plans were funded at or near the 80% funded ratio were at risk of forfeiting portions of their credit balance in order to maintain an 80% ratio, or at risk of not being able to use their credit balance at all in high cost years.

Solution: We advised our tax exempt clients with excess contribution capabilities, to maintain the excess contributions in an earmarked “stabilization” reserve outside the plan as part of entity net assets. In this way, the excess amounts remain available to the sponsor to be applied toward future contributions as necessary without restriction, and since the excess assets were generally invested tax free along with the entity net assets, there was no effect on financial statement under FAS 158.

Our clients who were tax exempt employers could minimize volatility in their annual pension plan contributions by establishing a “contribution stabilization reserve” outside the plan funded by excess budgeted amounts. As described above, under this approach only the minimum required amounts are deposited to the pension trust, and any excess budgeted amounts are invested in an account within the organization’s net assets or reserves. This approach permitted smoothing the contributions in high cost years with assets from the reserve. The contingency reserve can be invested tax free, much the same as the plan assets, and can be used to supplement future contributions in high cost years, without the restrictions which might apply if the excess budgeted amounts were deposited to the Plan and outside their control.

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Problem : Controlling Costs of Executive Pension Restoration Benefits

Executive benefit areas often require, rather than permit innovative approaches. Especially in the tax exempt and governmental sectors where benefits are subject to both 457 regulations as well as 409A rules, retirement programs can be very complex.


One of our tax exempt clients wished to provide a “top hat” supplemental plan which restored the defined benefit plan amounts not permitted because of the 401(a)(17) salary limitations, but wanted to be in control of the liabilities and did not want to have an unrestricted defined benefit supplemental plan and the associated, sometimes volatile, unfunded liability associated with leveraged benefit programs.

Solution: MWM developed a defined contribution restoration benefit program which provided each executive with the annual lump sum value of the restoration amount of the defined benefit plan formula over the restricted amount, on a tax deferred basis compliant with Section 457(f) and 409A. The annual benefits were not earned until approved by the Board, which allowed the Board to have confidence in their ability to control the increase in liability and costs associated with the program. The vesting schedules were developed to meet the incentive goals of the client, provide tax deferral to executives and remain in compliance with deferred compensation tax regulations.

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Problem : When to implement and how to evaluate asset allocation strategies such as Liability Driven Investment (LDI) based upon plan funding status and employer tax status.


Both our for profit and tax exempt sector clients have sought our perspective when developing their assets allocations. Reducing the volatility associated with defined benefit pension plans requires the consideration of the complete program and its various components: plan design, annual funding goals and investment strategy. Many clients, especially those with frozen benefits and fully funded programs are motivated to limit any threat to their funded status. Plan sponsors can use several techniques to “protect” plans against erosion in their funded status. In assessing the value of investment techniques such as the LDI approach described below, we have helped clients take into consideration the whole effect upon their balance sheets, and have separately identified the differences for tax-exempt and for profit employers.

Dynamic ALM forecast valuations (asset liability models) are useful in revealing the effects modifications in each of these aspects may have upon the funding of the Plan. There are a variety of techniques currently employed to address volatility issues. Investment techniques include adjusting asset allocations to contain “duration matched” fixed income investments (Liability Driven Investments – LDI) which synchronize the movement of the bond portfolio held by the Plan with the benefit liability when measured on a current bond yield curve.

There is usually a “cost” associated with an LDI approach in that the expected total return on investments is lower than that which would be expected if the Plan had a diversified portfolio which had allocations of equity and other risk related assets. The LDI approach may lower the overall expected return on assets depending on market conditions. The LDI approach becomes more attractive for “frozen” plans where additional benefits are no longer being accrued, or for plans that are very well funded and wish to protect their current funded status, and for those sponsors less concerned about increased future contributions. Many Plan sponsors choose to devote a portion of their portfolio to bonds on an LDI basis to hedge some of the interest rate risk and add stability to the funded ratio. In this way with a combined LDI/diversified portfolio, sponsors still achieve the additional returns associated with equity investments.

Solution : Tax Exempt Sponsor: Fully Funded Plan

Our tax exempt client sponsors a fully funded frozen pension plan with a significant surplus, and had at the recommendation of the investment advisor, been pursuing a total LDI investment approach. This approach protected the “funded status” of the plan in that the funding ratio would not deteriorate with changes in interest rates, however it subjected the funding surplus dollar value of the plan to significant erosion in an increasing interest rate environment, without any benefit to the plan. Since the surplus of a tax exempt employer is not subject to the 50% excise tax or income tax, retaining surplus amounts can have significant value to tax exempt employers. MWM actuaries illustrated to the investment advisor and the plan sponsor, the leveraged sensitivity of the surplus to changes in the interest rate under the total LDI approach and suggested that perhaps a significant portion of the surplus be invested in shorter duration bonds, or a more diversified asset mix. The investment advisor agreed and the surplus was invested in a mix of shorter duration bonds and some equity asset classes to protect the dollar value of the surplus, and the remaining portfolio which fully covered the plan liabilities was continued under a fully LDI matched approach.

Solution : For Profit Sponsors : Gradual Implementation with Full LDI at Full Funding

It is important to appreciate that the tax status of the plan sponsor, as well as the plan funded status, is a very critical factor in determining whether an LDI approach is advantageous since the risk/reward ratio changes. For profit sponsors are taxed at 80% on reversions from qualified plans. This means that a for profit employer will receive only 20 cents on the dollar for any excess assets which could be returned upon termination of a plan, but will have to pay 100 cents on the dollar for every dollar of underfunding. This relationship skews the normal risk / return tradeoff in favor of a very cautious investment portfolio once full funded status is achieved. It is also the reason why many for profit sponsors of frozen fully funded pension plans have elected to forego additional returns associated with equity allocations, in favor of a wholly LDI matched portfolio. However until the plan is fully funded, or if the plan is still accruing benefits, the risk/return proposition for asset allocation for a taxable employer is not skewed.

We have illustrated to tax exempt clients, and to taxable clients with unfunded benefits, that there is a cost of implementing a totally LDI investment approach, especially at low interest rates, in the amount of additional required contributions that will be expected. The stability associated with a total LDI approach, also precludes the anticipation of increased investment income being available to fund accrued and/or future benefits.

For our taxable clients with unfunded benefits in a frozen plan, we collaborated with the investment advisors to develop a partial LDI approach, where the LDI component increased as the funding ratio of the plan approached full funding.

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Problem : Pension Plan Design Balance and Cost Control

Our client’s defined benefit pension plan, valued and understood by their employees, was an important recruitment and retention tool in their overall compensation package. However, continuing increases in required annual contributions threatened their ability to predict and manage their annual cash flow. Our client asked for our help.


Solution : Program Re- Balance

The plan sponsor already had considered and implemented some investment strategies intended to mitigate volatility, but overall costs were still projected to remain elevated and potentially unstable for several years in the future. We suggested that a re-design of their retirement program. The overall goal was to retain their defined benefit plan, but at a lower cost level, to be supplemented with an enhanced defined contribution arrangement. The re-balanced program was designed to provide compensation incentives for both young and mature employees, with a strong foundation of long term retirement security.

We illustrated to our client the effect upon our clients projected contributions, and the effect upon each employee of plan design modification alternatives, such as career average formulas versus final pay formulas, and lower benefit accrual options. For example, the liability development in career average plan designs, and cash balance type plans (as opposed to Final Average Plans) are less sensitive to increases in salary progression. We illustrated how a career average plan with periodic “ad hoc” adjustments can be implemented to update benefits to a “final pay” basis depending upon the Plan’s funded status (i.e. surplus available to fund the update). Our client also considered hybrid plan designs such as cash balance plans, which also can be considered to incorporate features which can reduce sponsor risk. We also recommend that our client modify the early retirement plan features and direct employees to use their defined contribution plans to accommodate early retirement options. (Plans can be modified to reduce or eliminate early retirement subsidies on future accruals which can lessen the cost of the program and likelihood of unanticipated actuarial losses. Some of the hybrid designs such as cash value plans can lower costs simply because the early retirement subsidy is reduced or eliminated). Even though accrued benefits before the change can be elected at an earlier age, the effect of the later early retirement age on future accruals influences the participant’s election for early commencement.

Our client elected to modify their benefit formula from a final pay to a career average pay plan, with a slightly (20%) reduced formula for future accruals, and with an increase in the early retirement date to age 63. The sponsor’s match to the 401(k) plan was increased from 3% to 4% of pay. Each employee was provided with a “retirement planning” exercise which illustrated the effect the new program would have on their individual situation. The new program was very well received by employees who appreciated the effort our client was undertaking in the interest of providing employees with a substantive and sustainable retirement package.

Defined benefit plan formulas can be reduced and defined contribution plan formulas increased or added to a retirement program. Design modification decisions are usually made in a cost / benefit context with the impact upon participant groups identified and quantified, with the total cost/savings implications forecasted on a near and longer term basis, and with considerations given to the overall organizational, HR and financial strategies.

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