Key Takeaways
- Payouts vary with investment performance annually.
- Combines features of defined-benefit and defined-contribution plans.
- Employer contributions fixed; participant bears investment risk.
- Includes safeguards to limit benefit volatility.
What is Variable Benefit Plan: What It Means, History?
A variable benefit plan is a type of pension plan where retirement payouts vary based on investment returns rather than being fixed like traditional defined-benefit plans. It blends features of defined-benefit and defined-contribution models, adjusting benefits annually using a formula tied to actual investment performance versus a hurdle rate.
These plans emerged in the 2000s as employers sought to share investment and longevity risks with employees while controlling costs, gaining traction in public pension systems and union plans. The American Academy of Actuaries classifies variable benefit plans as defined-benefit but with fluctuating payments aligned with market outcomes.
Key Characteristics
Variable benefit plans combine predictable accruals with investment-linked adjustments to balance employer and participant risk:
- Benefit Accrual: Benefits increase annually by a fixed percentage of salary, similar to a 401(a) plan.
- Investment Adjustment: Annual payouts are modified based on actual returns compared to a hurdle rate, often around 5.5%, protecting against market downturns.
- Risk Sharing: Unlike traditional defined-benefit plans, investment risk partially shifts to participants, who may see benefit fluctuations.
- Volatility Controls: Many plans include floors to limit reductions and reserves to smooth benefit changes over time.
- Vesting Requirements: Typically require a minimum service period, such as five years or 1,000 hours annually, to qualify for benefits.
How It Works
Each year, your accrued benefit is recalculated by adjusting the previous year's amount according to investment performance relative to the hurdle rate. If returns exceed the hurdle, your benefit grows faster; if below, it may decrease, reflecting market conditions.
Employers contribute a fixed amount annually, while the benefit you receive depends on plan formulas that blend stable accruals with return-based adjustments. This approach offers more predictability than defined-contribution plans but exposes you to some investment volatility. Participants often manage withdrawals flexibly, akin to a tactical asset allocation strategy within retirement income planning.
Examples and Use Cases
Variable benefit plans are used by various organizations to balance risk and reward for retirement benefits:
- Airlines: Power Corporation has sponsored retirement plans with variable benefit features to manage pension costs amid market fluctuations.
- Bond Funds: Plans may invest in stable income vehicles like the BND bond fund to help smooth returns and reduce volatility in benefit adjustments.
- Dividend Growth Companies: Some plans include equities like Vanguard Dividend Appreciation ETF to capture growth with income stability, supporting benefit increases.
Important Considerations
When considering a variable benefit plan, understand that your retirement income is not guaranteed and will fluctuate with market performance. This shifts longevity and investment risk toward you but can offer upside potential in strong markets.
It's essential to evaluate how plan formulas align with your retirement goals and risk tolerance. Consulting resources on deferred acquisition costs and other pension accounting standards can clarify how these plans impact financial statements and long-term sustainability.
Final Words
Variable-benefit plans balance retirement security with investment risk by adjusting payouts based on actual returns versus a hurdle rate. To assess if this plan suits your needs, review the potential volatility and compare it against more traditional pension options.
Frequently Asked Questions
A variable-benefit plan is a pension plan where retirement payouts fluctuate based on investment performance, combining features of both defined-benefit and defined-contribution plans. Unlike fixed pensions, benefits adjust annually depending on how investments perform relative to a set hurdle rate.
Retirement benefits in variable-benefit plans are adjusted yearly using a formula that compares actual investment returns to a predefined hurdle rate, typically around 5.5%. If returns exceed this rate, payouts increase; if below, payouts decrease accordingly.
Traditional defined-benefit plans guarantee fixed payments with the employer bearing investment risk, while defined-contribution plans fix contributions and shift all investment risk to participants. Variable-benefit plans blend these models by having predictable employer costs but allowing benefits to fluctuate with investment returns.
Variable-benefit plans have been adopted in various public pension systems, such as those in Wisconsin and South Dakota in the U.S., which use reserves and smoothing techniques. In Canada, plans like PEPP and McGill University's option provide variable benefits as a retirement income choice from defined-contribution funds.
Variable-benefit plans offer lower and more predictable employer costs, potential upside from strong market returns, and some inflation protection without exposing participants to the full risk of defined-contribution plans. They balance security with investment growth opportunities.
Participants face risks such as possible reductions in benefits if investments perform poorly, as well as longevity and investment risks shifting from employers to employees. Additionally, the complexity of benefit calculations can be a challenge to fully understand.
To limit volatility, these plans often include safeguards like floors to prevent excessive benefit reductions, ceilings to cap increases, and stabilization reserves to smooth out fluctuations, helping maintain more stable retirement income.
Variable-benefit plans may suit individuals seeking a balance between predictable retirement income and growth potential, especially those comfortable with some investment risk but wanting protections not found in pure defined-contribution plans.
