While DB plans provide lifetime income to participants, they also expose plan sponsors to significant risks that are outside of their control like declining interest rates and investment volatility, which can negatively impact a plan’s ability to fund and provide benefits to participants over the long term. Conversely, DC plans allow sponsors to make predictable contributions to their participants’ retirement accounts but they also place investment and longevity risk (i.e., responsibility for growing and making savings last through retirement) squarely on employees.

A VAPP mitigates risks for both plan sponsors and participants.

Understanding Variable Annuity Pension Plans

VAPPs are a type of DB plan. As with traditional DB plans, VAPPs accrue benefits based on a specified accrual rate (e.g., percent of salary, flat dollar amount, percent of contributions) and provide determinable benefits that guarantee monthly payments for the lifetimes of participants.

What differentiates a VAPP from a traditional DB plan is the way annual accruals are adjusted each year based on how the plan’s assets perform compared to a pre-defined benchmark return (referred to as the hurdle rate). This feature helps plan sponsors better manage the plan’s liability (i.e., the present value of the benefit it owes to participants). These adjustments can continue even into a participant’s retirement, allowing their monthly benefit to increase in most years, similar to Social Security.

Additionally, participants benefit from VAPP’s pooled investments, which are professionally managed and seek long-term growth to maximize the potential benefit for everyone in the plan. This contrasts with DC plans in which individuals manage their own investments and often seek to de-risk those investments as they approach retirement.

Take an example of a 45-year-old participant, looking to retire in 20 years:

¹ Average since-inception return (21 years) of the Vanguard 2025 Target Date Fund
² Average annual return over last 21 years of the Vanguard 60/40 ETF
³ Average annual return of the Vanguard Target Retirement Income Fund

While VAPPs have existed for more than 70 years, they have gained traction within the last decade among organizations concerned about the risks associated with traditional DB plans. Plan sponsors can amend their existing DB plan to adopt a VAPP design, making the transition relatively easy. A VAPP may also be a more efficient alternative to providing retirement income in a DC plan.

How VAPPs mitigate risk

In traditional DB plans, sponsors must manage various risks, including interest rate volatility, investment performance and longevity risk. Poor investment returns and declining interest rates increase the likelihood of underfunded plans, which then must manage payouts for participants potentially living increasingly longer in retirement. VAPPs help mitigate these risks by balancing them more evenly between the sponsor and participants.

In a VAPP design, benefits vary in line with the plan’s investment returns. This feature allows liabilities to move in tandem with assets. In this way, the participants’ benefits — what they expect to receive in retirement — fluctuate over time with the financial markets. Additionally, plan liabilities are measured using an interest rate based on the hurdle rate, as opposed to a market-based interest rate (which fluctuates each year). Because the interest rate remains constant, it removes interest rate risk and helps to minimize unfunded liabilities and funded status volatility. What makes a VAPP more like a traditional DB plan than a DC plan, is how it provides participants with guaranteed lifetime income in retirement, therefore solving a significant need for many participants.

Other advantages of VAPPs

By managing key risks for both plan sponsors and participants, VAPPs offer a compelling way to design a retirement benefit that has broad appeal to many plan sponsors.

Organizations that sponsor a single-employer plan may be able to use a VAPP to help attract and retain top talent since the benefit offers participants meaningful, lifetime income in retirement. It also has the potential to provide benefit increases that keep up with inflation.

Single-employer plan sponsors in the private sector might also find VAPPs attractive because they may help reduce their PBGC variable rate premiums, which can be a significant expense for plans. The more underfunded a plan is, the higher that premium is.

By offering a VAPP, sponsors of multiemployer pension plans may be able to attract new contributing employers, allowing them to share costs across a larger group of employers and gain scale — and increased contributions — with a larger number of plan participants.

Customizing a VAPP for any organization

VAPPs can be customized in a variety of ways to meet any organization’s specific needs.

For example, plan sponsors can determine the following features:

• The hurdle rate. Typically, the hurdle rate is set in the 5–6 percent range. A participant’s benefit will be adjusted annually based on the VAPP’s market return.
• The return adjustment period. Plans may decide the timing for when they realize returns after a plan year ends. For example, they could use estimated or final returns (such as estimated returns three months after the plan year ends or final returns 12 months after). Additionally, plans may elect to use a period of multiple years to calculate the return adjustment.
• Whether to provide lump-sum distributions in addition to annuity options at retirement. For example, are lump sums available, or required, for smaller benefits (e.g., payouts under a certain threshold)?

Additionally, plan sponsors can choose to use a number of strategies to mitigate the downside investment risk to participants and beneficiaries. This includes how a VAPP realizes gains and losses from an accounting perspective (a process known as smoothing), and how it uses any reserve funds it generates from surplus market returns above its hurdle.

These strategies are ways the plan can minimize volatility for retirees (either by smoothing the returns or cushioning against negative adjustments through a reserve account). Both options can be adopted without any significant impact on employers’ contributions and can be designed to keep the plan at or near 100 percent funded (or above) while providing comfort to future retirees.

VAPPs are poised to become a key component of future retirement benefits

VAPPs present a viable and sustainable way of providing participants with lifetime income with less financial risk to the plan sponsor.

In recent years, our actuaries and consultants, have assisted in the design of dozens of VAPPs for corporate and multiemployer clients. As more organizations recognize the advantages of VAPPs, their numbers are likely to grow.