Hospitals and health systems face many of the same issues as employers in other industries when qualified retirement benefits are considered. The universal trend has been to freeze or terminate defined benefit plans and replace them with 403(b) or 401(k) plans. However, the issues that qualified defined benefit plans present do not translate to nonqualified supplemental executive retirement plans (SERPs). Nonqualified defined benefit plans are an effective way of delivering benefits to executives without the problems that qualified plans face.

THE VOLATILITY OF QUALIFIED DEFINED BENEFIT PLANS

In the past few years, the enactment of the Pension Protection Act and the Financial Accounting Standards Board’s (FASB’s) changes to pension plan accounting have put more focus on defined benefit plans. The FASB rules have further driven a wedge between the finance department and defined benefit plans. Under the new rules, the funded status of the plan (the difference between assets and liabilities) directly affects the employer’s balance sheet position. In many cases, the funded status is the difference between a relatively large asset amount and an equally large liability. A small change in either can make a big difference to the funded status.

Qualified defined benefit plans are required to adhere to minimum funding requirements. Organizations may in one year have a manageable contribution requirement and in the next year have a much larger obligation. Similarly, liabilities may vary from year to year depending on prevailing bond rates, and assets may experience huge swings from day to day. While investment experts are becoming more able to structure the assets so that liabilities and assets move in unison, the volatility of minimum funding contributions and the uncertainty of swings in assets have encouraged many organizations to freeze their defined benefit plans in favor of defined contribution plans.

NONQUALIFIED DEFINED BENEFIT PLANS

While it is widely believed and accepted that defined benefit plans cause more volatility on the balance sheet than their defined contribution counterparts, the distinction between qualified and nonqualified plans is often not made. The argument against qualified defined benefit plans is well articulated, but nonqualified defined benefit plans should not be tarred with the same reasoning.

Nonqualified defined benefit plans do not have the same minimum funding requirements as qualified plans. Therefore, the organization does not have to be concerned with unexpected large cash flows due to asset volatility. The only cash outlay is when benefits are due, which, depending on the design of the plan, may be much more predictable. And in the current environment, financial predictability is highly regarded.

The accounting rules do not take into account any assets in the valuation of a nonqualified pension plan, even if the organization has set aside some assets to pay for future benefits. Therefore, the funded status that now appears on the balance sheet is essentially the liability.

The majority of nonqualified plans aid executives who are, on average, closer to retirement age than the average age of qualified plan participants. The closer a participant is to retirement the less sensitive the liability is to changes in market interest rates. Compared to the qualified plan, there is minimal unexpected balance sheet impact from nonqualified plans.

THE ALTERNATIVE: A NONQUALIFIED DEFINED CONTRIBUTION PLAN

The alternative to a nonqualified defined benefit plan is a nonqualified defined contribution plan, where benefits are contingent on investment returns. Similar to its defined benefit counterpart, a nonqualified defined contribution plan is not required to be funded.

If a nonqualified defined contribution plan is not funded, then the organization is taking on investment risk. With no assets backing the benefits promise, the organization’s costs are directly affected by investment performance, and if the investment performance is higher than expected, then the benefits payment will be much larger. In this case, defined contribution plan costs are more volatile than for defined benefit plans. The most effective way to eliminate the investment risk is for the organization to hold investments that mirror the participant’s investment elections.

The use of a defined contribution approach for a nonqualified plan suggests that the plan should be fully funded. However, this means that less cash is available for the organization to use for other purposes, and ongoing administration and investment management is required.

HYBRID PLANS

An alternative to a traditional nonqualified defined benefit or defined contribution plan is to offer a hybrid plan. The benefits of a defined contribution plan – easy-to-understand account balances and contributions, transparent costs and simple accounting – can be combined with the funding flexibility of defined benefit plans by creating an account-based plan with interest credits. Those interest credits could be based on a fixed rate or a variable interest rate, but would be relatively predictable. This is similar to qualified cash balance plans.

Most SERP benefits in tax-exempt organizations are paid as a lump sum due to the tax treatment. The account-based approach aligns well with the lump sum form of payment and may avoid the complexity associated with the conversion of annuities to lump sums in some defined benefit plan structures.

THE BEST CHOICE FOR YOUR ORGANIZATION

Nonqualified defined benefit plans pose very little risk from a balance sheet perspective, and allow an organization more flexibility in the use of its assets. However, public perception may mean that a defined benefit approach is less desirable. Defined contribution plans are simple, but require funds to be set aside and managed.

Hybrid plans take the best features of defined benefit and defined contribution structures to create a simple, transparent benefit that is easy to communicate to executives, easy to administer and lends itself well to the standard lump sum form of payment.