Hybrid Retirement Plans
The Flexibility of 401(k) Plans without the Risk of Falling Account Balances.
The Flexibility of 401(k) Plans without the Risk of Falling Account Balances.
Traditional defined benefit (DB) retirement plans have received so much negative press in the past several years that it is likely they will never live down their notoriety.
Despite the retirement income security they provide, their cost and complexity has made it challenging for employers to use them as an effective employee attraction and retention tool. Many companies have shifted toward defined contribution (DC) retirement plans, which do not provide the same level of retirement income security to employees but are easy to understand, allow employees to have choice in the investment of their retirement money, and permit lump sum payouts long before retirement.
However, in recent times defined contribution plans have come under scrutiny as well. While they do provide employees with an effective way to invest pre-tax retirement dollars, the current volatility in financial markets means the amount of money employees will have at their disposal upon retirement is highly uncertain. In addition, many employees withdraw and spend their defined contribution money prior to retirement, which further increases the uncertainty of their retirement income. This creates a high risk for both employees and employers since employees may not be able to retire at their optimal age.
It seems that the way forward to providing effective retirement benefits in this turbulent economy is to take advantage of the best aspects of both defined benefit and defined contribution plans, paving the way for hybrid retirement plans.
Hybrid plans have been in existence for years, but now is the prime time to utilize them given the economic, demographic, and regulatory outlook. A hybrid plan is essentially a defined benefit plan since it guarantees the retirement benefit amount, and the benefit obligation must be pre-funded in a dedicated trust. However, the benefit is expressed like a defined contribution plan, making it much easier for employees to understand and appreciate.
The following table summarizes the DB and DC features of hybrid plans:
|Plan Features||Hybrid Plans Look More Like...|
|Funding||DB - plan sponsor sets aside funds in a trust that can only be used to pay benefits|
|Investment Risk||DB - employer bears entire investment risk|
|Guaranteed Benefit||DB - employer guarantees benefit at retirement|
|Benefit Formula||DC - usually defined as % of pay credits (or points) that accumulate over time|
|Form of Benefit||DC - lump sum distribution usually permitted at termination or retirement|
Cash balance plans are hybrid plans where employees receive a certain percent of their compensation as a contribution to a hypothetical account balance, which is then increased with interest until the funds are withdrawn by the employee.
Pension equity plans are hybrid plans where employees earn PEP points each year, which are usually based on a predefined age and service table. Upon retirement or termination, the accumulated points are multiplied by the average annual pay over the last few years before termination to come up with a lump sum benefit.
With hybrid plans the risk, return, and cost elements can be designed in a way that is beneficial to both the employees and the employer.
While in the past many employees welcomed the shift from traditional defined benefit plans to entirely defined contribution programs as an opportunity to invest their retirement money in equities and other high yielding strategies, recent stock market volatility has made these defined contribution plans risky to employees. Hybrid plans significantly alleviate the benefit uncertainty by pre-defining the ultimate retirement benefit (and the interest rate in the case of cash balance plans), which is appealing to employees who are becoming more risk averse. From the employer perspective, hybrid plans and other defined benefit plans are more risky than defined contribution plans because the investment return responsibility falls entirely on the employer.
The fact that hybrid plans are pre-funded (much like a defined benefit plan) means that the return on the retirement plan assets can be used to offset the annual benefit cost of the plan. There is no such offset with defined contribution plans where the plan cost is equal to the annual employer contribution to the employee accounts.
Hybrid plan benefits are normally expressed and communicated in a way resembling a defined contribution plan. However, hybrid plans are usually far less expensive to the employer than an equivalent defined contribution plan. From the employee's perspective, a 5% cash balance plan with a 6% fixed interest crediting rate is equivalent to a 5% defined contribution plan with an average investment return of 6% per year. However, the cost to the employer is quite different. The 5% defined contribution plan will cost exactly 5% of payroll, reported as an expense on the company's books. The cost of the 5% cash balance plan is determined by actuaries, taking into account the probability of the many uncertain future events that will affect the ultimate benefit amounts paid. The investment return on the plan assets is usually significantly higher over time than what an individual participant can earn on their retirement money, due to economies of scale, professional management, and diversification. If the pension fund backing the cash balance plan has an expected long-term rate of return exceeding the interest credit promised by the plan itself, this spread will reduce the current cost of the cash balance plan. In the case of the 5% cash balance plan with 6% interest rate, the ongoing plan cost is expected to be far less than 5% of payroll, possibly some 30 - 40% less. So the employee will receive 5% of pay under both the defined contribution plan and the cash balance plan, but the cash balance plan will cost the employer less and will provide stable guaranteed benefits to the employees.
Baby boomers are now starting to retire. This generation is the most adversely affected by shifts from defined benefit to defined contribution plans since they are too close to retirement to accrue sufficient defined contribution balances. This is because defined contribution plans usually offer the same accrual at all ages, while a defined benefit plan offers a significantly higher accrual as the participant approaches normal retirement age. With a hybrid plan, the sponsor has flexibility to structure the accrual curve to meet their HR objectives. Hybrid plans with a flat accrual curve can be as disadvantageous to older employees as defined contribution plans. However, most hybrid plans are heavily age-graded allowing baby boomers and mid-career hires to accrue adequate benefits by normal retirement age.
While hybrid plans can be structured to have similar accrual patterns as a defined benefit plan, they have one major advantage - they explicitly state the accrual rate at each age and service level. For a traditional defined benefit plan, the accrual pattern is not as obvious because it is based on actuarial calculations. For example, employees might perceive a 1% final average pay plan as providing a flat 1% accrual across all ages, while in reality the value of the accruals increases dramatically with age. As a result, the age-graded nature of traditional defined benefit plans has not been effective as an employee retention tool. On the contrary, an age-graded hybrid plan clearly shows accrual rates that increase with age and service, making it more appealing for employees to stay longer to earn the higher accruals.
One of the greatest appeals of defined contribution plans is that they allow employees to take their account balances with them upon termination of employment. Most hybrid plans have comparable portability features such as lump sum or rollover options. In addition, hybrid plans give employers much greater design flexibility with the lump sum option (for example, allowing lump sum distribution only upon retirement but not termination) to reduce the risk of employees withdrawing and spending their benefit money long before retirement.
Since today's workforce is paying close attention to the security of their retirement benefits while at the same time continuing to expect the flexibility of defined contribution plans, employers are now able to use hybrid plans as a strong attraction and retention tool. Through effective communication, hybrid plans can be shown to provide retirement income stability in times of financial market turmoil in addition to portability and lump sum features. A hybrid plan can also distinguish your organization from the competition since many employers currently offer only defined contribution plans.
Both defined benefit and defined contribution plans are designed to supplement employees' future retirement income, but the nature of these obligations is quite different. Under a defined contribution plan, the employer "pays off" its obligation each year as it accrues. The employer has no further obligation once the annual contribution is made to the employees' accounts. The end result is a high annual cost to the employer but no balance sheet liability.
Under both hybrid plans and traditional defined benefit plans, the employer obligation is not completely met until the participant receives her last pension payment (usually upon death). Due to the long-term nature of the benefit obligation, employers are required to pre-fund it by making annual contributions to a pension fund. Since the investment return earned by the pension fund reduces the future funding contributions, the annual cost is usually lower than that of a comparable defined contribution plan. The flip side is that in years of market downturns the pension fund assets may fall significantly below the plan's projected obligations. This funding deficit has to be reported on the company's balance sheet as a liability.
Like many new and creative ideas, hybrid plans faced much resistance and some high profile legal challenges in the earlier stages of their existence. Yet, more and more employers were willing to adopt them as they provided a much needed balance in their retirement benefit design. This and the increased market volatility faced by defined contribution plans contributed to the inclusion of a section in the Pension Protection Act of 2006, which clearly postulates that hybrid plans are legitimate and non-discriminatory as long as they satisfy certain transition and design requirements. The PPA effectively gave a green light to hybrid retirement plans, while at the same time addressing the potentially discriminatory practices that caused the earlier employee and union concerns.
Much like hybrid vehicles have quickly become a sensible and economically savvy way to help the environment, hybrid retirement plans are a way to provide effective retirement benefits that are attractive to both employers and employees. Employee risk is reduced, ensuring that retirement money will be available in the future. Through communication and education, employers will be able to use these plans as effective attraction and retention tools. Ultimately retirement costs will not be as much of a strain on a company's financial position as with a purely defined contribution approach, leading the way to both a financially stable organization and financially secure employees.