Hybrid Pension Plans: a Comprehensive Look at Their History, Economics and Features
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Hybrid Pension Plans: A Comprehensive Look at Their History, Economics and Features By Tomeka Hill, Gaobo Pang and Mark Warshawsky November 2010 their current hybrid plans into compliance. Moreover, Section 1: the lack of regulatory clarity appears to have changed some sponsors’ minds about converting their Introduction traditional pension plans to hybrid plans. A few other employers, however, have gone ahead with conversions. Among employers in the private sector, the shift Section 3 discusses trends in hybrid plan away from traditional defined benefit (DB) plans is sponsorship, participation and assets. The report well-documented. While there are many contributing uses information from three data sources: the Form factors, surveys identify employers’ desire to reduce 5500 Series database and two Towers Watson their exposure to risks, such as cost volatility and data sets. Plan sponsors use Form 5500 to report long liability durations, as paramount. Other information about their retirement, health and motivations include enhancing employee welfare plans to the U.S. Department of Labor (DOL) understanding and appreciation of benefits and and Internal Revenue Service (IRS). The first Towers providing more age-neutral benefit accruals. Watson data set tracks the changes in retirement Some companies have turned to defined contribution plan sponsorship among the 2009 Fortune 100 (DC) plans, but others have sought out alternative from 1998 to 2009. The second Towers Watson DB plans like hybrid plans. These plans share data set holds information about provisions and some design features with DC plans, such as conversion methods for 414 mostly large active accommodating worker mobility. But hybrid plans and inactive hybrid plans, which was collected in allocate the risks between sponsor and workers summer 2009. more evenly than either traditional DB plans at one Section 4 discusses in detail the current provisions end of the spectrum or 401(k) plans at the other. of hybrid plans, using the third data source Hybrid plans also offer desirable DB attributes, such mentioned above. We report participation and as funding flexibility and complete investment benefit accrual start dates, definitions of control for sponsors and lifetime income options pensionable earnings, pay credits, formula types, for participants. interest crediting rates and transition methods. To provide a better understanding of the flexibility A simple simulation using hybrid plan formulas and other features of hybrid plans, their implications illustrates how hybrid plan account balances grow for both participants and employers, and how hybrid over the careers of typical employees. plan sponsors are navigating the current legal and Section 5 summarizes the results from a stochastic regulatory environment, Towers Watson has compiled model comparing total cost and cost volatility, this new comprehensive report. We focus on the projected forward 40 years, for three benefit- most common types of hybrid plans — cash balance equivalent plans: a traditional DB plan, a DC plan plans (CBPs) and pension equity plans (PEPs). and a CBP. We then compare three total retirement The report is divided into six sections. Section 2 packages: a CBP with a supplemental DC plan, a describes hybrid plans, discusses the legal final-average-pay DB plan with a supplemental DC controversy and regulatory uncertainty of the last plan and a DC plan as the primary retirement plan. 20 years, and identifies the positive economic The analysis, which is done on a conservative return motivations for offering hybrid plans. The 2006 basis, shows the cost and volatility advantages of Pension Protection Act (PPA) essentially legitimized hybrid plans compared with traditional DB plans hybrid plans but imposed new requirements as well. and DC plans. Due to delays in regulatory guidance, however, many Section 6 presents some concluding remarks for plan sponsors have been holding off on bringing this study. The authors thank Mike Pollack, Russ Hall, Maria Sarli, Alan Glickstein, Monica Martin, Bridget Baumstark, Kyle Brown and Cindy Lyons for their assistance and helpful comments. They also thank Jonathan Zackey for his excellent research assistance. 2 towerswatson.com/research/insider Section 2: History and Economic Motivations for Hybrid Plans1 Defining Hybrid Plans participant terminates employment before retiring, one of various approaches might be taken. The A hybrid plan is an employer-sponsored retirement departing participant might be able to take the plan that combines aspects of DB and DC designs. account balance with him or her as a lump sum. The The most common hybrid designs are cash balance plan sponsor could convert the account into a future and to a lesser extent pension equity benefit annuity. Or, the plan sponsor might keep the account 2 formulas. CBPs and PEPs are legally classified as in the plan, where it would continue being credited DB plans. They accrue benefits to workers under with interest at a plan-specified rate (to be paid as a a defined fixed formula, like a traditional DB plan, lump sum or annuity at a future date). Like in CBPs, but the benefit is defined as a lump-sum account the percentage credits can either be uniform over balance rather than an annuity-style monthly benefit. workers’ ages and service or, more commonly, based Most CBPs and PEPs are converted from traditional on age and/or service. DB pension plans, although a few are new plans. CBPs can be viewed as career-average-pay plans In a CBP, a percentage of pay (i.e., a pay credit) is that accrue present values more evenly over a periodically allocated to the worker’s account, along career, while PEPs can be considered final-average- with periodic interest credits based on an employer- pay CBPs.4 Thus, a retirement benefit under a PEP selected interest crediting rate (variable, fixed or will typically be more in line with the worker’s wages 3 some combination). This is similar to the way a DC at retirement than a benefit under a CBP. Cash plan operates, but in a DC plan, the return is the balance benefits are influenced by both interest actual investment earnings on individual account credits and the rate of wage increases. If the rate of assets, which are generally selected by the wage increases exceeds the rate of interest credits participant. In a CBP, the account grows at a rate over a career, a PEP delivers a higher benefit than a specified in the plan document, regardless of the CBP for the same level of pay credits, and vice versa plan’s actual investment earnings. (assuming the pay credits are the same for the plans). Some CBPs provide the same pay credit (as a percentage of pay) over all ages and durations of History of Legal Controversy and service, but most have graded schedules that Regulatory Uncertainty provide higher pay credits to participants who have Bank of America is widely considered to have longer service and/or are older. The benefit is adopted the first CBP in the mid 1980s, and, for a primarily communicated as a lump sum, which is while, increasing numbers of large companies easily understood by participants and reflects adopted CBPs and PEPs. But, starting in the late common 401(k) plan practice. Despite their DC-like 1990s, conversions of traditional DB plans to hybrid features, as DB plans, CBPs must make an annuity plans generated controversy, reaching the highest payout the default distribution option (although most levels of the federal government. Adversaries participants select lump sums). These plans are claimed employers were adopting hybrid plans to subject to federal funding and accrual rules for reduce costs. They charged that the conversions single-employer DB plans and are covered by Pension discriminated against older workers and contravened Benefit Guaranty Corporation (PBGC) insurance. federal requirements in the calculation of lump-sum In a PEP, participants accrue percentage credits benefits. The transition methods used in some throughout their careers, and a lump-sum retirement conversions — referred to as “wear-away” — were benefit is calculated as the sum of the percentage accused of violating law and policy. More recently, in credits multiplied by final average pay (FAP). If a both the courts and the legislature, most of these 1 This section is largely based on Chapter 12 of Dan McGill, Kyle Brown, John Haley, Sylvester Schieber and Mark Warshawsky, Fundamentals of Private Pensions, Ninth Edition, Oxford University Press, 2010. 2 Less common (although not necessarily statutory) hybrid plans include stable value plans, whose formulas define the benefit account as payable at normal retirement age based on accumulation of pay-related credits; floor offset plans, which coordinate benefits between DB and DC plans; and target-benefit plans, which are DC plans that provide allocations to participants to fund a target defined benefit. 3 Occasionally, an equity-based index is used to adjust the future value of the allocation. 4 Fundamentals, op.cit., pp. 382-4, produces a proof of this view. Hybrid Pension Plans: A Comprehensive Look at Their History, Economics and Features 3 Benefits could be defined as an annuity or as an “ … but all the circuit courts ultimately individual account for purposes of this comparison. rejected the claim of inherent age Special rules also provide immunity from charges of age discrimination to plans that calculate benefits discrimination.” for older participants as either the “greater of” or “sum of” the formulas from the traditional DB plan charges have been dismissed or resolved and the hybrid plan. (although the outcomes have varied with individual circumstances). The regulations issued on October In determining the present value of any accrued DB 18, 2010, implementing PPA provisions should benefit and the amount of certain distributions, clarify key legal requirements and resolve regulatory including lump sums, the law mandates interest and ambiguities, thus possibly encouraging more mortality rates to be used in calculating a minimum employers to adopt hybrid plans.