Hybrid Pension Plans: a Comprehensive Look at Their History, Economics and Features

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 ““… but all the circuit courts ultimately Benefits could be defined as an annuity or as an 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. amount, even if the benefit is communicated as a lump sum. To meet these requirements, most courts Careful empirical analyses indeed found that, when (and at times the IRS) have held that CBPs must viewed in isolation, converting to a hybrid plan often project the notional account balance forward to the did reduce employers’ costs. However, many plan’s normal retirement age using the plan’s employers made other changes to their rewards interest-crediting rate and then discount it back programs concurrently, such as shifting the mix of using the lump-sum rates specified in the law. If the rewards from one program to another. When the interest-crediting rate is higher than the required analyses also looked at employers’ concomitant lump-sum rate, the minimum benefit payable higher contributions to DC plans, many employers typically will be higher than the CBP account were contributing the same — or even higher balance. This is called the “whipsaw” calculation, — amounts to retirement benefits. And for the which the PPA prospectively eliminated. minority that reduced their overall cost, the savings were relatively modest.5 Probably the most controversial aspect of hybrid plan conversions involved wear-away, particularly the The age discrimination claim was more complex, effective loss of subsidized early retirement benefits. involving subtle issues of legal language and Wear-away can occur any time a plan amendment interpretation. It is clear, as a matter of law, that reduces future benefits. While accrued benefits are retirement plans may not discontinue or reduce the protected under law, a new benefit program can stop rate of benefit accrual because of a participant’s benefit accruals for some employees while benefits age. For CBPs, however, resolution turned on under the new formula “catch up” to the benefit whether the applicable standard applied with accrued under the old formula. Wear-away in other respect to the pay credits or the projected annuity at contexts has been recognized and accepted by normal retirement age produced by those credits as various IRS regulations.6 Critics, however, seized adjusted with interest. Opponents of CBPs argued upon this occasional occurrence in hybrid plan for the latter, claiming these plans were inherently conversions and claimed it impermissibly age discriminatory because older workers have less discriminated against older workers. time to accumulate interest credits. Initial court decisions in the 2000s were split, but all the circuit To address the wear-away issue, many plan sponsors courts ultimately rejected the claim of inherent age adopted a variety of transition approaches for older discrimination. workers and/or longer-service employees. Some employers provided transitional benefits to their In the PPA, Congress declared that, after June 25, older and/or longer-service employees to minimize 2005, CBPs and PEPs that satisfied certain safe- or avoid the loss of future pension benefits. Some harbor requirements would not be viewed as plan sponsors grandfathered workers who were inherently age discriminatory. The PPA gave a safe relatively close to retirement eligibility under the old harbor from age discrimination claims to all DB formula, while others converted everyone to the plans that have accumulated benefits for each hybrid formula but gave older and/or longer-service participant that are no less than the accumulated workers a supplemental balance. Still others allowed benefit for any similarly situated (in every employees to choose between the old and new characteristic except age) younger individual, and formulas. The IRS itself has issued contradictory excluding consideration of early retirement benefits. regulations on wear-away over the years.

5 See, for example, Watson Wyatt Worldwide, “The Unfolding of a Predictable Surprise: A Comprehensive Analysis of the Shift From Traditional Pensions to Hybrid Plans,” 2000. 6 Fundamentals, op. cit., pp. 391-2.

4 towerswatson.com The PPA resolved the wear-away issue, prospectively, accrue benefits more evenly over the worker’s career, by mandating that employers use an “A+B” as younger workers and women are less likely than conversion method. Using this approach, the plan older men to remain with one employer over their maintains the prior DB benefit (A) accrued through entire careers. Commitment to an employer (as well the date of the conversion and begins accruing the as the longevity of the employer itself) has new hybrid benefit (B) after the conversion date. weakened among all workers over time, as reflected While the sponsor may choose to communicate the in higher turnover rates. Thus, traditional final- A benefit as an equivalent opening balance as of the average-pay pension plans, which concentrate plan conversion date, at retirement the plan must benefit accruals toward the end of the career, are pay the larger of A or B, where A is calculated on the attractive to fewer workers these days. Today’s participant’s annuity starting date under the old plan workers value a portable retirement benefit that formula using interest and mortality rates specified accrues benefits more evenly over years of service in the law. So the PPA prohibits wear-away for hybrid and is easy to understand, as evidenced by the conversions adopted and effective after June 29, popularity of 401(k) plans. 2005. Interestingly, the PPA did not prohibit wear- So the choice facing many employers was — and away for other types of plan changes. is — whether to maintain their current DB plan, Under the PPA, hybrid plans must have a shorter convert the traditional pension plan to a hybrid plan, vesting period than traditional DB plans, and a or freeze the traditional plan and make the hybrid plan’s interest-crediting rate may not exceed a supplementary DC plan the only retirement plan, to-be-defined market rate of interest. The broad with or without enhancements. policy logic behind the interest rate restrictions is In the late 1990s, many plan sponsors were that high, non-market rates would constitute age enjoying pension surpluses, and some decided a discrimination, because these higher rates would be hybrid approach might be less costly, as continuing more advantageous to younger workers than to older the DB plan with the hybrid plan formula offered ones. These requirements have led to competing them the option of gradually funding the hybrid with policy interests, however, because sometimes the the extra plan assets from the traditional pension purpose of using high fixed rates in hybrid plans was for a few years.8 Indeed, according to one empirical to avoid violating the accrual rules under the study, plans that were converted to hybrid plans Employee Retirement Income Security Act (ERISA), were less likely to be underfunded and more likely which limit the back-loading of benefits, even though to have funding levels between 90% and 130% of back-loading based on age favors older workers. their current liability than all DB plans.9 In the early Economic Motivations 2000s, pension surpluses largely disappeared. After the 2001 recession, they were beginning to The most common motivating factor in conversions re-emerge, but the financial crisis of 2007 set plan to hybrid plans is reducing the volatility of plan funding back again. The first funded status decline contributions. Volatility risk is much lower in hybrid occurred at around the same time the controversy plans than in traditional pension plans, as we will around hybrid plans intensified, and the IRS declared show below.The financial accounting also tends to a moratorium on determining the qualified status of be less volatile in hybrid plans than in traditional DB hybrid plans. Since then, more employers have plans, because the measurements are typically less chosen to freeze their traditional plan and use the sensitive to interest rates and pay fluctuations.7 DC plan as the primary retirement plan. Many such employers concurrently enhanced the DC plan, for Another factor behind hybrid conversions was example, by adding a non-matching contribution, but employers’ realization that changing workforce some realized a net cost savings.10 demographics would necessitate longer careers. Moreover, companies wanted to attract younger For other employers, the inherent advantages of workers and more women, particularly in the late hybrid plans over DC plans still win out. In a hybrid 1990s when labor markets tightened. This, in turn, plan, all eligible employees participate in the plan drove demand for individual account plans that and receive credits to their account, in contrast to

7 The additional liability for future pay increases that may or may not be realized is not part of the accounting liability for CBPs. 8 The confiscatory tax on the reversion of excess pension assets prevented employers from terminating their DB plans and capturing the overfunding, while setting up a replacement DC plan. 9 Robert L. Clark and Sylvester J. Schieber, “The Transition to Hybrid Pension Plans in the United States: An Empirical Analysis,” in William G. Gale, John B. Shoven and Mark J. Warshawsky, editors, Private Pensions and Public Policy, Washington, D.C.: Brookings Institution, 2004. 10 See Watson Wyatt Worldwide, Retirement Plan Design: Past, Present and Future, 2008, and Employer Commitment to Retirement Plans in the United States, 2009.

Hybrid Pension Plans: A Comprehensive Look at Their History, Economics and Features 5 ““… income replacement rates from vary somewhat over cohorts of retiring workers owing to secular trends in interest rate levels, replacement DC plans are much more volatile.” rates from DC plans are much more volatile. Finally, although benefits in hybrid plans are the prevalent form of 401(k) DC plan, in which denominated as an account balance, hybrids are employer credits are generally structured as a match DB plans, so a variety of annuity payout options are activated by employee contributions. Hybrid plan available, on institutional terms, including a life sponsors are responsible for managing plan assets annuity and a joint and survivor annuity. In annuities and being able to pay promised benefits. On the elected from hybrid plans, the longevity risk is other hand, employees of DC plan sponsors must shared among the participant group. That means affirmatively decide to participate, select contribution that the savings from retirees dying earlier than rates and allocate their assets. In most cases, they predicted are available to pay benefits to retirees can take loans or in-service distributions, which tend who outlive expectations. By contrast, most DC to dilute their savings. Investment risk is generally plans do not offer annuity payouts; thus, interested lower for participants in CBPs, because the interest- participants must purchase them in the commercial crediting rate is often tied to a bond yield, such as market, where terms are typically unfavorable, or the 10-year Treasury bond, sometimes with a small manage the account post-retirement to provide a premium added, and the principal is “guaranteed” steady income stream. This can be especially regardless of future changes in interest rates.11 difficult for those retirees who outlive the average Thus, while the income replacement rates of CBPs life expectancy.

11 For an illustration, see Brendan McFarland and Mark Warshawsky, “Balances and Retirement Income From Individual Accounts: U.S. Historical Simulations,” Benefits Quarterly, Second Quarter, 2010, pp. 36–40.

6 towerswatson.com Section 3: Trends in Hybrid Plan Sponsorship, Participation and Asset Size

To better understand the growth of hybrid plan Growth in Hybrid Plans sponsorship, participation and asset size, we use three different data sets: the Form 5500 Series In 1999, only 11% of all DB plans with at least database and the two Towers Watson data sets. 1,000 total participants were identified as hybrid The Form 5500 Series, which is publicly available plans in the Form 5500 Series. The share had grown under ERISA’s disclosure requirements, is used by to 16% by 2003 and to 18% by 2007 (Figure 1). The the DOL and IRS to gather information about percentages include active hybrid plans and hybrid employee retirement, health, and welfare plans. All plans that are either closed to new entrants or have organizations that sponsor an employee benefit plan frozen future accruals. The number of large hybrid subject to ERISA must file Form 5500 annually, so plans peaked in 2005 (671), but the percentage has the aggregated filings reveal important information continued to increase as the number of large DB about national trends in participation, contributions, plans (the denominator in Figure 1) has declined benefit disbursements and assets. In 1999, it over time. became easier to identify hybrid plans in the Form Figure 1. Number and incidence of hybrid plans 5500, so we use filings from 1999 to 2007, the with at least 1,000 participants, 1999–2007 latest year for which complete filings are available. Hybrid plans We focus on hybrid plans with at least 1,000 total Total number as percentage participants (including active participants, terminated Plan year of hybrid plans of all DB plans vested participants, retirees and beneficiaries). 1999 317 11% The first Towers Watson database tracks retirement 2000 459 11% plan trends for companies in the 2009 Fortune 100 2001 514 12% and provides historical details of retirement plan 2002 537 14% sponsorship from 1998 to 2009. 2003 655 16% Finally, we have compiled a second extensive Towers 2004 639 15% Watson database with detailed information on plan 2005 671 16% provisions and transition methods. The data are 2006 646 17% collected from several sources. We use our 2007 658 18% Comparison and Employee Benefit Information Source: Towers Watson, based on Form 5500. Center (EBIC) databases,12 which collect information on new salaried employees’ benefits. We also use The number and prevalence of hybrid plans vary by information from 10-Ks, proxies and/or company industry. Manufacturing companies offer more hybrid websites for various companies that we knew had a plans than companies in other industries, but hybrid hybrid plan. We also asked clients of Towers Watson plans constitute only 15% of all DB plans in this for the most recently available plan documents and group (Figures 2 and 3). One-third of all DB plans in summary plan descriptions for their hybrid plans. the Energy, Utilities and Natural Resources industry In total, we identified and collected information on are hybrid plans (Figure 3), and 25% of all DB plans 414 hybrid plans sponsored by 400 plan sponsors. in the Health Care and the Professional and We believe the information collected in this database Business Services industries are hybrid plans, is representative of all hybrid plans currently and, according to 2007 Form 5500 data. Only 5% of DB moreover, can be used to help identify trends over plans in the Property and Construction industry are the last 25 years. hybrid plans.

12 Comparison and EBIC are similar benchmarking services originally managed by former Watson Wyatt and former Towers Perrin, respectively. (Now a new merged company Towers Watson exists.) The Comparison and EBIC databases hold benefit plan information for salaried employees from more than 1,000 employers representing a broad cross- section of industries, geographical locations and company sizes. There is relatively little overlap of employers in the two databases.

Hybrid Pension Plans: A Comprehensive Look at Their History, Economics and Features 7 Figure 2. Number of hybrid plans by industry, 2007 Figure 3. Hybrid plans as percentage of all DB plans by industry, 2007

0 30 60 90 120 150 0% 5% 10% 15% 20% 25% 30% 35%

Property and Construction Property and Construction 14 5 Food Services and Beverages Food Services and Beverages 23 11 Transportation and Transportation Equipment Transportation and Transportation Equipment 29 12 Manufacturing Manufacturing 136 15 Retail Retail 9 16 Other Other 56 16 Wholesale Wholesale 14 16 Pharmaceuticals Pharmaceuticals 7 16 Aerospace and Defense Aerospace and Defense 9 18 Financial Services Financial Services 95 21 Communications/High Technology Communications/High Technology 46 22 Professional and Business Services Professional and Business Services 34 25 Health Care Health Care 120 25 Energy/Utilities/Natural Resources Energy/Utilities/Natural Resources 66 33

Source: Towers Watson, based on Form 5500. Source: Towers Watson, based on Form 5500.

To illustrate when companies adopted and sometimes Of closed and frozen hybrid plans, 71% became closed and/or froze hybrid plans, we use the Towers inactive in 2007 or later (Figure 4). Companies that Watson database with information on transition decided to stop offering an active hybrid plan were methods and provisions for 414 hybrid plans. Of most likely reacting to the economic recession that these hybrid plans, 84% are active and 16% are started in late 2007 and escalated in the fall of inactive (i.e., closed to new entrants or benefits 2008. Of inactive hybrid plans, 64% are frozen, 32% frozen). The first hybrid plan was adopted in the are closed to new employees, and the rest have 1980s, but it was not until the mid-1990s that the been terminated and are either under the PBGC’s number of hybrid plans surged (Figure 4). Roughly control or the funds have been transferred to a DC 72 percent of all hybrid plans were adopted between plan (Figure 5). On average, inactive CBPs were 1995 and 2003. Hybrid plan conversions fell off active for 9.3 years, with the longest-lived CBP between 2004 and 2006 when their legal status came active for 23 years. Inactive PEPs were active for into question and the effects of the 2001–2003 7.6 years, on average, with the longest run being recession were still rippling through the economy. 13 years. Three plan sponsors converted their Another 8% of hybrid plans were adopted in 2007 traditional DB plans to hybrid plans and and 2008, perhaps due to temporarily improving simultaneously closed the plans to new employees. economic conditions or the legal clarity conferred by the PPA.

8 towerswatson.com Figure 4. Effective and inactive dates of hybrid plans (number of plans) 40

0 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010

I Effective date I Inactive date

Source: Towers Watson.

To better understand the broader context of when Figure 5. Inactive status breakdown by hybrid plan type companies made their retirement transitions, we Cash balance Pension look at the types of retirement plans sponsored by plans equity plans Total companies in the 2009 Fortune 100 list from 1998 Closed 27% 50% 32% to 2009 for new salaried workers. Most of these companies no longer offer traditional DB plans. Frozen 68% 50% 64% Between 1998 and 2009, the number of Fortune Terminated (PBGC-controlled) 3% 0% 2% 100 companies offering a traditional DB plan to Transferred funds to DC plan 3% 0% 2% new employees dropped from 69 to 20 (Figure 6). Total 100% 100% 100%

Over the same period, the number of Fortune 100 Note: Due to rounding, columns may not add to 100%. companies offering a hybrid plan to new employees Source: Towers Watson. increased from eight to 24. The number of these Figure 6. Retirement plan sponsorship for 2009 Fortune 100 companies, companies offering only a DC plan to new employees 1998–2009 jumped from 23 to 56. 80 70 69 63 62 60 57 56 50 51 ““Between 1998 and 2009, 50 45 47 41 40 35 40 the number of Fortune 100 32 30 30 39 30 30 25 25 24 23 23 23 24 29 companies offering a hybrid 28 26 20 25 25 23 24 19 20 plan to new employees 10 14 15 8 0 increased from 8 to 24.” 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009

I Traditional DB plan + DC plan I Hybrid plan + DC plan I DC plan only

Source: Towers Watson.

Hybrid Pension Plans: A Comprehensive Look at Their History, Economics and Features 9 Figure 7. Year-to-year transitions in retirement plan sponsorship for 2009 Fortune 100 companies, 1998–2009 Transition from traditional DB Transition from Transition from plan+DC plan traditional DB hybrid plan+DC Continue to hybrid plan+ plan+DC plan to plan to DC plan traditional DB Continue hybrid Continue DC plan DC plan DC plan only only plan+DC plan plan+DC plan only 1998 to 1999 6 – – 63 8 23 1999 to 2000 1 – – 62 14 23 2000 to 2001 4 1 – 57 15 23 2001 to 2002 6 1 – 50 19 24 2002 to 2003 5 – – 45 25 25 2003 to 2004 – 4 – 41 30 25 2004 to 2005 – 1 2 40 28 29 2005 to 2006 – 5 2 35 26 32 2006 to 2007 1 4 4 30 22 39 2007 to 2008 3 3 1 24 22 47 2008 to 2009 3 1 4 20 21 51

Source: Towers Watson.

Figure 8. Active and total participants in hybrid plans with at least 1,000 participants, 1999–2007 Active hybrid participants Total hybrid participants as as percentage of all active Total percentage of all total participants in Active participants participants in all DB plans participants all DB plans 1999 1,856,376 15% 3,220,481 14% 2000 2,859,795 18% 5,102,485 16% 2001 3,336,540 20% 6,093,059 18% 2002 3,606,187 21% 6,735,091 20% 2003 4,920,408 26% 9,366,134 25% 2004 4,811,410 27% 9,453,089 25% 2005 5,118,274 29% 10,028,491 27% 2006 4,640,914 29% 9,578,742 27% 2007 4,901,970 31% 10,179,252 29%

Source: Towers Watson, based on Form 5500.

From 1998 to 2003, very few Fortune 100 sponsors Participants of a traditional DB plan transitioned to offering only a DC plan (Figure 7). Between 2004 and 2006, From 1999 to 2007, the number of active however, several Fortune 100 companies moved to a participants in hybrid plans climbed from almost DC-plan-only environment. None of these companies 1.9 million to 4.9 million (Figure 8), and the total adopted a hybrid plan. Again, this is likely because number of participants increased from 3.2 million to of the legal ambiguity of hybrids at that time. From 10.2 million. 2007 to 2009, there were new transitions from Looking at the numbers of active and total traditional DB plans to hybrid plans, but hybrid plans participants in hybrid plans as percentages of active were also being closed and frozen. and total participants in all DB plans, respectively, the growth of hybrid plans has escalated over the past decade. From 1999 to 2007, the number of active hybrid participants as a percentage of active participants in all DB plans swelled from 15% to 31%. The number of all hybrid participants as a percentage of total participants in all DB plans grew from 14% to 29%.

10 towerswatson.com Figure 9. Hybrid plans and all DB plans with at least 1,000 participants by active participant sizes, 2007 Hybrid plan sponsors by DB plan sponsors by active participation size active participation size Less than 1,000 19% 40% It is important to note that many inactive 1,000–2,499 29% 29% participants in hybrid plans never received a hybrid 2,500–4,999 20% 13% benefit because they left employment before the 5,000–9,999 15% 8% conversion or they were grandfathered into the prior 10,000–24,999 11% 6% plan. Because of the prevalence of lump sums, hybrid plans tend to create fewer inactive 25,000 or more 6% 3% participants than traditional plans. Total 100% 100% Note: Due to rounding, columns may not add to 100%. Hybrid plans are larger in terms of participants Source: Towers Watson, based on Form 5500. compared with all DB plans. Almost half (48%) of Figure 10. Hybrid plans and all DB plans with at least 1,000 participants by hybrid plans have fewer than 2,500 active total participant sizes, 2007 participants (Figure 9), according to the 2007 Form 5500 filings. However, 69% of all DB plans have Hybrid plan sponsors by DB plan sponsors by fewer than 2,500 active employees. Six percent of total participation size total participation size hybrid plans have at least 25,000 active participants Less than 1,000 0% 0% compared with 3% of all DB plans. As for total 1,000–2,499 27% 45% participants, 27% of hybrid plans have 1,000–2,499 2,500–4,999 23% 23% participants, while 45% of all DB plans have 5,000–9,999 18% 15% 1,000–2,499 participants (Figure 10). Fourteen 10,000–24,999 18% 10% percent of hybrid plans have at least 25,000 25,000 or more 14% 8% participants compared with 8% of all DB plans. Total 100% 100%

Note: Due to rounding, columns may not add to 100%. Assets Source: Towers Watson, based on Form 5500.

From 1999 to 2007, total current assets reported Figure 11. Assets in hybrid plans with at least 1,000 participants, 1999–2007 on Form 5500s increased, but asset growth has been bumpy due to economic instability. Total assets Total assets as percentage of all current in hybrid plans increased from $158.8 billion in Total assets Average assets assets in all DB plans 1999 to $631 billion in 2007 (Figure 11). The 1999 $158.8 billion $328.8 million 17% average asset size of these hybrid plans has also grown, but even more erratically. On average, hybrid 2000 304.7 billion 356.8 million 21% plans held assets of $328.8 million in 1999, which 2001 320.8 billion 351.3 million 22% dipped to $317.5 million in 2003 and then rose to 2002 345.4 billion 349.3 million 26% $492.4 million in 2007. 2003 426.6 billion 317.5 million 32% The portion of DB assets in hybrid plans increased 2004 501.4 billion 372.3 million 32% into the early 2000s, but growth was flatter from 2005 534.1 billion 420.7 million 31% 2003 to 2007. In 1999, assets in hybrid plans were 2006 545.4 billion 441.1 million 32% 17% of assets in all DB plans. By 2003, this 2007 631.0 billion 492.4 million 34% percentage had jumped to 32%, and by 2007, it had Source: Towers Watson, based on Form 5500. inched slightly higher to 34%. Figure 12. Hybrid plans and all DB plans with at least 1,000 participants by Overall, hybrid plans tend to have more assets than asset size, 2007 other DB plans. In their 2007 Form 5500 filings, 35% of hybrid plans reported having less than $100 Percentage of Percentage of all Current assets hybrid plans DB plans million in assets, compared with 47% of all DB plans (Figure 12). Eighteen percent of hybrid plans Less than $10 million 2% 2% reported having $1 billion or more in assets $10 million-$99.9 million 33% 45% compared with 10% of all DB plans. $100 million-$249.9 million 25% 25% $250 million-$499.9 million 13% 12% $500 million-$999.9 million 10% 7% $1 billion or more 18% 10% Total 100% 100%

Note: Due to rounding, columns may not add to 100%. Source: Towers Watson, based on Form 5500.

Hybrid Pension Plans: A Comprehensive Look at Their History, Economics and Features 11 Section 4: Plan Provisions

To further our understanding of the current status of 24% require employees to be at least age 21 and hybrid plans, what they offer and who is eligible to have one year of service, and 23% have no age participate, we look again to the Towers Watson requirement but require one year of service database with detailed information about plan (Figure 13). provisions and transition methods. As noted earlier, Twenty-four percent of CBPs require participants to this database has information from company- be at least 21 and have one year of service, and provided plan documents, the Comparison and EBIC 22% of CBPs have no eligibility requirements. databases and data from 10-Ks, proxies and Twenty-seven percent of PEPs require participants to corporate web pages. We collected information on be at least 21 and have one year of service, while 414 hybrid plans sponsored by 400 plan sponsors. 16% of PEPs have no participation requirements. The data set includes 366 CBPs and 48 PEPs. Because of the variety of data sources, not all When Benefit Accruals Begin information is available for every hybrid plan. Workers get accruals of pay credits as of their date Participation Rules of hire (Figure 14) in 71% of hybrid plans. In the remaining 29% of plans, employees start earning Hybrid plan sponsors have a variety of participation benefits after meeting the participation rules shown requirements for new employees. Although more in Figure 13. In other words, for most plans, even than one in five hybrid plans have no requirements, those with age and/or service requirements to participate, benefit accruals are granted retroactively ““Hybrid plan sponsors have a variety to the date of hire, after employees meet these participation requirements. Sixty-eight percent of of participation requirements for new CBPs and 94% of PEPs give accruals as of the date employees.” of hire.

Figure 13. Participation rules

Cash balance Pension equity plans plans All hybrid plans Immediate (no age or service requirement) 22% 16% 21% Any age/6 months of service 1% 3% 1% Any age/1 year of service1 23% 19% 23% Any age/other service requirement 10% 14% 10% Age 18 6% 3% 6% Age 21/immediate service 4% 3% 4% Age 21/1 year of service1 24% 27% 24% Age 21/other service requirement 4% 3% 4% Other age/service requirement 6% 14% 7% Total 100% 100% 100% 11 year of service and/or 1,000 hours of service. Note: Due to rounding, columns may not add to 100%. Source: Towers Watson.

Figure 14. Date benefit accruals are made as of: Cash balance Pension equity plans plans All hybrid plans Date of hire 68% 94% 71% Date of participation 32% 6% 29% Total 100% 100% 100%

Source: Towers Watson.

12 towerswatson.com Pensionable Earnings Non-Integrated Hybrid Plans Non-integrated hybrid plans with an age-based Sixty percent of all hybrid plan sponsors in the formula typically increase pay credit percentages database include bonuses, overtime pay and every five to 10 years (Figure 17). A typical commissions along with base salary as pensionable participant younger than 25 receives a pay credit of earnings when calculating the hybrid plan benefit 2.8% in a CBP and a pay credit of 4.2% in a PEP. A (Figure 15). Twenty-six percent of PEPs and 18% of typical participant 60 or older receives a pay credit CBPs use base salaries only. CBPs are more likely of 8.2% in a CBP and a pay credit of 12.3% in a PEP. than PEPs to use base pay plus bonuses when determining benefits, whereas PEPs are more likely Non-integrated hybrid plans with a service-based than CBPs to use base pay plus overtime and formula typically increase pay credit percentages commissions. every five to 10 years. On average, newly hired participants receive 3.2% in a CBP and 3.8% in a PEP. Pay Credit Schedules Figure 15. Pensionable earnings Of all hybrid plans, 72% use a graded pay credit Cash balance Pension All hybrid schedule based on age, service or points plans equity plans plans (combination of age and service). Only 29% of CBPs Base pay only 18% 26% 20% and 15% of PEPs use a single credit rate for all participants. For the rest of all hybrid plans, age-, Base pay plus bonus 10% 3% 9% Base pay plus overtime and service-, and especially points-graded pay credit 10% 19% 12% commissions schedules are used. Significantly more PEPs than Base pay plus bonus, overtime CBPs base the grading on age alone (Figure 16). 61% 52% 60% and commissions Pay Credit Averages Total 100% 100% 100% Note: Due to rounding, columns may not add to 100%. Overall, the PEPs in our database provide higher Source: Towers Watson. pay credits than CBPs to comparable employees. Figure 16. Pay credit formulas Although nothing inherent to either plan design requires this, the pattern holds throughout all the Cash balance Pension All hybrid various breakdowns of plan data shown below. The plans equity plans plans Fixed percentage or fixed dollar differences could reflect a stronger desire among 29% 15% 28% PEP sponsors to more closely replicate the benefit contribution accrual pattern of the final-average-pay plan being Age graded 14% 38% 17% replaced. Below we explore patterns of pay credit Service graded 26% 21% 25% averages for plans with each type of grading Points graded 28% 26% 27% approach. Observations might indicate real Other 3% 0% 3% differences in design approaches, but the sample Total 100% 100% 100% sizes are sometimes too small to support broad Source: Towers Watson. conclusions. Figure 17: Average pay credit for non-integrated CBPs and PEPs with age- The database includes both non-integrated and based formulas integrated plans. Non-integrated plans do not consider Social Security benefits at all. Integrated Cash balance plans Pension equity plans hybrid plans explicitly adjust their benefit structure Average pay credit for plans not Average FAP credit for plans to compensate for the employer’s contribution to Age integrated not integrated Social Security. The objective in offering integrated < 25 2.8% 4.2% plans is for all employees across all salary levels to 25–29 2.9% 4.3% receive roughly the same percentage of total 30–34 3.5% 4.8% retirement income from the employer’s retirement 35–39 4.1% 5.3% plan and Social Security combined. In integrated hybrid plans, the plan is typically designed using the 40–44 5.0% 7.0% excess rate method, in which the accrual rate is 45–49 6.0% 7.9% lower for earnings below the Social Security taxable 50–54 7.1% 10.1% maximum (or some other defined salary maximum) 55–59 7.9% 11.2% than above it. 60+ 8.2% 12.3%

Source: Towers Watson.

Hybrid Pension Plans: A Comprehensive Look at Their History, Economics and Features 13 Those with 35 or more years of service receive, Seventy-one non-integrated CBPs in the Towers on average, 7.5% in a CBP and 10.6% in a PEP Watson database use a fixed-percentage formula (Figure 18). and provide an average of 4.6% to all participants. Three PEPs offer a fixed percentage and provide an Non-integrated hybrid plans that use points typically average of 7%. One plan sponsor of three PEPs adds use the sum of age and service as the basis. Some a fixed-dollar amount to the accounts. companies use a grid formula to determine pay credits, and one company uses the formula two Integrated Hybrid Plans times age plus service. For a typical participant with For hybrid plans that are integrated with Social fewer than 25 points, pay credits average 3.3% in a Security, we again calculate the average pay credits CBP and 2.3% in a PEP (Figure 19). For a typical but separately for pay below the Social Security participant with at least 95 points, pay credits Wage Base (SSWB — $106,800 for 2010) and for average 8.9% in a CBP and 14.7% in a PEP. pay above the SSWB by age.13 For CBPs that have age-based formulas and are integrated with the Figure 18. Average pay credit for non-integrated CBPs and PEPs with SSWB, the typical employee receives a benefit for service-based formulas pay below the SSWB that ranges from 3% for those under 25 years old to 7.9% for those age 60 or Cash balance plans Pension equity plans older (Figure 20). For CBPs, the benefit accrual for Service Average pay credit for Average FAP credit for pay above the SSWB ranges from 5.7% for those (in years) plans not integrated plans not integrated under age 25 to 12.7% for those age 60 or older. < 1 3.2% 3.8% For PEPs that have age-based formulas and are 1–4 3.8% 4.4% integrated with the SSWB, the typical employee 5–9 4.7% 5.4% receives a benefit for pay below the SSWB that 10–14 5.6% 7.2% ranges from 2.9% for those under 25 years old to 15–19 6.3% 8.6% 14.7% for those age 60 or older. For PEPs, the FAP 20–24 7.0% 10.6% credit for pay above the SSWB ranges from 3.5% for 25–29 7.4% 10.6% those under age 25 to 18.8% for those 60 or older. 30–34 7.6% 10.6% For CBPs that have service-based formulas and are 35+ 7.5% 10.6% integrated with the SSWB, the typical employee Source: Towers Watson. receives a benefit for pay below the SSWB that Figure 19. Average pay credit for non-integrated CBPs and PEPs with age- ranges from 2.8% for those newly hired to 6.6% for and service-based formulas those with 35 years of service or more (Figure 21). For CBPs, the benefit accrual for pay above the Cash balance plans Pension equity plans SSWB ranges from 5.1% for those newly hired to Points Average pay credit for Average FAP credit for 10.1% for those with 35 years of service or more. (age and service) plans not integrated plans not integrated Because only two PEPs in the Towers Watson < 25 3.3% 2.3% database are integrated with service-based 25–29 3.3% 2.4% formulas, pay credit averages for that plan type are 30–34 3.6% 3.0% not reported here. 35–39 3.8% 3.2% For CBPs that have points-based formulas and are 40–44 4.3% 4.5% integrated with the SSWB, the typical employee 45–49 4.6% 5.2% receives a benefit for pay below the SSWB ranging 50–54 5.2% 6.8% from 3% for those with fewer than 25 points to 7.4% 55–59 5.5% 7.6% for those with 95 points or more (Figure 22). For CBPs, the benefit accrual for pay above the SSWB 60–64 6.2% 9.3% ranges from 5.5% for those with fewer than 25 65–69 6.6% 9.7% points to 12% for those with 95 points or more. 70–74 7.5% 11.4% For PEPs that have points-based formulas and are 75–79 7.9% 11.7% integrated with the SSWB, the typical employee 80–84 8.6% 13.4% receives a benefit for pay below the SSWB that 85–89 8.7% 13.6% ranges from 4.3% for those with fewer than 25 90–94 8.9% 14.5% points to 14.5% for those with 95 points or more. 95+ 8.9% 14.7%

13 Source: Towers Watson. A small number of plans use a maximum pay level other than the SSWB.

14 towerswatson.com Figure 20. Average pay credit for integrated CBPs and PEPs with age-based formulas Cash balance plans Pension equity plans Average FAP credit Average pay credit for Average pay credit for pay Average FAP credit percentage for pay in pay up to the SSWB for in excess of the SSWB for percentage for pay up to the excess of the SSWB for Age integrated plans integrated plans SSWB for integrated plans integrated plans < 25 3.0% 5.7% 2.9% 3.5% 25–29 3.1% 5.9% 3.0% 3.6% 30–34 3.7% 6.6% 3.8% 4.8% 35–39 4.0% 7.3% 4.9% 6.7% 40–44 5.1% 8.7% 6.7% 8.9% 45–49 5.6% 9.5% 8.5% 11.6% 50–54 6.6% 10.8% 10.5% 13.6% 55–59 7.4% 11.9% 12.7% 16.5% 60+ 7.9% 12.7% 14.7% 18.8%

Source: Towers Watson.

Figure 21. Average pay credit for integrated CBPs and PEPs with service-based formulas Cash balance plans Pension equity plans Average pay credit for Average pay credit for pay Average FAP credit for Average FAP credit for pay Service pay up to the SSWB for in excess of the SSWB for pay up to the SSWB for in excess of the SSWB for (in years) integrated plans integrated plans integrated plans integrated plans < 1 2.8% 5.1% * * 1–4 3.4% 5.6% * * 5–9 4.0% 6.6% * * 10–14 4.8% 7.7% * * 15–19 5.4% 8.6% * * 20–24 6.3% 10.0% * * 25–29 6.7% 10.6% * * 30–34 6.8% 10.5% * * 35+ 6.6% 10.1% * *

*Because we have only 2 PEPs in this category, pay credit averages are not reported. Source: Towers Watson.

Figure 22. Average pay credit for integrated CBPs and PEPs with points-based formulas Cash balance plans Pension equity plans Points Average pay credit for Average pay credit for pay Average FAP credit for Average FAP credit for pay (age and pay up to the SSWB for in excess of the SSWB for pay up to the SSWB for in excess of the SSWB for service) integrated plans integrated plans integrated plans integrated plans < 25 3.0% 5.5% 4.3% 6.8% 25–29 3.0% 5.5% 4.3% 6.9% 30–34 3.0% 5.6% 4.6% 7.2% 35–39 3.6% 6.3% 4.7% 7.4% 40–44 3.8% 6.8% 5.4% 8.1% 45–49 4.1% 7.3% 5.6% 8.4% 50–54 4.5% 7.9% 6.9% 10.0% 55–59 4.9% 8.4% 7.6% 10.7% 60–64 5.2% 8.9% 9.1% 12.7% 65–69 6.1% 9.9% 9.7% 13.4% 70–74 6.2% 10.1% 11.3% 15.3% 75–79 6.5% 10.4% 12.0% 16.2% 80–84 7.1% 11.1% 13.3% 17.7% 85–89 7.2% 11.2% 13.7% 18.2% 90–94 7.4% 11.4% 14.5% 19.0% 95+ 7.4% 12.0% 14.5% 19.0%

Source: Towers Watson.

Hybrid Pension Plans: A Comprehensive Look at Their History, Economics and Features 15 Figure 23. Simulated CBP account balances by formula type for average worker For PEPs, the benefit accrual for pay above the 2.5 SSWB ranges from 6.8% for those with fewer than 25 points to 19% for those with 95 points or more. Fourteen CBPs using a fixed-percentage formula integrated with the SSWB provide an average 5% pay credit for pay up to the SSWB and 8.8% for pay that 2.0 exceeds the SSWB. Account Balance Accumulations To illustrate how hybrid plan benefits accrue over a participant’s career, we simulate account balances 1.5 at all ages under different formula types separately for CBPs and PEPs. As there are more than 300 CBPs in our Towers Watson database, we assemble a sample of 25 CBPs with an age-based formula, 25 CBPs with a service-based formula, 25 CBPs with a

Ratio to nal pay points formula and 25 CBPs with a fixed-percentage 1.0 formula to determine account balances. Of these 100 CBPs, 23 are integrated with Social Security. Because our sample of PEPs is small, we use all the PEPs in the Towers Watson data set to calculate account balances — 14 with an age-based formula, 0.5 seven with a service-based formula and 10 with a points formula.14 Of these PEPs, 10 are integrated with Social Security. We calculate averages of the annual account balances by hybrid plan type and formula type. 0.0 1 5 10 15 20 25 30 We look at the career paths of two hypothetical Years of service workers. The “average” employee starts work at age I Age and service (points) I Age I Service I Fixed percentage 35 and works for the firm for 30 years until age 65. His starting salary is $40,000, and he receives a Source: Towers Watson. 4% raise every year. The other worker is considered a “fast-track” employee. Her starting salary is $40,000 and she receives a 5% raise every year. However, in her 8th, 16th and 24th years, she receives 25% raises linked to promotions. The interest crediting rate is assumed to be the average rate over the 1979–2009 period for the index or yield specified in the plan formula, e.g., the yield on the 10-year Treasury bond. We first focus on CBPs and the average worker (Figure 23). For this employee, the average cash balance benefit based on a fixed percentage is slightly higher earlier in the career compared with the average benefit under the other formulas. This is not surprising, as a level pay credit would logically start out higher but end lower than a graded credit. Toward the end of the employee’s career, the

14 One PEP has an age-based formula and another one has a points-based formula, where the formula details are not known. One plan sponsor offers three identical PEPs and contributes a fixed-dollar amount to the employees’ notional accounts. Three other plans have fixed-percentage formulas. Because only four unique plans are based on a fixed percentage or a fixed-dollar amount, there was insufficient information to calculate the average account balances for PEPs without a graded formula.

16 towerswatson.com average account determined by a fixed percentage Figure 24. Simulated CBP account balances by formula type for falls below the averages of the accounts with graded fast-track worker formulas. 1.8 In our sample, the age-graded formulas provide the biggest benefit toward the end of the average worker’s career. The service-graded formulas tend to 1.6 lag the other graded formulas somewhat but still exceed the fixed formulas by the time of retirement. After 30 years of service, the average worker will 1.4 have, on average, an account balance of 2.36 times final salary based on a points formula, 2.4 times final salary based on an age formula, 2.18 times 1.2 final salary based on a service formula, and 1.98 times final salary based on a fixed-percentage formula. Bear in mind, however, that the lower 1.0 benefits full-career employees receive under the average fixed-percentage formula do not necessarily equate to less expense for the plan sponsor. For 0.8 example, for an employer with high turnover (so that Ratio to nal pay more employees terminate at the lower age/service levels where the flat-percentage formula is more 0.6 generous, and fewer become full-career employees), the average fixed-percentage formula could be the most costly. 0.4 We next focus on the fast-track worker (Figure 24). She greatly benefits later in her career from a CBP that is integrated with Social Security. She also 0.2 benefits from graded formulas because her pay increases exceed the interest credits, resulting in more valuable accruals in her later years. The 0.0 1 5 10 15 20 25 30 average account balances are relatively close across Years of service formula types until the fast-track employee reaches I Age and service (points) I Age I Service I Fixed percentage her 16th year of service (i.e., the second promotion in the model). At that point, account balances under Source: Towers Watson. the graded formulas start to overtake those under the fixed formula, with the points and age grading rising the fastest. The account balances under the fixed percentage increase slightly faster early in the fast-track worker’s career but much more slowly than the other formulas later in her career. When the fast-track employee is promoted and receives her 25% raise, the account balance as a percentage of pay dips, because the raise does not affect the account balance. Thus, her salary is outpacing her CB account. After 30 years of service, her account balance is a lesser percentage of pay than the account of the average worker, whose raises were only 4%. Under a CBP, the fast-track worker will receive, on average, a final lump-sum benefit accrual of 1.68 times final salary based on a points formula, 1.66 times final salary based on an age formula, 1.48 times final salary based on a service formula and 1.29 times final salary based on a fixed-

Hybrid Pension Plans: A Comprehensive Look at Their History, Economics and Features 17 Figure 25. Simulated PEP account balances by formula type for average worker percentage formula. That fast-track employees fare 3.0 worse than typical employees is an often-voiced criticism of CBPs from a design perspective. We look again at the same two hypothetical workers, this time in PEPs with different formula types. As noted earlier, the hypothetical average worker has a 2.5 starting salary of $40,000 and receives 4% annual raises. The fast-track worker also has a starting salary of $40,000. She receives regular annual raises of 5% and three 25% raises tied to promotions 2.0 in her 8th, 16th and 24th year of service. Both hypothetical workers complete 30 years of service. We calculated benefit accruals for 31 PEPs — 10 using a points formula, 14 using an age-based formula and seven using a service-only formula. 1.5 The average worker receives the highest benefit from PEPs with age-based formulas (Figure 25). Benefits Ratio to nal pay determined under PEPs with points formulas are lowest early in the worker’s career, but catch up to 1.0 age-based formulas toward the end of the worker’s career. After 30 years, the hypothetical worker will receive, on average, a final lump-sum benefit that is 2.6 times final salary based on a points formula, 0.5 2.59 times final salary based on an age formula and 2.33 times final salary based on a service formula. For benefit accruals for the fast-track worker under a PEP, relationships among the grading methods are 0.0 similar to those for the average worker. The age- 1 5 10 15 20 25 30 graded formulas provide higher average benefits, Years of service with the points-based formulas lagging early but I Age and service (points) I Age I Service catching up later, and the service-based formulas always lagging (Figure 26). Source: Towers Watson. After 30 years of service, the fast-track worker will receive, on average, a final lump-sum benefit that is 2.56 times final salary based on a points formula, 2.55 times final salary based on an age formula and 2.29 times final salary based on a service formula. Note that these final lump-sum benefits as a multiple of final salary are quite comparable to those of the first hypothetical worker, illustrating that under a PEP — unlike under a CBP — benefits keep up with the growing salary of a fast-track worker.

18 towerswatson.com Pay Credit Frequency Figure 26. Simulated PEP account balances by formula type for fast-track worker The frequency of pay credits varies among our 3.0 sample plan sponsors (Figure 27). Of CBPs, 64% record pay credits annually, 23% provide them monthly and 8% provide them quarterly. Almost all PEPs — 95% — record FAP credit percentages annually. These results make sense because a PEP 2.5 account is essentially predetermined at any point in time based on the accumulated credits and then- current final average pay, and any earned FAP credit percentages are recorded at termination during the year, so the frequency of pay credits for ongoing 2.0 employees typically does not affect their ultimate benefits. This contrasts with CBPs, where more frequent credits typically result in slightly more interest credits being earned over the career. 1.5 Interest Rates Ratio to nal pay Among the most significant issues for hybrid plan sponsors is determining appropriate interest 1.0 crediting rates for CBPs and post-termination interest crediting rates for PEPs that have them. As set out in the PPA, the IRS requires hybrid plan sponsors to choose interest rates that do not exceed a regulation-determined market rate of 0.5 return. Also, plan sponsors with certain graded pay credit schedules must use a minimum interest credit rate to avoid violating the prohibition on back-loading accruals. Hybrid plans using graded scales generally 0.0 must use a minimum interest credit if the pay credit 1 5 10 15 20 25 30 percentage received in one year is more than Years of service 1 133 /3% of the pay credit percentage received in any I Age and service (points) I Age I Service earlier year. Because hybrid sponsors have been waiting for IRS guidance on the issue, however, they Source: Towers Watson. have remained somewhat in limbo — especially those with fixed rates or a minimum rate. Figure 27. Pay credit frequency Cash balance Pension equity Plan sponsors typically choose from one of several plans plans All hybrid plans types of interest rates. Some choose a fixed interest Annual 64% 95% 67% rate, such as 4%. Others use a variable interest rate based on a bond yield, such as the yield on 30-year Semiannual 1% 0% 1% Treasury bonds for a specific month before the start Monthly 23% 5% 21% of the year. Others use a mixture of several variable Quarterly 8% 0% 7% rates (e.g., the lesser of six-month Treasuries or Pay period 3% 0% 3% 30-year Treasuries or the average of five-year and Biweekly 0% 0% 0% 10-year Treasuries), or what is called a combination Weekly 0% 0% 0% rate, which is a variable rate used with a minimum Total 100% 100% 100% and/or a maximum fixed rate (e.g., 10-year Treasury Note: Due to rounding, columns may not add to 100%. rate with a 5% minimum and 10% maximum). Source: Towers Watson.

Hybrid Pension Plans: A Comprehensive Look at Their History, Economics and Features 19 Figure 28. Interest crediting rate Of CBPs, 63% use a variable interest rate with no defined minimum or maximum and 30% use a Cash balance Pension equity plan plan interest post-termination combination interest rate as their interest crediting rate. crediting rate rate All hybrid plans Of PEPs, one-half also use a variable interest rate with Variable 63% 51% 62% no defined minimum or maximum and 34% use a fixed Combination 30% 14% 29% interest rate as their post-termination rate (Figure 28). Fixed 7% 34% 9% Seventy percent of CBPs with fixed pay credit schedules Total 100% 100% 100% use a variable interest rate with no maximum or

Note: Due to rounding, columns may not add to 100%. minimum (Figure 29). This is not surprising as these Source: Towers Watson. plans need not worry about back-loading. More than Figure 29. CBP formula type by interest rate type half of CBPs with graded formulas, however, also use variable rates with no minimum or maximum. This is Interest rate surprising, as these plans could require a minimum Fixed rate Variable rate Combination interest credit to demonstrate compliance with the Benefit formula only only rate Total anti-back-loading rules. It might be because they are Fixed percentage 6% 70% 25% 100% using an implied rate rather than an explicitly Service 5% 65% 29% 100% declared one, or because the “slope” of the graded Points 2% 63% 35% 100% formula for plans without a minimum interest rate Age 5% 51% 44% 100% was determined not to violate the back-loading rules Other 11% 44% 44% 100% even at an assumed interest rate of zero. Combination

Note: Due to rounding, columns may not add to 100%. rates are not used except for age-based formulas in Source: Towers Watson. PEPs, while fixed rates are used more frequently Figure 30. PEP formula type by interest rate type regardless of benefit formula (Figure 30). Interest rate In Figures 31 and 32, we invert the focus to the Fixed rate Variable Combination interest rate type by benefit formula. Of CBPs using Benefit formula only rate only rate Total combination interest rates, a plurality (30%) use a Service 40% 60% 0% 100% points-based formula to determine the benefit. Of Fixed-dollar rate 25% 75% 0% 100% CBPs using fixed and variable interest rates, Age 18% 55% 27% 100% pluralities (36% and 32%, respectively) use a fixed-percentage-based formula. Most PEPs with Points 17% 83% 0% 100% variable interest rates use age-based formulas to Source: Towers Watson. determine the benefit (35%). Of PEPs using fixed Figure 31. Interest rate type by CBP formula interest rates, 33% use service-based formulas and Interest rate 33% use age-based formulas. All PEPs using combination rates employ an age-based formula. Benefit formula Fixed rate only Variable rate only Combination rate Fixed percentage 36% 32% 23% The most popular interest rate for hybrid plans is the Service 29% 27% 24% 30-year Treasury bond yield, which is used by 41% of CBPs and 40% of PEPs (Figure 33). Among CBPs, Points 14% 28% 30% one-year Treasury (19%) and 10-year Treasury (9%) Age 14% 11% 20% are the second and third most frequently used Other 7% 2% 4% interest rates, respectively. Seven percent of CBPs Total 100% 100% 100% use a fixed interest rate. For PEP post-termination Note: Due to rounding, columns may not add to 100%. rates, although the 30-year Treasury yield is used Source: Towers Watson. most often, 34% of PEPs use a fixed rate, and the Figure 32. Interest rate type by PEP formula rest use 417(e) rates — the interest rates used to Interest rate determine the present value of accrued benefits and Benefit formula Fixed rate only Variable rate only Combination rate the amount of any distribution (including a single sum) other than an annuity (26%).15 Service 33% 18% 0%

Fixed dollar 17% 18% 0% 15 Prior to the PPA, the §417(e) rate was based on 30-year Treasury bonds (a monthly average rate). More specifically, for calendar-year plans, this applied for years prior Age 33% 35% 100% to 2008. For 2012 and beyond, the rate is now defined as a 24-month average of the long-term corporate bond rates published by the IRS. The new rates will be phased Points 17% 29% 0% in from 2009 to 2011. Sponsors also must make decisions about look-back months Total 100% 100% 100% and other details. Some plan sponsors may have incorporated the §417(e) rate by reference in describing their cash balance interest crediting, so it is important to Source: Towers Watson. ensure what was actually intended, given the PPA changes.

20 towerswatson.com Interest credits on the pay credits generally begin to add interest daily. Eighty-five percent of PEPs add accrue as soon as they are recorded. The frequency interest to accounts of terminated participants with which interest is added to hybrid plan accounts annually, while 8% add interest monthly and 8% add varies. Most hybrid plans — 59% — add interest interest quarterly. For CBPs, the frequency of annually (Figure 34). Fifty-eight percent of CBPs add interest crediting generally aligns with the frequency interest annually, while 22% add interest monthly of pay credits shown in Figure 27, but there are and 13% add interest quarterly. Only 4% of CBPs some differences.

Figure 33. Prevalence of interest rates CBP interest PEP post-termination crediting rate rate All hybrid plans 30-year Treasury1 41% 40% 41% 1-year Treasury2 19% 0% 17% 10-year Treasury3 9% 0% 8% Fixed rate4 7% 34% 9% 5-year Treasury 6% 0% 5% Other Treasury5 5% 0% 5% Mixture of interest rates6 3% 0% 3% §417(e) (post 12/31/2007) 2% 26% 5% CPI7 2% 0% 2% Equity-based interest rate 2% 0% 2% Corporate bond rate 2% 0% 2% Determined annually by board/committee 1% 0% 1% Highest Notice 96-8 rate 1% 0% 1% Code §430(h)(2)( C) 1% 0% 1% Determined by participants 1% 0% 0% Total 100% 100% 100% 1 Two CBPs add 1% to 30-year Treasury, one CBP uses 90% of 30-year Treasury rate. 2 27 CBPs add between 0.5% and 1.5% to 1-year Treasury. 3 One CBP adds 1% to 10-year Treasury. 4 Rates are between 3% and 8%. 5 “Other” Treasury rates include 3-month Treasury, 6-month Treasury, 2-year Treasury, 20-year Treasury and 3-year Treasury. Most of the CBPs using one of these rates also add additional basis points. The additional percentages added are between 0.5% and 2% depending on the rate chosen. 6 “Mixture of Interest Rates” includes rates that are a combination of variable rates, such as the lesser of 6-month Treasuries or 30-year Treasuries or the average of 5-year Treasuries and 10-year Treasuries. It does not include combinations of a fixed rate in which a variable rate is used with a minimum and/or maximum fixed rate. Plans with a combination of a fixed rate and a variable rate are included in the category corresponding to the variable rate. 7 One CBP adds an additional 2% to CPI; two CBPs add an additional 3% to CPI. Note: Due to rounding, columns may not add to 100%. Source: Towers Watson.

Figure 34. Frequency of adding interest Cash balance Pension equity plans plans All hybrid plans Annual 58% 85% 59% Semiannual 1% 0% 1% Monthly 22% 8% 21% Quarterly 13% 8% 13% Daily 4% 0% 3% Pay period 1% 0% 1% Biweekly 1% 0% 1% Weekly 1% 0% 0% Total 100% 100% 100%

Note: Due to rounding, columns may not add to 100%. Source: Towers Watson.

Hybrid Pension Plans: A Comprehensive Look at Their History, Economics and Features 21 Transition Methods prior plan benefit accrued up to the conversion date plus the hybrid plan benefit accrued after the Plan sponsors have always used a variety of effective date. The A+B method has become methods to convert their traditional DB plans to considerably more popular since 2006, as it is hybrid plans, but in 2006, the passage of the PPA required as a minimum by the PPA. Based on the changed conversions dramatically. The most Towers Watson data, after the passage of PPA, 33% common method pre-PPA — used by 40% of CBPs of CBP conversions employed the A+B method. and 26% of PEPs — was establishing an opening account balance equal to the current lump-sum Before the PPA, some plan sponsors grandfathered value of accrued benefits in the traditional DB plan certain employees in the prior benefit plan. In other and adding future credits to the account under the words, these plan sponsors moved employees into hybrid formula (Figures 35 and 36). None of the plan the hybrid plan only after a certain future date or sponsors in our database used an opening account they used provisions based on age and/or service balance as a transition method post-PPA. to determine whether an employee would be in the hybrid plan or the traditional DB plan. The Some plan sponsors — 7% of CBP sponsors and 5% grandfathering might have been for a temporary of PEPs — used the A+B method before the period, such as five or 10 years, or for the remainder passage of the PPA. Under the A+B method, the of the grandfathered employees’ careers. Prior to account balance is calculated as the sum of the the passage of the PPA, 21% of both CBPs and PEPs

Figure 35. Transition methods for cash balance plans Pre-PPA Post-PPA Both periods Opening account balance 40% 40% 0% 0% 35% 35% A+B method (sum of frozen prior plan benefit and current 7% 7% 33% 33% 10% 10% hybrid plan benefit as of effective date)

Grandfathered employees remained in prior plan, employees 15% 47% 19% hired after a specific date participated in hybrid plan Grandfathered employees remained in prior plan, employees not meeting requirements were given a choice and were 6% 21% 7% 53% 6% 25% transitioned into the hybrid plan if they chose it Grandfathered employees remained in prior plan, remaining 1% 0% 1% employees moved to hybrid plan using A+B method Greater of prior plan benefit and current hybrid plan benefit 8% 0% 7% once the employee leaves the company Greater of prior plan benefit and current hybrid plan benefit. 13% 0% 11% Opening account balance was used to determine current 5% 0% 4% benefit if hybrid plan provided greater benefit

Employee choice, opening account balance was established 7% 7% 7% for those that chose to participate in hybrid plan

Employee choice, participants moved to hybrid as if the plan 3% 10% 0% 7% 2% 10% already existed Employee choice, if hybrid was chosen, then sum of frozen prior plan and current hybrid plan as of effective date was 1% 0% 1% used to determine benefit (A+B) New plan 2% 2% 7% 7% 2% 2% Combination1 7% 7% 0% 0% 6% 6% Total 100% 100% 100% 100% 100% 100% 1Plan sponsors used several conversion methods for different groups in company. Note: Due to rounding, some subtotals may not equal the sum of cells. Source: Towers Watson.

22 towerswatson.com transitioned employees who did not meet the violate the accrual rules against back-loading. The grandfathering requirements into the new hybrid plan IRS had earlier taken the position that the two using the A+B method, applying the opening account benefit formulas (traditional and hybrid) had to be balance method or moving only those who did not aggregated for purposes of the accrual rules — but meet certain other requirements into the hybrid that such aggregation often could not satisfy the plan. After the passage of the PPA, 53% of plan accrual rules. Although the IRS finally released sponsors used grandfathering to transition to CBPs, proposed regulations allowing a narrow exception for either retaining the prior plan for all employees hired greater-of conversions to cash balance designs, in after a certain date or allowing them to choose which each formula is tested separately under the between plans. accrual rules, final guidance has been slow to arrive. Also, these proposed greater-of regulations might In pre-PPA days, 13% of CBPs and 16% of PEPs used cause problems for other DB plan designs. the “greater of” conversion method, which pays benefits under whichever formula — the traditional Before passage of the PPA, 10% of CBPs and 21% of DB or the hybrid —pays out the larger amount. No PEPs allowed current employees to choose whether plan sponsors used this method post-PPA. This is to remain in the old plan or join the new hybrid. Since not surprising, as the PPA rules made such an the passage of the PPA, only 7% of plan sponsors approach difficult. In its determination letter process, have used this method when converting to a CBP. the IRS claimed these greater-of transitions could

Figure 36. Transition methods for pension equity plans

Pre-PPA Post-PPA3 Both periods Opening account balance 26% 26% 0% 0% 25% 25% A+B method (sum of frozen prior plan benefit and current 5% 5% 0% 0% 5% 5% hybrid plan benefit as of effective date) Grandfathered employees remained in prior plan, employees 5% 0% 10% hired after a specific date participated in hybrid plan Grandfathered employees1 remained in prior plan, other employees moved to hybrid plan using opening account 5% 21% 0% 0% 5% 20% balance Grandfathered employees1 receive greater of the prior plan 11% 0% 5% benefit or current hybrid plan benefit Greater of prior plan benefit and current hybrid plan benefit 16% 0% 15% once the employee leaves the company Greater of prior plan benefit and current hybrid plan benefit. 16% 0% 15% Opening account balance was used to determine current 0% 0% 0% benefit if hybrid plan provided greater benefit Employee choice, opening account balance was established 0% 0% 0% for those that chose to participate in hybrid plan Employee choice, participants moved to hybrid as if the plan 16% 0% 15% already existed 21% 100% 25% Employee choice, if hybrid was chosen, then sum of frozen prior plan and current hybrid plan as of effective date was 5% 100% 10% used to determine benefit (A+B) New plan 0% 0% 0% 0% 0% 0% Always hybrid plan 5% 5% 0% 0% 5% 5% Combination2 5% 5% 0% 0% 5% 5% Total 100% 100% 100% 100% 100% 100% 1Grandfathered provisions based on effective date or age and/or service provision. 2Plan sponsors used several conversion methods for different groups in company. 3 We have only one PEP that was established post-PPA. Note: Due to rounding, some subtotals may not equal the sum of cells. Source: Towers Watson.

Hybrid Pension Plans: A Comprehensive Look at Their History, Economics and Features 23 Section 5: Simulated Costs and Risks of Hybrid Plans Compared With Traditional DB and DC Plans Through stochastic simulations, we assess the 60%, benefit accruals are not allowed. The analysis costs and risks to a sponsor of a hybrid plan.16 We ignores other benefit restrictions triggered at various use a CBP as the representative hybrid plan and funded levels, such as a prohibition on plan compare it with a DC plan and a traditional DB plan. amendments or the inability to pay lump sums. The DB plan provisions reflect common practice, The hypothetical workforce in these simulations starts while the DC plan and CBP are set to be comparable with 100 employees between the ages of 26 and 60, to the DB plan in terms of benefit generosity. with an average age of 40. Workers with a high school In the traditional DB plan, one year of service education are considered. These workers earn accrues 1% of final five-year average pay that will be between $19,000 and $81,000 a year, with the delivered as a fixed lifetime annuity in retirement. average $43,000 initially. The annual real wage The CBP and DC plan pay participants a lump sum increase is determined stochastically with an average at retirement. The CBP benefit is determined by pay 1% throughout the workers’ careers. All employees credit and interest credit rates that are guaranteed work for the employer until they retire at age 65. The by the sponsor. The interest credit rate is assumed hypothetical workforce is also expanding and aging. to be variable and tied to long-term 30-year Treasury Five new workers join the workforce annually in the yields, following common practice. The pay credit rate same 26–60 age distribution and participate in the is fixed and determined in the model so the CBP and retirement plan. Simulations of labor earnings capture DB plan have equal lump-sum value when the the lifecycle age-earning profile of workers, idiosyncratic participant retires at age 65.17 The calculation uses (random) individual income variations and correlations the average simulated earnings, applies the average of wage levels with macroeconomic shocks. Simulated 30-year Treasury yield as the interest credit rate and real earnings average about $40,000 at age 30 and assumes a certain plan population (see below). The pay $52,000 for workers in their 50s. credit rate is about 9% for the CBP to be comparable We run simulations for each worker and calculate to the 1% final-average DB plan. For clarity, the aggregate summary statistics for the workforce benefit equivalence operates at the plan level, but after 40 years. Levels and variations of funding the eventual benefits to participants in the CBP vary costs are measured on a per worker basis. The mean along with the 30-year Treasury yield over the years. statistics show the average level of costs, including We also use this CBP pay credit rate as the employer extraordinary values, and standard deviations contribution rate in the DC plan. This assumes that indicate the volatility of costs. 30-year Treasury yields are equally earned by DC plan participants without any loss of principal when Asset returns and interest rates are stochastically interest rates rise or gain in principal when interest rates simulated. The model includes standard market fall, as might be, at least theoretically, experienced if shocks in normal times and low-probability, large- a stable-value investment fund were used. magnitude rare economic disasters. Asset returns reflect persistence of shocks over time and Plan funding in the model operates under legal and correlations across different classes. Asset regulatory requirements and common practice. allocations in the DB plan and CBP are assumed to Plan contributions are subject to government limits. be a typical 60/40 mix of equities and corporate As mandated by the PPA, funding shortfalls in DB bonds. Returns are simulated based on S&P 500 Total plans and CBPs are amortized over seven years. Return and Barclays Capital Aggregate Bond Indices, A faster six-year amortization schedule is used if respectively. Discount rates used in valuing CBP and funding is less than 70%, approximating the effect of DB plan liabilities are simulated based on the the accelerated funding rules that apply when a plan composite corporate bond rates (CCBR), which are is considered “at-risk.” If the funding ratio is below published by the IRS for various regulatory purposes.

16 This section briefly outlines the simulation assumptions and results. Readers are referred to the complete analysis “Comparative Costs and Risks for Sponsors of Traditional Defined Benefit, Defined Contribution and Hybrid Plans” by Gaobo Pang and Mark J. Warshawsky, 2010, Towers Watson working paper. 17 No job turnover is assumed in this analysis. The cost pattern could differ if benefit generosity were defined differently, such as the termination values at various ages. Benefits paid to participants who leave before retirement age are often larger, and thus more costly, under the hybrid plan than under the traditional final-average-pay DB plan. On the other hand, the DB plan may be more costly if turnover is low or early retirement is heavily subsidized.

24 towerswatson.com Figure 37 summarizes the simulated yields, rates add further volatility to their funding costs. Still, the and returns. The incorporation of rare economic CBP and DB plan are more cost-efficient than the DC disasters significantly lowers the expected real plan. Average costs as a percentage of payroll are asset returns and increases their volatilities. The 7.2% in the DB plan and 7.5% in the CBP — versus conservative investment returns here avoid particularly 8.9% in the DC plan. favoring the DB and CBP versus the DC plan. If Required contributions are more volatile for the DB plan economic disasters were not considered, the simulated than for the CBP. The DB plan costs as percentages average nominal equity return would be 7.4%. of payroll exhibit a generally upward trend, as shown Figures 38 and 39 report the results of the stochastic in Figure 39, because the recognition of benefit simulations. The DC plan has the lowest year-to-year accruals is concentrated in the years preceding fluctuations in funding cost, while the DB plan and the CBP experience significantly larger swings. Annual Figure 37. Statistics of simulated yields, rates and returns with nominal costs for the DC plan have a standard economic disasters (%) deviation of $5,500 versus $7,100 for the CBP and Composite 30-year $8,900 for the DB plan. Expressed as a percentage Equity Corporate corporate T-bond of total payroll, cost volatilities are 0.3% for the DC return bond return bond yield yield Inflation plan, 5.7% for the CBP and 6.6% for the DB plan. Real The cost volatility for the traditional DB plan and the Mean 3.5 1.9 2.1 1.5 –– CBP can be addressed through investment Std. dev. 21.5 6.6 4.6 4.8 –– strategies, at the expense of expected investment Nominal return. This consideration however, is beyond the Mean 6.7 5.1 5.3 4.7 3.2 scope of this paper. Std. dev. 19.5 4.1 0.9 1.9 4.8 In the long run, however, the DC plan is more costly than the DB plan and the CBP. Mean annual nominal Source: Towers Watson. costs are roughly $9,300 per worker for the DC plan, $7,200 for the CBP and $7,600 for the DB plan. Over Figure 38. Funding costs and volatilities per worker for a prototypical plan the 40-year period, the long-run total funding costs in population real terms per worker average around $119,800, Annual nominal cost $000 Cost as % of payroll $98,700 and $89,200 for these plans, respectively Mean Std. dev. Mean Std. dev. (results not shown here; available in the complete DC 9.3 5.5 8.9 0.3 analysis). Capital market fluctuations can cause CBP 7.2 7.1 7.5 5.7 funding shortfalls in the CBP and the DB plan, which are generally not considered a risk for the DC plan DB 7.6 8.9 7.2 6.6 sponsor. Episodic economic and financial disasters Source: Towers Watson. Figure 39. Average funding costs as a percentage of payroll in each year

12%

10%

0% 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 27 28 29 30 31 32 33 34 35 36 37 38 39 40 I DC I CBP I DB Years

Source: Towers Watson.

Hybrid Pension Plans: A Comprehensive Look at Their History, Economics and Features 25 Figure 40. Funding costs and volatilities per worker for a career-average DB plan and comparable DC plan and CBP Annual nominal cost $000 Cost as % of payroll Mean Std. dev. Mean Std. dev. DC 6.0 3.6 5.7 0.1 years. Calculated as present values of future CBP 5.0 4.8 5.1 3.7 benefits over a typically long duration, liabilities are DB 5.4 5.8 5.4 4.5 also highly sensitive to changes in interest rates. Source: Towers Watson. Liability variations are mitigated in the CBP by its accrual formula. The CBP benefits are expressed as Figure 41. Funding costs and volatilities per worker, mixed plans for an account balances upon retirement, and the pay expanding and aging plan population credit rate is fixed. The liability accruals vary with Annual nominal cost $000 Cost as % of payroll new realizations of crediting interest rates. Liabilities Mean Std. dev. Mean Std. dev. are typically much less interest-rate sensitive under DC-only 11.7 7.7 10.9 0.4 a CBP than under a traditional DB plan. For example, CBP+DC 10.4 7.4 10.2 4.0 declines in interest rates for the CBP increase discounted plan liabilities but also reduce plan DB+DC 10.0 11.1 9.3 7.4 benefits through lower assumed interest credits. Notes: For comparable benefit generosity, these mixed plans are set as follows: DC-only has an 11% employer contribution rate; CBP+DC has a cash balance plan with a 6% pay credit rate and a DC plan with a 5% employer contribution; and These opposite forces fully or partially offset each DB+DC has a final-average DB plan with a 1% accrual rate and a DC plan with a 2% employer contribution. other. The lower volatility in liabilities is an important Source: Towers Watson. retirement and the population is assumed to be aging. advantage of CBPs over traditional DB plans. More importantly, the figure shows sharp variations We also consider an alternative career-average-pay from year to year. This uncertainty imposes a DB plan with a 1% accrual rate. For benefit management burden on the traditional DB plan equivalence, the pay credit rate is 5.8% for the CBP sponsor under the assumed investment strategy. and DC plan. Figure 40 reports the results. Costs for Like the DB plan, the CBP funding cost varies with all of the plans are lower than those in Figure 38 realizations of asset returns, interest rates and because the previous plan provisions offered more benefit accruals. The trajectories of average costs generous benefits to participants. Using career over time, however, are relatively stable for the CBP. average pay in the DB benefit formula mitigates the As the workers approach retirement, more of their risk of unanticipated wage inflation, especially later ultimate benefits are funded in the CBP compared in workers’ careers. The results again show that the with the DB plan. The CBP has a slightly better DB plan and CBP have a cost efficiency advantage chance than the traditional DB plan of being 120% over the DC plan but carry the volatility disadvantage. overfunded or not falling below 80% funded. The CBP outperforms the DB plan in terms of lower The differences in costs and risks are explained by cost and volatility, once again because liabilities are the sources of uncertainties in these retirement less sensitive to changes in interest rates. plans. The DC plan sponsor contributes a fixed Finally, we consider a scenario in which workers are percentage of pay. The responsibility for investment covered by a mix of retirement plans. Some strategies and outcomes rests with participants. employers may choose to have benefit accrual in Volatilities of dollar costs for sponsors lie in the one plan and simultaneously add or enhance the stochastic changes in labor earnings. benefit in another. Figure 41 reports the results for For CBPs and DB plans, the sponsors are responsible the plans described in the notes. for investing assets. This helps participants by The DB+DC mix has a larger DB feature than other insulating their retirement benefits from market mixes — recall that a 1% final-average DB plan is fluctuations. It might also benefit sponsors because equivalent to a DC plan or CBP with a 9% pay credit the longer investment horizon may give them rate. This mix has the lowest average cost but the opportunities to explore higher returns (plus various largest volatility. The CBP+DC mix benefits from the more sophisticated strategies, risk pooling and CBP component in terms of lower cost volatility, but scales of economy in aggregate investment that are the average cost increases as the mix moves toward not directly modeled here), which can eventually the DC type. DC-only has the highest cost over the reduce costs.18 There is, however, the downside risk long run. Funding costs account for about 10.9%, of substantial market losses necessitating sharply 10.2% and 9.3% of payroll with standard deviations larger contributions. of 0.4%, 4% and 7.4% for DC-only, CBP+DC and In addition, CBPs and DB plans face uncertainties in DB+DC, respectively. In terms of annual average liability valuations. Traditional DB plan liabilities grow nominal cost, the CBP+DC mix gives an even lower and fluctuate with salary increases and service standard deviation than the DC-only coverage.

18 A series of empirical studies found that, over time, DB plans attained higher returns than 401(k) plans by roughly an average of 1 percentage point a year. See “Defined Benefit vs. 401(k) Investment Returns: The 2006–2008 Update,” Insider, Watson Wyatt, December 2009.

26 towerswatson.com Section 6: Concluding Remarks As the name suggests, hybrids offer a mix of the understanding and the ability to guarantee lifetime attributes of both DB and DC plans in terms of risk income, have obvious benefits to the sponsor as well. sharing, funding volatility, cost control and lifetime Despite the advantages hybrids offer to employers income. The prevalence of hybrid plans varies widely and employees alike, their future is still evolving. among industries and the plans differ from one While the courts have rejected the age discrimination company to the next — clearly one size does not fit charges, the delay in final regulations has left some all. In all variations, hybrid plans generally offer employers hesitant to switch to hybrids. Some have advantages for both employees and sponsors. gone ahead with a DC-plan only approach, while The portable benefits in hybrid plans make the plans others have assumed a wait-and-see position. more attractive to employees who are less likely to The recently issued IRS regulations are critical to work for a company until they retire. Hybrid plan this evolution. After the new guidance is digested, participants also avoid the risk and responsibility of many plan sponsors will have to amend their plans investing their retirement funds themselves. In to comply, particularly with regard to maximum addition, many hybrid plans offer interest credits at interest crediting rates and transition methods. levels not available to employees otherwise — More importantly, the guidance is expected to clarify namely a return on long-term bonds, with the return legal requirements and resolve lingering ambiguities, reset each year to current levels, but with no risk of and may thereby encourage more employers to principal. Having a portion of retirement savings convert their traditional DB plans to hybrid plans. earning this type of return can enable participants to tolerate more risk in investing other retirement assets, such as 401(k) balances. ““Choosing a plan design is a complex Hybrid plan benefits are easier to understand than decision, which should reflect a wide range those in traditional DB plans, and hybrid plan participants need not fear a huge investment loss of factors unique to each sponsor. But as this just before retiring. Employees with hybrid plans are less likely to elect annuities at retirement than study demonstrates, for many employers, those in traditional DB plans. Hybrid plan hybrid plans might well emerge as the right participants that elect to receive their benefits in a lump sum thus take on the burden of managing retirement plan choice.” their retirement income, which increases the risk of outliving one’s income. As DB plans, however, The recent deep recession shows the very attractive hybrid plans must offer participants a lifetime risk- and cost-balancing features of hybrid plans to annuity option, so this risk is optional. Unlike DC greater advantage, especially given the consequent plans, hybrid plans always offer participants the high contributions and funding volatility in traditional opportunity to eliminate the risk of outliving their DB plans and the significant asset losses to many retirement income. DC accounts. Employers might better appreciate From the sponsor’s perspective, hybrid plans also hybrids’ mix of DB and DC features, while workers offer a combination of the attributes of traditional are likely to welcome their reliability and certainty. DB plans and DC plans. Plan costs and liabilities While hybrid plans offer many advantages, no one tend to be less volatile in hybrid plans than in type of plan — hybrid, traditional DB or DC — is traditional DB plans, but hybrids are more volatile right for all sponsors. Choosing a plan design is a than DC plans. Conversely, as there is a natural complex decision, which should reflect a wide range tradeoff between cost and volatility, hybrid plans of factors unique to each sponsor. But as this study are somewhat more cost-efficient than DC plans, demonstrates, for many employers, hybrid plans although somewhat less so than traditional DB might well emerge as the best retirement plan choice. plans. From a workforce management perspective, hybrid plans typically do not include incentives to continue working or to retire at certain times as many traditional DB plans do, so turnover is likely to be more “natural.” Some of the other employee advantages mentioned above, such as improved

Hybrid Pension Plans: A Comprehensive Look at Their History, Economics and Features 27 About Towers Watson Towers Watson is a leading global professional services company that helps organizations improve performance through effective people, risk and financial management. With 14,000 associates around the world, we offer solutions in the areas of employee benefits, talent management, rewards, and risk and capital management.