An employer-sponsored retirement plan that offers the features of both a defined contribution plan and a defined benefit pension plan is known as a hybrid pension plan. This article evaluates the leading types of hybrid plans, the regulatory basis for pension plans, common concerns, and the future outlook for hybrid plans.
Cash Balance Hybrid Pension Plans
Cash balance pension plans typically provide the participant with a combined value based on the participant’s own contributions, frequently but not always matched in whole or in part by the plan sponsor, and supplemented by an earned interest rate. In these plans the interest rate may be specified by the plan sponsor in order to provide greater levels of predictability and less exposure to interest rate risk.
The most common type of cash balance plan is the defined benefit model, funded only by the employer. The participant’s benefit grows based on pay and service credits and is expressed as a notional balance.
Pension Equity Hybrid Pension Plans
Pension equity hybrid plans allow a plan sponsor to offer participants a lump sum benefit tied to a percentage of pay. While pension equity plans appear to resemble defined benefit plans, they are independent of life expectancy projections or interest rates. Employers typically have greater control over costs in a pension equity plan. These plans also provide participants with the opportunity to roll over payments to IRA or other qualified plans.
Pension Protection Act of 2006 Encouraged Hybrid Plans
The Pension Protection Act of 2006 (PPA) amended the Employee Retirement Income Security Act (ERISA), the Internal Revenue Code (the “Code”) and the Age Discrimination in Employment Act (“ADEA”). The amendment stipulated that a hybrid plan complies with ERISA, qualifies for tax-exempt status under the tax Code, and is not considered to be discriminatory on the basis of age assuming certain requirements are met.
The PPA provisions apply to years beginning after December 31, 2007, unless the plan sponsor elects the application of such requirements for any period after June 29, 2005.
Hybrid Pension Plan Usage Grows
At least eight states, including Michigan, Utah, Oregon and Washington, have adopted some form of hybrid pension plan for state workers in recent years. Indiana maintains a hybrid plan dating back to 1955, and Orange County, California has a new defined benefit/defined contribution (DB/DC) formula.
Many of these hybrid state plans combine the features of a 401(k) plan with some level of a guaranteed benefit. The ability to manage costs is a key advantage to state and municipal plan sponsors, since plan participants play a more significant role in funding retirement benefits.
Issues Associated with Hybrid Pension Plans
Participants in hybrid pension plans frequently express disappointment, particularly older workers who were accustomed to a more favorable defined benefit plan. This may be offset, as younger workers are happy to receive any level of pension benefit, compared to the alternative of having no employer-sponsored plan.
The most controversial aspect of cash balance plans occurred when traditional defined benefit plans were frozen and the cash balance formula was substituted. The frozen benefit was of course protected, but for some employees benefit accruals did not resume until their benefit under the new formula, calculated as if it had always been the plan’s rule, was greater than the frozen benefit, an approach called “wear away”. Wear away was abolished by the PPA.
The Pew Center on the States recently reported a $1.26 trillion shortfall between pension and retiree health benefits promised to state employees and the money set aside to pay for them, as of fiscal year 2009. As this funding deficit continues to grow, more states will be forced to adopt hybrid plans as a cost-savings measure.
One impact may be that states have a more difficult time attracting future qualified workers, as their historically high level of pension and retirement benefits become less available to supplement government’s lower perceived wages.