Demystifying the hybrid pension plan

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By John W. Ehrhardt | 01 May 2006

The pundits, academics and other prognosticators have spoken. Their verdict: the traditional pension plan in the U.S. is dead and the only remaining formality is the burial.

News outlets, both print and electronic, trumpet the wholesale abandonment of pension plans by high profile companies caught up in bankruptcy proceedings. The experts on the Sunday morning talk shows paint a gloomy landscape, describing "cents on the dollar" payouts by the Pension Benefit Guaranty Corporation (PBGC) to retirees from companies in Chapter Eleven. More front page stories detail the decisions by some major corporations to close or "freeze" their defined benefit pension plans in favor of increased corporate contributions to employees’ 401(k) defined contribution plans. In those instances where companies tried to offer workers something in between (the hybrid "cash balance" plans), suspicion, hostility, and even lawsuits often followed.

The scary headlines and seeming collective rush to judgment all point in one direction: pensions and future retirees in America are in big trouble. And the trouble we are now confronting is, to a large degree, the handiwork of the very body that is now charged with fixing the mess: the United States Congress. In an apparent bow to the Law of Unintended Consequences, congressional revenue tweaking in the 70s and 80s has come home to roost, with potentially devastating results for U.S. retirees and for our economy as a whole. Ironically, it is the individual employee and future retiree upon whom the onus has now been placed for managing his or her retirement planning.

Without a clear resolution in sight, this chain of events has created considerable confusion and consternation among both workers and employers alike. Recently, even executives at profitable companies with solid balance sheets and well-funded traditional pension plans have begun asking questions and demanding answers. "Should we consider modifying our pension plan? Are we somehow placing ourselves at a competitive disadvantage if we stay the course? How will our shareholders react?"

The pendulum has swung

The definitive answers to those questions are as unique as the executives who pose them and the companies that employ them. For some, change is inevitable, driven by the myriad variables that affect individual companies, markets, and the business cycle. They will follow the lead of others away from the traditional defined benefit plan in favor of less cumbersome and less costly defined contribution pension plans. For others, however, maintaining and prudently managing their existing defined benefit plans or, more likely, a "hybrid" version, may well prove to be an integral element in a successful long-term strategy. Further, it may be one that will become increasingly difficult for competitors to match. To understand how these events might play out it is helpful both to consider the historical perspective and to lift the hybrid veil of mystery.

Once upon a time, a corporate pension plan in America was a defined benefit plan. Period. Often forgotten by many people is the fact that the 401(k) plan was conceived and introduced as a supplemental vehicle. It was created as a means to augment the Defined Benefit (DB) plan, not to replace it. Here is what happened.

Original intent of the defined contribution plan

The 401(k) Defined Contribution (DC) plan was set up as a supplemental means for employees to contribute to their own retirement on a tax deferred basis. These contributions would provide an additional lump sum, allowing employees some flexibility beyond their fixed annuity Defined Benefit plan. The DB plan paid that guaranteed annuity based on final average pay at the time of retirement. In most cases the worker received the annuity following a fairly long 20 to 30 year career with the same employer.

Things began to change significantly following enactment by Congress of the Employee Retirement Income Security Act of 1974 (ERISA). In fairly rapid succession, that new law was followed by a number of additional statutes, notably the Tax Reform Act of 1986 that imposed an excise tax on any asset reversion from a terminated pension plan and the Omnibus Budget Reconciliation Act of 1987 (OBRA87). These changes were designed to limit the amount of contributions or benefits that could be paid into or flow out from DB plans.

Importantly, most of these new laws totally ignored any retirement policy. They were purely revenue driven. As a result, the maximum benefit that could be paid, the maximum salary that could be reflected in a DB plan, and the maximum tax deductible contribution a corporation could make were limited. Not surprisingly, three things happened: some companies stopped contributing to their DB plans; benefits were cut (especially for executives); and plans became much more complicated and therefore more costly to administer.

Fast-forward to the "Go Go" late 80s and early 90s. Driven by a booming stock market, assets ran up and DB plans became fully funded. Despite strong earnings and healthy markets, prudent companies still saw a need to contribute to their pension plans, given their expectations of continued growth, the need to provide for new hires, etc. But under the existing rules, contributions most likely would not be tax deductible, and instead might be subject to a 10% excise tax. That prompted many companies to go on what looked at the time to be a very long "contribution holiday."

That government-imposed cutoff in plan funding had companies looking for another way to provide benefits to their employees. They had a budget for benefits that they no longer needed from a cash point of view, so 401(k) plans became more popular, including a few new wrinkles like increased investment options, daily valuation of accounts, increased use of matching contributions, shorter vesting periods, and improved employee communications. Still, the 401(k) plan remained a supplement to the DB plan.

Concurrently, new companies were starting up that didn’t want to take on the administrative burden of DB plans. And there were other considerations. At the beginning of the dot com bubble, stock was the "big new thing" in compensation. For these companies, awards of shares and future stock options replaced the traditional defined benefit plans.

As the leaders of this genre (Microsoft, Intel, Dell, and others) have grown up and become corporate mainstays, their old-line competitors, especially in the technology industries, increasingly found themselves on an uneven playing field, disadvantaged financially by their expensive DB plans. And the bad situation was about to get much worse. The stock market crashed and asset performance and interest rates nose-dived. Coupled with the bursting of the dot com bubble, DB plans suddenly and rapidly required big contributions.

What had been a trend became a stampede. 401(k) plans were increasingly in demand and the vast majority of new companies began to go "Defined Contribution-only." Some of the old-line companies responded by closing or freezing their DB plans; instead, they offered enriched contributions to their workers in new DC plans.

Another fundamental shift was also underway, this time on the employee side. The concept of cradle-to-grave service at one employer was rapidly evaporating. Sometimes induced by layoffs or downsizing, sometimes pursued as career advancement, job-hopping had lost its old stigma. With a potential benefits gap for job-hoppers at retirement, the traditional DB plans designed for career-service with one employer were no longer attractive to the suddenly mobile workforce.

Enter the hybrids

Companies were between the proverbial rock and a hard place. They had overfunded DB plans with excess assets. They wanted to use the money to provide benefits to their employees, but the rules governing DB plans were onerous. So some employers came up with an innovative solution. They would convert their existing final average pay plan to a "cash balance" plan where they would basically create a DC-type account within the DB plan. The only difference between that and a real DC plan (from the employee point of view) was the fact that the investment return on a cash balance account was defined, usually at some kind of fixed-income level, like 30-year Treasury rates. It was not tied to the actual return on plan assets.

Another innovation was the Pension Equity Plan (PEP). In those plans the benefit would be paid as a lump sum but based on a percentage of final average pay. Each year employees would earn a certain percentage of final average pay, ultimately payable as a lump sum rather than as an annuity. Unlike a cash balance plan which is an account-based, indexed career average plan, a PEP plan was truly based on final average pay.

The line between DB and DC had begun to blur as other innovations followed. In a cash balance scenario, employers also could "grandfather" people near retirement and continue to provide guaranteed annuity benefits. And there were still more possibilities. As these new hybrids were reaching their peak of popularity, "employee choice" was introduced. It was simple: give employees a choice between the old plan and the new plan. The employer still had the investment risk because the company was contributing to the hybrid plans, and they were "defined benefit" because they had to pay out these promised accounts with an option for an annuity at retirement. 401(k) plans, on the other hand, normally don’t offer annuity options. The fundamental concept of a secure retirement remained: a defined benefit where the employer is taking the investment risk coupled with the option to pool the employees' longevity risks through the payment of annuity benefits. The employer could cover the annuity, as he had in a large traditional DB plan, or he could purchase an annuity and have an insurance company cover the risk.

And, perhaps most important of all, the new concept was portable. The employee who chose to change jobs could simply take the accrued benefit with him as a lump sum and roll it over into his new employer's 401(k) plan. It looked to many people like the best of all worlds.

The pendulum is still moving

Not everyone saw it that way. As these pages went to press, lawsuits charging age discrimination in cash balance plans were still being adjudicated, Congress continued to wrestle with pension reform legislation, companies were still freezing defined benefit plans and, in the interests of transparency, efforts continued to change accounting treatments by aligning the US Generally Accepted Accounting Principles (GAAP) with international accounting standards (IAS).

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Clearly, the last chapter in the "pension wars" has not been written. In reality, it will probably never be written. Forty years ago, no one imagined working for five or even ten employers over the course of a career. No one envisioned a pension plan directed by the employee. No one considered a retirement without a guaranteed annuity. And nowadays, it seems increasingly reasonable to assume that, in order to attract and retain a quality workforce, successful employers will need the flexibility to offer something more than highly competitive base compensation and a defined contribution 401(k) pension plan. In other words, pension plans will and should continue to evolve, in order to reflect the current reality of the workplace and serve their expressed purpose.

Uncharted waters

The old saying was never more appropriate: "The only certainty is that things will change." A year ago on these pages we wrote that some sort of Social Security reform seemed inevitable. As events have unfolded, what we saw as inevitable has been pushed a lot farther into the future. Undaunted, here is another attempt to read the tea leaves.

  • Hybrid pension plans will emerge and take hold. Their precise structure is not yet known but they will accommodate both the employer’s need to attract and retain a talented workforce and the employee's increasing demands for a flexible, portable retirement benefit that assumes a pooled share of both the investment and longevity risks.
  • Hybrid DC plans will continue to emerge and evolve, while incorporating valuable features that are traditional to DB plans, such as variable annuity options to cover the employees' longevity risks.
  • For those companies with straight defined contribution plans, workers will increasingly find themselves enrolled automatically. They will begin to save for retirement from the moment they start their first job and continue to do so through every job change.
  • Small employers will receive tax credits for offering employees the opportunity to make auto-enrollment-like deposits into their IRA accounts.
  • We'll offer a few thoughts, also, on health coverage in retirement. Long before the current controversy over pensions began, companies were already scaling back retiree health coverage. It now seems clear that if employers provide anything to employees for medical benefits in retirement, the trend will continue toward essentially defined contribution health reimbursement arrangements (HRAs) and high deductible plans for medical coverage. Retirees will accumulate either real dollars or credits that can be used to purchase medical benefits. The longevity risk, the medical risk, and the medical inflation risk will continue to be pushed onto the employee.

For our nation and for our implied social contract, the greatest danger always lies at the lowest end of the spectrum, where retirees have a limited source of assets. Lacking some kind of guaranteed annuity, with increases looming in both living costs and medical costs, future retirees will be forced to target something much longer than average life expectancy in order to be sure they don't outlive their assets.

John W. Ehrhardt is a principal and consulting actuary based in Milliman's New York office. He specializes in corporate retirement programs, including defined benefit plans, profit-sharing plans, 401(k) plans, and cash balance plans. John is the author of Milliman's annual Pension Funding Survey, which analyzes the funded status of the pension plans of 100 of the largest US corporations.