By Tomeka Hill and Nancy Campbell
Hybrid pension plans have been around since the mid-1980s and their evolution has been a rocky one, with very strong initial adoption rates among large employers followed by legal challenges and regulatory glitches and delays. In the 1990s and early 2000s, the media tended to focus on what happened to participants when their employers replaced their traditional defined benefit (DB) formulas with cash balance designs. Today's news, however, is as much about comparing hybrid plans with defined contribution (DC) plans, such as 401(k) plans, in light of the financial crisis.
This article presents highlights from Towers Watson's new report: Hybrid Pension Plans: A Comprehensive Look at Their History, Economics and Features (by Tomeka Hill, Gaobo Pang and Mark Warshawsky). The full report focuses on the most common types of hybrid plans: cash balance plans (CBPs) and pension equity plans (PEPs). It describes the economic, legislative and regulatory conditions that have made hybrid plans more — and sometimes less — attractive over the years, both to plan sponsors and to participants. The analysis looks at broad trends in hybrid sponsorship, participation and asset holdings, and takes a close look at the details of plan provisions and transition methods. It also uses a simulation model to compare the costs and risks of sponsoring a typical CBP, a traditional DB plan and a DC plan. As has long been known to many but might still be surprising news to some, over the long term, the DC plan is typically more expensive than a CBP that provides similar retirement benefits.
The history of hybrid plans is linked to the long-standing shift away from traditional DB plans, which has been fueled by a range of factors. Employer surveys identify the desire to reduce exposure to pension risks, such as cost volatility and long liability durations, as paramount. Other motivations include enhancing employee understanding and appreciation of benefits (including enhanced portability of benefits) and providing more age-neutral benefit accruals.
For these and other reasons, some employers started converting their DB formulas into hybrid account designs in the mid-1980s. Starting in the late 1990s, hybrid conversions sparked considerable controversy. Critics claimed employers were adopting hybrid plans to cut costs — to the detriment of older workers — and that the way these plans calculated lump-sum benefits violated fairness. The transition methods used in some conversions — referred to as "wear-away" — were accused of violating law and policy.
While the courts and the government have dismissed or resolved most of these charges over the years, complete clarity has been slow to emerge, leaving hybrid plans in regulatory and legal limbo. In the meantime, many companies adopted a DC-only approach to pension benefits prospectively. The Pension Protection Act of 2006 (PPA) set out a clear path for hybrid plans, and the recently released Internal Revenue Service (IRS) regulatory guidance, once finalized, will mark the final stage of that landmark legislation. At the same time the legal fog has mostly lifted, the financial crisis has rubbed some of the gloss off 401(k) plans, most of which suffered large market losses.
Hybrids combine some of the most attractive features of DB and DC plan designs, and minimize what many consider their drawbacks. Legally classified as DB plans, CBPs and PEPs accrue benefits under a fixed formula, like a traditional DB plan. The benefit is defined as a lump-sum account balance rather than as an annuity (and is typically available in a lump-sum payment upon termination of employment), but the default payout option is an annuity. Hybrid plans are subject to federal funding and accrual rules for single-employer DB plans and are covered by Pension Benefit Guaranty Corporation (PBGC) insurance.
A CBP periodically allocates a percentage of pay (i.e., a pay credit) to the worker's account, along with periodic interest credits based on an employer-selected interest crediting rate. The account grows at a plan-specified rate, typically regardless of the plan's actual investment earnings. In PEPs, participants accrue percentage credits throughout their careers, and a lump-sum retirement benefit is calculated as the sum of the percentage credits multiplied by final average pay. Most CBPs and PEPs provide higher pay credits to participants who have longer service and/or are older.
Benefits in hybrid plans are portable. If a hybrid plan participant terminates employment before retiring, the participant can almost always take the account balance as a lump sum. Or, the participant could convert the account into a future annuity or keep the account in the plan.
Based on our simulation model, volatility risk is much lower in hybrid plans than in traditional DB pension plans (based on final average pay). The financial accounting in hybrids also tends to be less volatile because the measurements are typically less sensitive to interest rates and pay fluctuations.
In hybrid plans, all eligible employees participate in the plan and receive employer credits to their account, unlike 401(k) plans, in which employer credits are generally in the form of a match activated by employee contributions. Hybrid plan sponsors are responsible for managing plan assets and paying promised benefits. In DC plans, workers typically must affirmatively decide to participate (or, increasingly, not opt out of "automatic enrollment"), select contribution rates and manage their investments (although, as with participation, default options are becoming more common). Unlike hybrid plans, many DC plans also allow participants to borrow from their accounts, which potentially dilutes their savings.
Investment risk is generally lower for participants in CBPs because the interest-crediting rate is often tied to a bond yield, such as the 10-year Treasury bond, sometimes with a small premium added, and the principal is "guaranteed." Thus, while the income replacement rates of CBPs vary somewhat over different cohorts of retiring workers, they are much less volatile than replacement rates from DC plans.1
Between 1999 and 2007, the share of all DB plans with at least 1,000 participants identified as hybrid plans grew from 11% to 18% (see Figure 1). While the number of large hybrid plans peaked in 2005 (at 671), the percentage has continued to rise as the number of large DB plans has fallen.
Figure 1: Number and incidence of hybrid plans with at least 1,000 participants, 1999-2007
|
Plan year |
Total number of hybrid plans | Hybrid plans as percentage of all DB plans |
|
1999 |
317 | 11% |
|
2000 |
459 | 11% |
|
2001 |
514 | 12% |
| 2002 | 537 | 14% |
| 2003 | 655 | 16% |
| 2004 | 639 | 15% |
| 2005 | 671 | 16% |
| 2006 | 646 | 17% |
| 2007 | 658 | 18% |
Source: Towers Watson, based on Form 5500.
Hybrid plans are more common in some industries than others (see Figure 2). For example, hybrid plans constitute 15% of all DB plans in the manufacturing sector, 33% of all DB plans in the energy, utilities and natural resources industry, and 25% of all DB plans in the health care and the professional and business services industries. Only 5% of DB plans in the property and construction industry are hybrid plans.
Figure 2: Hybrid plans as percentage of all DB plans by industry, 2007
Source: Towers Watson based on Form 5500, N=658.
Roughly 72% of all hybrid plans were adopted between 1995 and 2003, and another 8% were adopted in 2007 and 2008, perhaps due to the improved clarity conferred by the PPA.
About 16% of all hybrid plans are currently inactive (i.e., closed to new entrants or benefits frozen). Of the closed and frozen hybrid plans, 71% became inactive in 2007 or later. Employers that decided to stop offering active hybrid plans were most likely reacting to the economic recession that started in late 2007 and escalated in fall 2008. Of inactive hybrid plans, 64% are frozen, 32% are closed to new employees, and the rest have been terminated and are either under the PBGC's control or the funds have been transferred to a DC plan.
Most of the companies in the 2009 Fortune 100 from 1998 to 2009 no longer offer traditional DB plans to new salaried workers. Between 1998 and 2009, the number of such companies offering both a traditional DB plan and a DC plan to new employees dropped from 69 to 20. Over the same period, the number of such companies offering a hybrid plan and a DC plan to new employees increased from 8 to 24, and the number of these companies offering only a DC plan to new employees jumped from 23 to 56.
From 1998 to 2003, 17% of the Fortune 100 sponsors of a traditional DB plan transitioned to a hybrid plan — very few transitioned to offering only a DC plan. But between 2004 and 2006, 10% of the Fortune 100 companies opted for a DC-plan-only approach, and none adopted a hybrid plan. Again, this is, in part, because of the legal ambiguity of hybrids at that time. From 2007 to 2009, six Fortune 100 companies transitioned from traditional DB plans to hybrid plans, while five Fortune 100 companies closed or froze their hybrid plans.
The number of participants in hybrid plans has escalated over the past decade. From 1999 to 2007, the number of active hybrid plan participants climbed from almost 1.9 million to 4.9 million, and the total number of participants increased from 3.2 million to 10.2 million. 2 Over the period, 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%.
Hybrid plans tend to have more participants than DB plans. While 69% of all DB plans have fewer than 2,500 active employees, the percentage is not quite half (48%) for hybrid plans. Only 3% of all DB plans have at least 25,000 active participants versus 6% of hybrid plans.
From 1999 to 2007, total current assets in hybrid plans increased, but asset growth has been bumpy due to economic instability. Total assets in hybrid plans increased from $158.8 billion in 1999 to $631 billion in 2007. The average asset size of these hybrid plans has also grown, but even more erratically. On average, hybrid plans held assets of $328.8 million in 1999, which dipped to $317.5 million in 2003 and then rose to $492.4 million in 2007.
The portion of DB assets in hybrid plans increased into the early 2000s, but growth was flatter from 2003 to 2007. In 1999, assets in hybrid plans were 17% of assets in all DB plans. By 2003, this percentage had jumped to 32%, and by 2007, it had inched slightly higher to 34%.
Hybrid plans tend to have more assets than other DB plans. In their 2007 Form 5500 filings, 35% of hybrid plans reported having less than $100 million in assets, compared with 47% of all DB plans. Eighteen percent of hybrid plans reported having $1 billion or more in assets compared with 10% of all DB plans.
Participation. Hybrid plans vary in their participation requirements. More than one in five hybrid plans have no participation requirements, 24% require employees to be at least age 21 and have one year of service, and 23% require one year of service.
Pay credit formula. Of all hybrid plans, 72% use a graded pay scale schedule based on age, service or points (combination of age and service), as shown in Figure 3. Only 29% of CBPs and 15% of PEPs use a single credit rate for all participants. Significantly more PEPs than CBPs base the grading on age alone. Pay credits in CBPs average 3% to 9% annually, depending on the participant's age and/or service. PEPs provide final average pay credits that average 3% to 14% annually, depending on age and/or service. Overall, the PEPs in our study provide higher pay credits than CBPs to comparable employees. Although nothing inherent to either plan design requires this, the pattern holds throughout all the various breakdowns of the different plan formulas.
Figure 3: Pay credit formulas
|
|
Cash balance plans | Pension equity plans | All hybrid plans |
| Fixed percentage or fixed dollar contribution | 29% | 15% | 28% |
| Age graded | 14% | 38% | 17% |
| Service graded | 26% | 21% | 25% |
| Points graded | 28% | 26% | 27% |
| Other | 3% | 0% | 3% |
| 100% | 100% | 100% |
Source: Towers Watson, N=316 CBPs, 39 PEPs.
Interest crediting rates. Under the PPA, hybrid plan sponsors must use account balance interest crediting rates that do not exceed a market rate of return. And plan sponsors with certain graded pay credit schedules must use a minimum interest credit rate to avoid violating the prohibition on back-loading accruals.
The most popular interest crediting rate for hybrid plans is the 30-year Treasury yield,3 which is used by 40.5% of CBPs and 40% of PEPs (see Figure 4). Among CBPs, one-year Treasury (18.6%) and 10-year Treasury (8.5%) are the second and third most frequently used interest rates, respectively.
Figure 4: Prevalence of interest rates
|
|
CBP interest crediting rate %8 |
PEP post-termination rate |
All hybrid plans |
|
30-year Treasury1 |
40.5% |
40.0% |
40.5% |
|
1-year Treasury2 |
18.6% |
|
16.8% |
|
10-year Treasury3 |
8.5% |
|
7.7% |
| Fixed rate4 | 6.7% | 34.3% | 9.4% |
| 5-year Treasury | 5.8% | 5.2% | |
| Other Treasury5 | 5.2% | 4.7% | |
| Mixture of interest rates6 | 2.7% | 2.5% | |
| §417(e) (after 12/31/2007) | 2.4% | 25.7% | 4.7% |
| Consumer Price Index (CPI)7 | 2.4% | 2.2% | |
| Equity-based interest rate | 2.1% | 1.9% | |
| Corporate bond rate | 2.1% | 1.9% | |
| Determined annually by board/committee | 0.9% | 0.8% | |
| Highest notice 96-8 rate | 0.9% | 0.8% | |
| Code §430(h)(2)(C) | 0.6% | 0.6% | |
| Determined by participants | 0.3% | 0.3% | |
|
Total |
100.0% |
100.0% |
100.0% |
1Two CBPs add 1% to 30-year Treasury rate, and one CBP uses 90% of 30-year Treasury rate.
2Twenty-seven CBPs add between 0.5% and 1.5% to one-year Treasury rate.
3 One CBP adds 1% to 10-year Treasury rate.
4 Rates are between 3% and 8%.
5 Other Treasury rates include three-month Treasury, six-month Treasury, two-year Treasury, three-year Treasury and 20-year Treasury. Most of the CBPs using one of these rates also add additional basis points. The 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 six-month Treasuries or 30-year Treasuries or the average of five-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.
7One CBP adds an additional 2% to the CPI; two CBPs add an additional 3% to the CPI.
8Column total does not equal the sum of column entries due to rounding.
Source: Towers Watson.
The frequency with which interest is added to hybrid plan accounts varies. Fifty-eight percent of CBPs add interest annually, while 22% add interest monthly and 13% add interest quarterly. Only 4% of CBPs add interest daily.
Transition/conversion methods. Before the PPA was enacted, the most common transition method — used by 40% of CBPs — was establishing an opening account balance equal to the current lump-sum value of accrued benefits in the traditional DB plan and adding future credits to the account under the hybrid formula (see Figure 5).
The PPA requires the "A+B" method as a minimum, so after its enactment, the percentage of CBP sponsors using the A+B transition method jumped from 7% to 33%. Under the A+B method, the account balance is calculated as the sum of the prior plan benefit accrued up to the conversion date plus the hybrid plan benefit accrued after the effective date. Many companies grandfathered current participants in the prior plan, while employees hired after a specific date were enrolled in the new hybrid plan. The percentage of companies that grandfathered current employees and placed new hires into the hybrid plan jumped from 15% to 47% after the PPA was passed. In post-PPA years, 7% of plan sponsors allowed their employees to choose between plans.
Figure 5: Transition methods for cash balance plans
1Plan sponsors used several conversion methods for different groups in company.
Note: Due to rounding, some subtotals might not equal the sum of cells.
Source: Towers Watson.
As the name suggests, hybrids offer a mix of attributes from both DB and DC plans in terms of risk sharing, funding flexibility, cost control and lifetime income. The prevalence of hybrid plans varies widely among industries, and the plans differ from one employer to the next. In all variations, hybrid plans generally offer advantages over traditional DB plans and DC plans for both employees and sponsors.
The portable benefits in hybrid plans make the plans more attractive to employees who are less likely to work for a company until they retire. Hybrid plan participants avoid the risk and responsibility of investing their retirement funds themselves. In addition, many hybrid plans offer interest credits not available to employees otherwise — namely a return on long-term bonds, with the return reset each year to current levels, but with no risk of principal. Participants with a retirement account earning this type of return can thus "afford" more risk in their other retirement investments, such as 401(k) balances.
Plan costs and liabilities are more volatile in hybrid plans than in DC plans but less so than in traditional DB plans. Conversely, as there is a natural trade-off between cost and volatility, hybrid plans are somewhat more cost-efficient than DC plans (although somewhat less so than traditional DB plans). From a workforce management perspective, hybrid plans typically do not feature strong incentives to continue working or to retire at certain times as many traditional DB plans do, so turnover is likely to be more "natural" (and significantly, less influenced by the financial market cycles than DC plans alone). Some of the other employee advantages mentioned above, such as improved understanding and the ability to guarantee lifetime income, have benefits to the sponsor as well.
Plan costs and liabilities are more volatile in hybrid plans than in DC plans but less so than in traditional DB plans. Conversely, as there is a natural trade-off between cost and volatility, hybrid plans are somewhat more cost-efficient than DC plans (although somewhat less so than traditional DB plans). From a workforce management perspective, hybrid plans typically do not feature strong incentives to continue working or to retire at certain times as many traditional DB plans do, so turnover is likely to be more "natural" (and significantly, less influenced by the financial market cycles than DC plans alone). Some of the other employee advantages mentioned above, such as improved understanding and the ability to guarantee lifetime income, have benefits to the sponsor as well.
The report uses information from three data sources: the Form 5500 Series database and two Towers Watson data sets. Defined benefit plan sponsors use Form 5500 to report information about their retirement, health and welfare plans to the Department of Labor and IRS. Form 5500 data are publicly available through 2007. We consider all retirement plans in this data set identified as hybrid plans with at least 1,000 participants. The first Towers Watson data set tracks the changes in retirement plan sponsorship among the 2009 Fortune 100 from 1998 to 2009. The second Towers Watson data set holds information about provisions and conversion methods for 414 mostly large, active and inactive hybrid plans that was collected in summer 2009.
1Brendan McFarland and Mark J. Warshawsky, "Balances and Retirement Income From Individual Accounts: U.S. Historical Simulations," Benefits Quarterly, Volume 26, Number 2 (2010 Second Quarter), pp. 36-40.
2Some participants reported in the hybrid plans from the Form 5500 database may be grandfathered participants who are still covered by the prior traditional DB formula.
3The 30-year Treasury rate is used most often because it was prescribed under section 417(e) before the PPA changes and was generally the highest of the safe harbor rates permitted under IRS Notice 96-8.
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