The ongoing long-term decline of traditional defined benefit pensions in the private sector could take a breather as advisers and employers take a closer look at various hybrid DB plan designs. That is most likely to be the case among smaller employers whose owners do not look at a DB plan exclusively from the perspective of maximizing their personal tax-deferred retirement savings opportunities, but also focus their employees’ ultimate financial capacity to retire at reasonable age.
Hybrid designs provide a more balanced sharing of risk between employers and participants. They are sometimes adopted by employers to replace their original standard DB plan, finding it unsustainable. In other cases they may simply start from scratch.
“You’re seeing a lot of new plans in the small market, because some of these newer designs where you can vary the crediting rate based on the investment return plan on assets” has appeal, notes Kent A. Mason, a partner and ERISA attorney with the Davis & Hartman firm in Washington.
Adds Rich Hudson, a principal consulting actuary for Cheiron, an actuarial consulting based in McLean, Va.: “Since you can design a DB plan to accept a fixed contribution scheme like a DC plan and the plan will provide a pooling of mortality risk and provide participants with a lifetime annuity, it really seems like a win-win for everyone.”
Advisers will, of course, need to make that determination on a case-by-base basis with their clients. But the general pitch for hybrid designs is worth considering.
The original hybrid DB design, dating back several decades and initially embraced by a few pioneering large employers, was the cash balance plan. Those plans feature hypothetical participant “accounts” into which annual pay credits (e.g. 5% of pay) and interest credits (based on, for example, Treasury bond yields) are “deposited.” But the employer remains on the hook for the full cumulative amount of the interest credit, even if underlying investments don’t pan out based on the formula. At retirement, employees can either elect a life annuity based on the value of the account, or roll those funds into an IRA (with spousal consent).
The “APP” plan
A newer hybrid plan design, the variable, or adjustable pension plan (APP), works differently. Cheiron’s Hudson has been introducing the concept to a variety of clients. Some labor unions (including the Newspaper Guild in New York) have adopted the design. It is being considered by public employers as well as some small private employers, according to Hudson.
The APP creates a minimum (floor) pension benefit based on a conservative investment return assumption (e.g. 5%) that effectively eliminates, or at least substantially reduces, depending on the assumption used, the employer’s investment risk. This in turn enables a predictable flow of contributions to fund the benefit. That floor benefit can be defined either as flat monthly dollar benefit based on years of service (e.g. $50) or as a percentage of annual earnings, as in a standard DB formula.
The “adjustable” component is the benefit credits earned by participants to the extent the cumulative investment performance of the underlying fund exceeds the minimum rate established for the floor benefit. (That amount can be capped to allow the excess to create a surplus in the plan for possible use during a period of sustained underperformance relative to the minimum guaranteed crediting rate.)
The ultimate benefit combining the floor and adjustable components is fixed when employees retire or leave the company. The plan at that point can secure an annuity for the participant, or for larger companies, establish a dedicated bond portfolio to fund the benefit securely.
“Once people understand this, it is well accepted by many,” Hudson says. “I would not limit consideration based on plan size,” he adds.
A more detailed description of the APP design is available here.
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