Hybrid Retirement Plan Design

Hybrid plans offer a combination of defined benefit (DB) and defined contribution (DC) plan features and can be offered as a primary, optional, or supplemental plan.

(A) Hybrid Account-Balance Plans

The key difference between defined contribution plans and hybrid plans is that defined contribution plans establish an actual funded account for each participant, which contains employer and employee contributions and investment gains and losses, while hybrid plans establish accounting, or notional, accounts for each participant. The participant’s balance in a hybrid plan continues to grow throughout employment, and the benefit is defined by the current value of the account The most common hybrid account-balance plans are:

Cash balance plans. In a cash balance plan, the participant’s account is periodically credited with a pay credit— typically a set percentage of pay—and an investment credit, can be defined as a fixed rate, an external benchmark (often with a minimum or maximum), or the actual investment return of the plan’s assets or a portion of the plan’s assets. A cash balance plan is a DB plan in which employer contributions to fund the accounts are not necessarily equal to the sum of the pay credits. The employer invests the funds, retaining all investment income and bearing investment risk to the extent that investment credits are guaranteed. The plans generally provide participants the option of receiving their vested account balances as an annuity or as a lump sum. 

Pension equity plans. In a pension equity plan, the balance in the employee’s account equals a given percentage of the employee’s final average salary for each year of service. Some plans increase the percentage with additional years of service. Pension equity plans have flexible features that should be analyzed before a plan is selected. The plans generally provide participants the option of receiving their vested account balances as an annuity or as a lump sum.

(B) Plans with Hybrid Features

DB Plan with DC Features. Section 401(a) of the Internal Revenue Code allows public-sector plans to add a DC feature to a DB plan. There are different ways to set up a DB plan with DC features; sponsors can offera blended plan, or combination plan, or a it can establish a DB plan and a separate voluntary DC plan such as a 457, 403(b) or 401(k) plan (although this is not considered a traditional hybrid plan or feature).

DC Plan with DB Features. Some DC plans allow members to manage the risk of outliving their moneythrough the purchase of an annuity contract, or by transferring out of the DC plan into aDB plan where the employee can annuitize this transferred balance.

Separate best practices have been adopted for Defined Benefit Retirement Plans and Defined Contribution Plans, and they should be consulted accordingly. The fundamental goal of retirement plan design is to adequately meet the needs of employees, consistent with the plan sponsor’s available resources.

Governments consider many elements in a comprehensive retirement plan design, including:

• Provision of disability and survivor coverage in place.
• The advantages and disadvantages of lump sum payments, roll-over options, annuity purchase options, and periodic payment options.
• The potential use and liability of offering investment advice and financial education.
• A plan for effective communication and reporting to participants.
• Board governance policies and practices.
• Plan features that can provide tax diversification and flexibility as allowable (e.g., pre-tax and after tax contributions).

Once public plan sponsors develop a policy statement that will guide their plan design decisions, they need to decide upon the essential elements of the primary retirement vehicle.

Key plan design considerations.

• Whether the hybrid plan will be the primary income replacement vehicle or a supplement to a DB or DC plan.
• Whether the hybrid plan will replace an existing DB plan or DC plan, become part of a blended plan, or be offered as an alternative to all employees or to new employees at the time of hire. This will determine how the plan will be used: to reduce the employer’s cost through cost control features (e.g., the way investment risk is allocated between the employer and employee) and/or to enhance the employer’s ability to recruit and retain employees (i.e., older, younger, or more mobile employees).
• Whether the hybrid plan or feature under consideration achieves the employer’s stated purpose for changing, supplementing, or replacing the current plan.
• The desired amount of the benefits to be provided, or the intended income replacement level. This will depend, in part, on whether plan participants are covered by Social Security.
• Whether there are projected short- and long-term costs and/or savings as a result of changing the plan or feature, and if the the plan or feature will be sustainable over the long term. Evaluation of costs and/or savings should include not only direct pension costs but also an estimate of the impact on other benefits and total compensation costs. Also consider possible cost increases  from administering additional plans or more complex plan features.
• What employee groups will be eligible to participate. Determine whether eligible employees will be designated by the employer/plan sponsor or if eligibility will be negotiated with organized employee groups.
• The vesting requirements. Determine when and under what circumstance members become entitled to some form of benefit. Include a policy for refunding employee contributions, if any, to members who leave the plan, and the interest rate that will be credited on those contributions.
• Components of the benefit structure, including accrual pattern and annuitization rates for hybrid features.
• Other benefit options such as early retirement, joint and survivor options, and lump-sum withdrawals.
• Disability and survivor benefit provisions, whether addressed within the plan or through supplemental coverage outside of the plan, including integration with available Social Security benefits, if applicable.
• A determination as to whether the plan should include purchase of service provisions such as prior military or other government service.

Funding policy considerations. [1]

• The key components that determine plan costs; these are determined through actuarial analysis.
• Manageable funding mechanisms for meeting the desired benefit levels. Determine the cost-sharing strategy between the employer and employees, specifically if employee contributions will be participatory.
• Investment returns on the fund’s assets. Design a comprehensive investment program to meet the desired level of return investment determined by the plan sponsors. The board of trustees should adopt an investment policy that contains the elements set forth in the GFOA Best Practice, Investment Fee Guidelines for External Management of Defined Benefit Plans.
• An actuarial valuation on all benefit enhancements, done before enhancements can be approved. This ensures a complete understanding of long-term financial impacts. Then, a plan should be adopted to fund the changes.

Board governance considerations.

Trustees and staff have a fiduciary duty to administer the plan for the exclusive benefit of plan members (duty of loyalty) and must act in accordance with reasonable standards of prudence. For more information, see the GFOA Best Practice, Governance of Public Employee Postretirement Benefits Systems.

Plan conversion considerations

Seek competent professional advice and legal assistance. Consider whether the hybrid plan or plan feature complies with the Pension Protection Act of 2006, paying particular attention to age discrimination issues. Also review disability and survivor benefits that had been provided in a defined benefit plan; these may require external arrangements in a hybrid plan.

Participant education considerations

Develop participant education programs that give employees a better understanding of the benefits available from their retirement system. This includes the following:

• Provide a summary plan description about plan benefits to participants as a written document. For more information on this topic, see the GFOA Best Practice, Preparing an Effective Summary Plan Description.
• Emphasize the purpose and goals of retirement planning, including the possibility of integrating the employer’s hybrid plan with other potential retirement income sources such as defined contribution savings plans, personal savings, and Social Security.
• Discuss retiree health-care options and health insurance costs, including Medicare.
• Provide employees with tools such as worksheet templates on estimating retirement benefits.
• Communicate benefits using a variety of communication methods and formats, and explain important information in understandable terms.

Notes: 

1. For additional recommendations on investment and allocation policies, consult the GFOA Best Practice on Asset Allocation for Defined Benefit Plans and Investment Policies for Defined Benefit Plans.
   
   For an in-depth discussion of investment risks, see “Public Pension Systems: Statement of Key Investment Risks and Common Practices to Address Those Risks,” Association of Public Pension Fund Auditors (APPFA), July 2000. For an in-depth discussion of operational risks, see “Public Pension Systems: Operational Risks of Defined Benefit  Plans and  Related Plans and Controls to Mitigate those Risks,” APPFA, July 2003.