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Which defined benefit hybrid plan should be adopted?

This question comes from a director of benefits at an organization that now sponsors a traditional defined benefit plan. The organization expects to increasingly be seeking mid-career hires to provide the core capabilities it needs. In order to align its defined benefit plan to attract these hires, the organization determined that the defined benefit plan should deliver the same benefit value as a percentage of pay for each year of service, regardless of whether the service is rendered at 25, 45 or 65. The current defined benefit plan provides greater value to longer-service employees.

The organization is reviewing its options, considering a pension equity plan or a cash balance plan. For a career employee with a typical earnings progression-which, for this organization, represents increases of 4% per year-either plan can be designed to provide the same benefit value as a percentage of pay for each year. The director of benefits is trying to decide which plan is better in light of the organization's other design objectives.

The plans are similar in one respect. Both define the benefit as a lump sum. For a cash balance plan, the lump sum benefit is the value in a hypothetical account balance that is similar to an account balance in a defined contribution plan.

Each year, the hypothetical account balance increases by an employer "contribution" to the hypothetical account, and by interest on the prior year's account balance. For example, a plan might provide a "contribution" to the hypothetical account of 5% of pay and credit interest based on the yield on 10-year Treasury securities.

For a PEP, the benefit is a lump sum calculated using a percentage of highest average earnings, typically a three- or five-year average. To figure the percentage, an employee is credited with percentage points for each year of service. At retirement, these percentage points are accumulated and multiplied by the highest average earnings to determine the lump sum benefit. The lump sum for a career employee might be 200% of the highest average earnings. For example, the lump sum in such a case would be $100,000 for an employee with highest average earnings of $50,000.

A key factor for a plan sponsor in choosing to adopt either a PEP or a cash balance plan is what happens when the employee's true salary progression does not match the salary assumption used in plan design. For employees who receive above-average increases-4% per year is average for this organization-a PEP will do a better job of delivering the same benefit as a percentage of pay per year of service.

For example, a fast-tracker-an employee who averages pay increases of 8% per year-will receive a lower benefit as a percentage of pay with a cash balance plan than with a PEP. And a slow-tracker-who averages pay increases of 2% per year-will receive a greater benefit as a percentage of pay with a cash balance plan than with a PEP. This means a PEP generally will be more effective in delivering benefits to executives, who typically are fast-trackers.

A PEP also has advantages in inflationary environments. Because a PEP bases benefits on highest earnings, it automatically adjusts benefits if inflation accelerates beyond current levels. With a cash balance plan, some inflation protection is provided through the interest credit, but additional benefits may be necessary through periodic benefit update.

Cash balance plans do have advantages over PEPs:

While both PEPs and cash balance plans are easier for an employee to understand than a traditional defined benefit plan, the cash balance plan is often more easily understood than a PEP. A cash balance plan operates much like a defined contribution plan; that similarity often makes it easier for employees to understand cash balance plans.

A cash balance plan can be designed to meet a non-discrimination safe harbor rule. In general, a defined benefit plan can provide highly compensated employees with greater benefits than non-highly compensated employees, but only within certain limits. The IRS will deem that a plan provides benefits within these limits if its benefit formula meets certain requirements known as a safe harbor.

Under Internal Revenue Service regulations, a cash balance plan can have a safe harbor design, but a PEP cannot. A safe harbor design can be beneficial in reducing the plan sponsor's administrative cost for complying with the non-discrimination requirements, and it can provide year-to-year certainty that the requirement will be met.

However, in practice, very few plan sponsors design cash balance plans to meet the safe harbor requirements, because some aspects of these requirements are at odds with a typical employer's plan design objectives. For example, the required approach for crediting interest to the hypothetical account balance may not meet the plan sponsor's objectives.

For a sponsor with an overfunded traditional pension plan, cash balance plans can be an intermediate step to a defined contribution plan. After the overfunding is exhausted by using it on employer "contributions" and interest credits, the cash balance plan can be terminated and replaced smoothly with a defined contribution plan.

In these circumstances, a PEP usually does not provide a smooth transition because employees expect that PEP points will be multiplied by their highest average earnings, which typically are at career end. These expectations are not met when a PEP plan is terminated in the middle of an employee's career, creating employee dissatisfaction and less than a smooth transition.

Ultimately, the choice of a PEP or cash balance plan depends on the sponsor's priorities. The unique advantages of the PEP and cash balance plan must be considered against what the sponsor values. And different sponsors will have different priorities, as evidenced by the adoption of both types of plans throughout the United States.