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Hybrid Pension Plans: A Comprehensive Look at Their History, Economics and Features

By Tomeka Hill, Gaobo Pang and Mark Warshawsky

November 2010

Section 1: IntroductionAmong employers in the private sector, the shift away from traditional defined benefit (DB) plans is well-documented. While there are many contributing factors, surveys identify employers’ desire to reduce their exposure to risks, such as cost volatility and long liability durations, as paramount. Other motivations include enhancing employee understanding and appreciation of benefits and providing more age-neutral benefit accruals.

Some companies have turned to defined contribution (DC) plans, but others have sought out alternative DB plans like hybrid plans. These plans share some design features with DC plans, such as accommodating worker mobility. But hybrid plans allocate the risks between sponsor and workers more evenly than either traditional DB plans at one end of the spectrum or 401(k) plans at the other. Hybrid plans also offer desirable DB attributes, such as funding flexibility and complete investment control for sponsors and lifetime income options for participants.

To provide a better understanding of the flexibility and other features of hybrid plans, their implications for both participants and employers, and how hybrid plan sponsors are navigating the current legal and regulatory environment, Towers Watson has compiled this new comprehensive report. We focus on the most common types of hybrid plans — cash balance plans (CBPs) and pension equity plans (PEPs).

The report is divided into six sections. Section 2 describes hybrid plans, discusses the legal controversy and regulatory uncertainty of the last 20 years, and identifies the positive economic motivations for offering hybrid plans. The 2006 Pension Protection Act (PPA) essentially legitimized hybrid plans but imposed new requirements as well. Due to delays in regulatory guidance, however, many plan sponsors have been holding off on bringing

their current hybrid plans into compliance. Moreover, the lack of regulatory clarity appears to have changed some sponsors’ minds about converting their traditional pension plans to hybrid plans. A few other employers, however, have gone ahead with conversions.

Section 3 discusses trends in hybrid plan sponsorship, participation and assets. The report uses information from three data sources: the Form 5500 Series database and two Towers Watson data sets. Plan sponsors use Form 5500 to report information about their retirement, health and welfare plans to the U.S. Department of Labor (DOL) and Internal Revenue Service (IRS). 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, which was collected in summer 2009.

Section 4 discusses in detail the current provisions of hybrid plans, using the third data source mentioned above. We report participation and benefit accrual start dates, definitions of pensionable earnings, pay credits, formula types, interest crediting rates and transition methods. A simple simulation using hybrid plan formulas illustrates how hybrid plan account balances grow over the careers of typical employees.

Section 5 summarizes the results from a stochastic model comparing total cost and cost volatility, projected forward 40 years, for three benefit-equivalent plans: a traditional DB plan, a DC plan and a CBP. We then compare three total retirement packages: a CBP with a supplemental DC plan, a final-average-pay DB plan with a supplemental DC plan and a DC plan as the primary retirement plan. The analysis, which is done on a conservative return basis, shows the cost and volatility advantages of hybrid plans compared with traditional DB plans and DC plans.

Section 6 presents some concluding remarks for this study.

2 towerswatson.com/research/insider

The authors thank Mike Pollack, Russ Hall, Maria Sarli, Alan Glickstein, Monica Martin, Bridget Baumstark, Kyle Brown and Cindy Lyons for their assistance and helpful comments. They also thank Jonathan Zackey for his excellent research assistance.

Hybrid Pension Plans: A Comprehensive Look at Their History, Economics and Features 3

Section 2: History and Economic Motivations for Hybrid Plans1

Defining Hybrid Plans

A hybrid plan is an employer-sponsored retirement plan that combines aspects of DB and DC designs. The most common hybrid designs are cash balance and to a lesser extent pension equity benefit formulas.2 CBPs and PEPs are legally classified as DB plans. They accrue benefits to workers under a defined fixed formula, like a traditional DB plan, but the benefit is defined as a lump-sum account balance rather than an annuity-style monthly benefit. Most CBPs and PEPs are converted from traditional DB pension plans, although a few are new plans.

In a CBP, a percentage of pay (i.e., a pay credit) is periodically allocated to the worker’s account, along with periodic interest credits based on an employer-selected interest crediting rate (variable, fixed or some combination).3 This is similar to the way a DC plan operates, but in a DC plan, the return is the actual investment earnings on individual account assets, which are generally selected by the participant. In a CBP, the account grows at a rate specified in the plan document, regardless of the plan’s actual investment earnings.

Some CBPs provide the same pay credit (as a percentage of pay) over all ages and durations of service, but most have graded schedules that provide higher pay credits to participants who have longer service and/or are older. The benefit is primarily communicated as a lump sum, which is easily understood by participants and reflects common 401(k) plan practice. Despite their DC-like features, as DB plans, CBPs must make an annuity payout the default distribution option (although most participants select lump sums). These plans are subject to federal funding and accrual rules for single-employer DB plans and are covered by Pension Benefit Guaranty Corporation (PBGC) insurance.

In a PEP, 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 (FAP). If a

participant terminates employment before retiring, one of various approaches might be taken. The departing participant might be able to take the account balance with him or her as a lump sum. The plan sponsor could convert the account into a future annuity. Or, the plan sponsor might keep the account in the plan, where it would continue being credited with interest at a plan-specified rate (to be paid as a lump sum or annuity at a future date). Like in CBPs, the percentage credits can either be uniform over workers’ ages and service or, more commonly, based on age and/or service.

CBPs can be viewed as career-average-pay plans that accrue present values more evenly over a career, while PEPs can be considered final-average-pay CBPs.4 Thus, a retirement benefit under a PEP will typically be more in line with the worker’s wages at retirement than a benefit under a CBP. Cash balance benefits are influenced by both interest credits and the rate of wage increases. If the rate of wage increases exceeds the rate of interest credits over a career, a PEP delivers a higher benefit than a CBP for the same level of pay credits, and vice versa (assuming the pay credits are the same for the plans).

History of Legal Controversy and Regulatory Uncertainty

Bank of America is widely considered to have adopted the first CBP in the mid 1980s, and, for a while, increasing numbers of large companies adopted CBPs and PEPs. But, starting in the late 1990s, conversions of traditional DB plans to hybrid plans generated controversy, reaching the highest levels of the federal government. Adversaries claimed employers were adopting hybrid plans to reduce costs. They charged that the conversions discriminated against older workers and contravened federal requirements in the calculation of lump-sum benefits. The transition methods used in some conversions — referred to as “wear-away” — were accused of violating law and policy. More recently, in both the courts and the legislature, most of these

1 This section is largely based on Chapter 12 of Dan McGill, Kyle Brown, John Haley, Sylvester Schieber and Mark Warshawsky, Fundamentals of Private Pensions, Ninth Edition, Oxford University Press, 2010.

2 Less common (although not necessarily statutory) hybrid plans include stable value plans, whose formulas define the benefit account as payable at normal retirement age based on accumulation of pay-related credits; floor offset plans, which coordinate benefits between DB and DC plans; and target-benefit plans, which are DC plans that provide allocations to participants to fund a target defined benefit.

3 Occasionally, an equity-based index is used to adjust the future value of the allocation.

4 Fundamentals, op.cit., pp. 382-4, produces a proof of this view.

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charges have been dismissed or resolved (although the outcomes have varied with individual circumstances). The regulations issued on October 18, 2010, implementing PPA provisions should clarify key legal requirements and resolve regulatory ambiguities, thus possibly encouraging more employers to adopt hybrid plans.

Careful empirical analyses indeed found that, when viewed in isolation, converting to a hybrid plan often did reduce employers’ costs. However, many employers made other changes to their rewards programs concurrently, such as shifting the mix of rewards from one program to another. When the analyses also looked at employers’ concomitant higher contributions to DC plans, many employers were contributing the same — or even higher — amounts to retirement benefits. And for the minority that reduced their overall cost, the savings were relatively modest.5

The age discrimination claim was more complex, involving subtle issues of legal language and interpretation. It is clear, as a matter of law, that retirement plans may not discontinue or reduce the rate of benefit accrual because of a participant’s age. For CBPs, however, resolution turned on whether the applicable standard applied with respect to the pay credits or the projected annuity at normal retirement age produced by those credits as adjusted with interest. Opponents of CBPs argued for the latter, claiming these plans were inherently age discriminatory because older workers have less time to accumulate interest credits. Initial court decisions in the 2000s were split, but all the circuit courts ultimately rejected the claim of inherent age discrimination.

In the PPA, Congress declared that, after June 25, 2005, CBPs and PEPs that satisfied certain safe-harbor requirements would not be viewed as inherently age discriminatory. The PPA gave a safe harbor from age discrimination claims to all DB plans that have accumulated benefits for each participant that are no less than the accumulated benefit for any similarly situated (in every characteristic except age) younger individual, and excluding consideration of early retirement benefits.

Benefits could be defined as an annuity or as an individual account for purposes of this comparison. Special rules also provide immunity from charges of age discrimination to plans that calculate benefits for older participants as either the “greater of” or “sum of” the formulas from the traditional DB plan and the hybrid plan.

In determining the present value of any accrued DB benefit and the amount of certain distributions, including lump sums, the law mandates interest and mortality rates to be used in calculating a minimum amount, even if the benefit is communicated as a lump sum. To meet these requirements, most courts (and at times the IRS) have held that CBPs must project the notional account balance forward to the plan’s normal retirement age using the plan’s interest-crediting rate and then discount it back using the lump-sum rates specified in the law. If the interest-crediting rate is higher than the required lump-sum rate, the minimum benefit payable typically will be higher than the CBP account balance. This is called the “whipsaw” calculation, which the PPA prospectively eliminated.

Probably the most controversial aspect of hybrid plan conversions involved wear-away, particularly the effective loss of subsidized early retirement benefits. Wear-away can occur any time a plan amendment reduces future benefits. While accrued benefits are protected under law, a new benefit program can stop benefit accruals for some employees while benefits under the new formula “catch up” to the benefit accrued under the old formula. Wear-away in other contexts has been recognized and accepted by various IRS regulations.6 Critics, however, seized upon this occasional occurrence in hybrid plan conversions and claimed it impermissibly discriminated against older workers.

To address the wear-away issue, many plan sponsors adopted a variety of transition approaches for older workers and/or longer-service employees. Some employers provided transitional benefits to their older and/or longer-service employees to minimize or avoid the loss of future pension benefits. Some plan sponsors grandfathered workers who were relatively close to retirement eligibility under the old formula, while others converted everyone to the hybrid formula but gave older and/or longer-service workers a supplemental balance. Still others allowed employees to choose between the old and new formulas. The IRS itself has issued contradictory regulations on wear-away over the years.

5 See, for example, Watson Wyatt Worldwide, “The Unfolding of a Predictable Surprise: A Comprehensive Analysis of the Shift From Traditional Pensions to Hybrid Plans,” 2000.

6 Fundamentals, op. cit., pp. 391-2.

“… but all the circuit courts ultimately rejected the claim of inherent age discrimination.”


The PPA resolved the wear-away issue, prospectively, by mandating that employers use an “A+B” conversion method. Using this approach, the plan maintains the prior DB benefit (A) accrued through the date of the conversion and begins accruing the new hybrid benefit (B) after the conversion date. While the sponsor may choose to communicate the A benefit as an equivalent opening balance as of the plan conversion date, at retirement the plan must pay the larger of A or B, where A is calculated on the participant’s annuity starting date under the old plan formula using interest and mortality rates specified in the law. So the PPA prohibits wear-away for hybrid conversions adopted and effective after June 29, 2005. Interestingly, the PPA did not prohibit wear-away for other types of plan changes.

Under the PPA, hybrid plans must have a shorter vesting period than traditional DB plans, and a hybrid plan’s interest-crediting rate may not exceed a to-be-defined market rate of interest. The broad policy logic behind the interest rate restrictions is that high, non-market rates would constitute age discrimination, because these higher rates would be more advantageous to younger workers than to older ones. These requirements have led to competing policy interests, however, because sometimes the purpose of using high fixed rates in hybrid plans was to avoid violating the accrual rules under the Employee Retirement Income Security Act (ERISA), which limit the back-loading of benefits, even though back-loading based on age favors older workers.

Economic Motivations

The most common motivating factor in conversions to hybrid plans is reducing the volatility of plan contributions. Volatility risk is much lower in hybrid plans than in traditional pension plans, as we will show below.The financial accounting also tends to be less volatile in hybrid plans than in traditional DB plans, because the measurements are typically less sensitive to interest rates and pay fluctuations.7

Another factor behind hybrid conversions was employers’ realization that changing workforce demographics would necessitate longer careers. Moreover, companies wanted to attract younger workers and more women, particularly in the late 1990s when labor markets tightened. This, in turn, drove demand for individual account plans that

accrue benefits more evenly over the worker’s career, as younger workers and women are less likely than older men to remain with one employer over their entire careers. Commitment to an employer (as well as the longevity of the employer itself) has weakened among all workers over time, as reflected in higher turnover rates. Thus, traditional final-average-pay pension plans, which concentrate benefit accruals toward the end of the career, are attractive to fewer workers these days. Today’s workers value a portable retirement benefit that accrues benefits more evenly over years of service and is easy to understand, as evidenced by the popularity of 401(k) plans.

So the choice facing many employers was — and is — whether to maintain their current DB plan, convert the traditional pension plan to a hybrid plan, or freeze the traditional plan and make the supplementary DC plan the only retirement plan, with or without enhancements.

In the late 1990s, many plan sponsors were enjoying pension surpluses, and some decided a hybrid approach might be less costly, as continuing the DB plan with the hybrid plan formula offered them the option of gradually funding the hybrid with the extra plan assets from the traditional pension for a few years.8 Indeed, according to one empirical study, plans that were converted to hybrid plans were less likely to be underfunded and more likely to have funding levels between 90% and 130% of their current liability than all DB plans.9 In the early 2000s, pension surpluses largely disappeared. After the 2001 recession, they were beginning to re-emerge, but the financial crisis of 2007 set plan funding back again. The first funded status decline occurred at around the same time the controversy around hybrid plans intensified, and the IRS declared a moratorium on determining the qualified status of hybrid plans. Since then, more employers have chosen to freeze their traditional plan and use the DC plan as the primary retirement plan. Many such employers concurrently enhanced the DC plan, for example, by adding a non-matching contribution, but some realized a net cost savings.10

For other employers, the inherent advantages of hybrid plans over DC plans still win out. In a hybrid plan, all eligible employees participate in the plan and receive credits to their account, in contrast to

7 The additional liability for future pay increases that may or may not be realized is not part of the accounting liability for CBPs.

8 The confiscatory tax on the reversion of excess pension assets prevented employers from terminating their DB plans and capturing the overfunding, while setting up a replacement DC plan.

9 Robert L. Clark and Sylvester J. Schieber, “The Transition to Hybrid Pension Plans in the United States: An Empirical Analysis,” in William G. Gale, John B. Shoven and Mark J. Warshawsky, editors, Private Pensions and Public Policy, Washington, D.C.: Brookings Institution, 2004.

10 See Watson Wyatt Worldwide, Retirement Plan Design: Past, Present and Future, 2008, and Employer Commitment to Retirement Plans in the United States, 2009.

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the prevalent form of 401(k) DC plan, in which employer credits are generally structured as a match activated by employee contributions. Hybrid plan sponsors are responsible for managing plan assets and being able to pay promised benefits. On the other hand, employees of DC plan sponsors must affirmatively decide to participate, select contribution rates and allocate their assets. In most cases, they can take loans or in-service distributions, which tend to dilute 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” regardless of future changes in interest rates.11 Thus, while the income replacement rates of CBPs

vary somewhat over cohorts of retiring workers owing to secular trends in interest rate levels, replacement rates from DC plans are much more volatile.

Finally, although benefits in hybrid plans are denominated as an account balance, hybrids are DB plans, so a variety of annuity payout options are available, on institutional terms, including a life annuity and a joint and survivor annuity. In annuities elected from hybrid plans, the longevity risk is shared among the participant group. That means that the savings from retirees dying earlier than predicted are available to pay benefits to retirees who outlive expectations. By contrast, most DC plans do not offer annuity payouts; thus, interested participants must purchase them in the commercial market, where terms are typically unfavorable, or manage the account post-retirement to provide a steady income stream. This can be especially difficult for those retirees who outlive the average life expectancy.

“… income replacement rates from DC plans are much more volatile.”

11 For an illustration, see Brendan McFarland and Mark Warshawsky, “Balances and Retirement Income From Individual Accounts: U.S. Historical Simulations,” Benefits Quarterly, Second Quarter, 2010, pp. 36–40.


Section 3: Trends in Hybrid Plan Sponsorship, Participation and Asset Size

12 Comparison and EBIC are similar benchmarking services originally managed by former Watson Wyatt and former Towers Perrin, respectively. (Now a new merged company Towers Watson exists.) The Comparison and EBIC databases hold benefit plan information for salaried employees from more than 1,000 employers representing a broad cross-section of industries, geographical locations and company sizes. There is relatively little overlap of employers in the two databases.

To better understand the growth of hybrid plan sponsorship, participation and asset size, we use three different data sets: the Form 5500 Series database and the two Towers Watson data sets. The Form 5500 Series, which is publicly available under ERISA’s disclosure requirements, is used by the DOL and IRS to gather information about employee retirement, health, and welfare plans. All organizations that sponsor an employee benefit plan subject to ERISA must file Form 5500 annually, so the aggregated filings reveal important information about national trends in participation, contributions, benefit disbursements and assets. In 1999, it became easier to identify hybrid plans in the Form 5500, so we use filings from 1999 to 2007, the latest year for which complete filings are available. We focus on hybrid plans with at least 1,000 total participants (including active participants, terminated vested participants, retirees and beneficiaries).

The first Towers Watson database tracks retirement plan trends for companies in the 2009 Fortune 100 and provides historical details of retirement plan sponsorship from 1998 to 2009.

Finally, we have compiled a second extensive Towers Watson database with detailed information on plan provisions and transition methods. The data are collected from several sources. We use our Comparison and Employee Benefit Information Center (EBIC) databases,12 which collect information on new salaried employees’ benefits. We also use information from 10-Ks, proxies and/or company websites for various companies that we knew had a hybrid plan. We also asked clients of Towers Watson for the most recently available plan documents and summary plan descriptions for their hybrid plans. In total, we identified and collected information on 414 hybrid plans sponsored by 400 plan sponsors. We believe the information collected in this database is representative of all hybrid plans currently and, moreover, can be used to help identify trends over the last 25 years.

Growth in Hybrid Plans

In 1999, only 11% of all DB plans with at least 1,000 total participants were identified as hybrid plans in the Form 5500 Series. The share had grown to 16% by 2003 and to 18% by 2007 (Figure 1). The percentages include active hybrid plans and hybrid plans that are either closed to new entrants or have frozen future accruals. The number of large hybrid plans peaked in 2005 (671), but the percentage has continued to increase as the number of large DB plans (the denominator in Figure 1) has declined over time.

Figure 1. Number and incidence of hybrid plans with at least 1,000 participants, 1999–2007

Plan yearTotal 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.

The number and prevalence of hybrid plans vary by industry. Manufacturing companies offer more hybrid plans than companies in other industries, but hybrid plans constitute only 15% of all DB plans in this group (Figures 2 and 3). One-third of all DB plans in the Energy, Utilities and Natural Resources industry are hybrid plans (Figure 3), and 25% of all DB plans in the Health Care and the Professional and Business Services industries are hybrid plans, according to 2007 Form 5500 data. Only 5% of DB plans in the Property and Construction industry are hybrid plans.

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To illustrate when companies adopted and sometimes closed and/or froze hybrid plans, we use the Towers Watson database with information on transition methods and provisions for 414 hybrid plans. Of these hybrid plans, 84% are active and 16% are inactive (i.e., closed to new entrants or benefits frozen). The first hybrid plan was adopted in the 1980s, but it was not until the mid-1990s that the number of hybrid plans surged (Figure 4). Roughly 72 percent of all hybrid plans were adopted between 1995 and 2003. Hybrid plan conversions fell off between 2004 and 2006 when their legal status came into question and the effects of the 2001–2003 recession were still rippling through the economy. Another 8% of hybrid plans were adopted in 2007 and 2008, perhaps due to temporarily improving economic conditions or the legal clarity conferred by the PPA.

Of closed and frozen hybrid plans, 71% became inactive in 2007 or later (Figure 4). Companies that decided to stop offering an active hybrid plan were most likely reacting to the economic recession that started in late 2007 and escalated in the fall of 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 (Figure 5). On average, inactive CBPs were active for 9.3 years, with the longest-lived CBP active for 23 years. Inactive PEPs were active for 7.6 years, on average, with the longest run being 13 years. Three plan sponsors converted their traditional DB plans to hybrid plans and simultaneously closed the plans to new employees.

Figure 2. Number of hybrid plans by industry, 2007

0 30 60 90 120 150

Energy/Utilities/Natural Resources

Health Care

Professional and Business Services

Communications/High Technology

Financial Services

Aerospace and Defense

Pharmaceuticals

Wholesale

Other

Retail

Manufacturing

Transportation and Transportation Equipment

Food Services and Beverages

Property and Construction1414

2323

2929

136136

99

5656

1414

77

99

9595

4646

3434

120120

6666


Figure 3. Hybrid plans as percentage of all DB plans by industry, 2007

0% 5% 10% 15% 20% 25% 30% 35%

Energy/Utilities/Natural Resources

Health Care

Professional and Business Services

Communications/High Technology

Financial Services

Aerospace and Defense

Pharmaceuticals

Wholesale

Other

Retail

Manufacturing

Transportation and Transportation Equipment

Food Services and Beverages

Property and Construction55

1111

1212

1515

1616

1616

1616

1616

1818

2121

2222

2525

2525

3333



Figure 4. Effective and inactive dates of hybrid plans (number of plans)

0

5

10

15

20

25

30

35

40

20102009200820072006200520042003200220012000199919981997199619951994199319921991199019891988198719861985

� Effective date � Inactive date

Source: Towers Watson.

To better understand the broader context of when companies made their retirement transitions, we look at the types of retirement plans sponsored by companies in the 2009 Fortune 100 list from 1998 to 2009 for new salaried workers. Most of these companies no longer offer traditional DB plans. Between 1998 and 2009, the number of Fortune 100 companies offering a traditional DB plan to new employees dropped from 69 to 20 (Figure 6). Over the same period, the number of Fortune 100 companies offering a hybrid plan to new employees increased from eight to 24. The number of these companies offering only a DC plan to new employees jumped from 23 to 56.

Figure 5. Inactive status breakdown by hybrid plan type

Cash balance plans

Pension equity plans Total

Closed 27% 50% 32%

Frozen 68% 50% 64%

Terminated (PBGC-controlled) 3% 0% 2%

Transferred funds to DC plan 3% 0% 2%

Total 100% 100% 100%

Note: Due to rounding, columns may not add to 100%. Source: Towers Watson.

Figure 6. Retirement plan sponsorship for 2009 Fortune 100 companies, 1998–2009

0

10

20

30

40

50

60

70

80

200920082007200620052004200320022001200019991998

� Traditional DB plan + DC plan � Hybrid plan + DC plan � DC plan only

69696363

2323

1414

6262

1515

2323

5757

2424

1919

5050

2525

2525

4545

3030

2525

4141

3030

2929

4040

3232

28283939

3535

2626

3030

4747

2323 2424

2525

5151

2020

2424

5656

2323

88


“Between 1998 and 2009, the number of Fortune 100 companies offering a hybrid plan to new employees increased from 8 to 24.”

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From 1998 to 2003, very few Fortune 100 sponsors of a traditional DB plan transitioned to offering only a DC plan (Figure 7). Between 2004 and 2006, however, several Fortune 100 companies moved to a DC-plan-only environment. None of these companies adopted a hybrid plan. Again, this is likely because of the legal ambiguity of hybrids at that time. From 2007 to 2009, there were new transitions from traditional DB plans to hybrid plans, but hybrid plans were also being closed and frozen.

Participants

From 1999 to 2007, the number of active participants in hybrid plans climbed from almost 1.9 million to 4.9 million (Figure 8), and the total number of participants increased from 3.2 million to 10.2 million.

Looking at the numbers of active and total participants in hybrid plans as percentages of active and total participants in all DB plans, respectively, the growth of hybrid plans has escalated over the past decade. From 1999 to 2007, 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%.

Figure 7. Year-to-year transitions in retirement plan sponsorship for 2009 Fortune 100 companies, 1998–2009

Transition from traditional DB plan+DC plan to hybrid plan+ DC plan

Transition from traditional DB plan+DC plan to DC plan only

Transition from hybrid plan+DC plan to DC plan only

Continue traditional DB plan+DC plan

Continue hybrid plan+DC plan

Continue DC plan only

1998 to 1999 6 – – 63 8 23

1999 to 2000 1 – – 62 14 23

2000 to 2001 4 1 – 57 15 23

2001 to 2002 6 1 – 50 19 24

2002 to 2003 5 – – 45 25 25

2003 to 2004 – 4 – 41 30 25

2004 to 2005 – 1 2 40 28 29

2005 to 2006 – 5 2 35 26 32

2006 to 2007 1 4 4 30 22 39

2007 to 2008 3 3 1 24 22 47

2008 to 2009 3 1 4 20 21 51


Figure 8. Active and total participants in hybrid plans with at least 1,000 participants, 1999–2007

Active participants

Active hybrid participants as percentage of all active participants in all DB plans

Total participants

Total hybrid participants as percentage of all total participants in all DB plans

1999 1,856,376 15% 3,220,481 14%

2000 2,859,795 18% 5,102,485 16%

2001 3,336,540 20% 6,093,059 18%

2002 3,606,187 21% 6,735,091 20%

2003 4,920,408 26% 9,366,134 25%

2004 4,811,410 27% 9,453,089 25%

2005 5,118,274 29% 10,028,491 27%

2006 4,640,914 29% 9,578,742 27%

2007 4,901,970 31% 10,179,252 29%



It is important to note that many inactive participants in hybrid plans never received a hybrid benefit because they left employment before the conversion or they were grandfathered into the prior plan. Because of the prevalence of lump sums, hybrid plans tend to create fewer inactive participants than traditional plans.

Hybrid plans are larger in terms of participants compared with all DB plans. Almost half (48%) of hybrid plans have fewer than 2,500 active participants (Figure 9), according to the 2007 Form 5500 filings. However, 69% of all DB plans have fewer than 2,500 active employees. Six percent of hybrid plans have at least 25,000 active participants compared with 3% of all DB plans. As for total participants, 27% of hybrid plans have 1,000–2,499 participants, while 45% of all DB plans have 1,000–2,499 participants (Figure 10). Fourteen percent of hybrid plans have at least 25,000 participants compared with 8% of all DB plans.

Assets

From 1999 to 2007, total current assets reported on Form 5500s 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 (Figure 11). 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%.

Overall, 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 (Figure 12). Eighteen percent of hybrid plans reported having $1 billion or more in assets compared with 10% of all DB plans.

Figure 9. Hybrid plans and all DB plans with at least 1,000 participants by active participant sizes, 2007

Hybrid plan sponsors by active participation size

DB plan sponsors by active participation size

Less than 1,000 19% 40%

1,000–2,499 29% 29%

2,500–4,999 20% 13%

5,000–9,999 15% 8%

10,000–24,999 11% 6%

25,000 or more 6% 3%

Total 100% 100%

Note: Due to rounding, columns may not add to 100%. Source: Towers Watson, based on Form 5500.

Figure 10. Hybrid plans and all DB plans with at least 1,000 participants by total participant sizes, 2007

Hybrid plan sponsors by total participation size

DB plan sponsors by total participation size

Less than 1,000 0% 0%

1,000–2,499 27% 45%

2,500–4,999 23% 23%

5,000–9,999 18% 15%

10,000–24,999 18% 10%

25,000 or more 14% 8%

Total 100% 100%


Figure 11. Assets in hybrid plans with at least 1,000 participants, 1999–2007

Total assets Average assets

Total assets as percentage of all current assets in all DB plans

1999 $158.8 billion $328.8 million 17%

2000 304.7 billion 356.8 million 21%

2001 320.8 billion 351.3 million 22%

2002 345.4 billion 349.3 million 26%

2003 426.6 billion 317.5 million 32%

2004 501.4 billion 372.3 million 32%

2005 534.1 billion 420.7 million 31%

2006 545.4 billion 441.1 million 32%

2007 631.0 billion 492.4 million 34%


Figure 12. Hybrid plans and all DB plans with at least 1,000 participants by asset size, 2007

Current assetsPercentage of hybrid plans

Percentage of all DB plans

Less than $10 million 2% 2%

$10 million-$99.9 million 33% 45%




$1 billion or more 18% 10%

Total 100% 100%


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Section 4: Plan ProvisionsTo further our understanding of the current status of hybrid plans, what they offer and who is eligible to participate, we look again to the Towers Watson database with detailed information about plan provisions and transition methods. As noted earlier, this database has information from company-provided plan documents, the Comparison and EBIC databases and data from 10-Ks, proxies and corporate web pages. We collected information on 414 hybrid plans sponsored by 400 plan sponsors. The data set includes 366 CBPs and 48 PEPs. Because of the variety of data sources, not all information is available for every hybrid plan.

Participation Rules

Hybrid plan sponsors have a variety of participation requirements for new employees. Although more than one in five hybrid plans have no requirements,

24% require employees to be at least age 21 and have one year of service, and 23% have no age requirement but require one year of service (Figure 13).

Twenty-four percent of CBPs require participants to be at least 21 and have one year of service, and 22% of CBPs have no eligibility requirements. Twenty-seven percent of PEPs require participants to be at least 21 and have one year of service, while 16% of PEPs have no participation requirements.

When Benefit Accruals Begin

Workers get accruals of pay credits as of their date of hire (Figure 14) in 71% of hybrid plans. In the remaining 29% of plans, employees start earning benefits after meeting the participation rules shown in Figure 13. In other words, for most plans, even those with age and/or service requirements to participate, benefit accruals are granted retroactively to the date of hire, after employees meet these participation requirements. Sixty-eight percent of CBPs and 94% of PEPs give accruals as of the date of hire.

Figure 13. Participation rules

Cash balance plans

Pension equity plans All hybrid plans

Immediate (no age or service requirement) 22% 16% 21%

Any age/6 months of service 1% 3% 1%

Any age/1 year of service1 23% 19% 23%

Any age/other service requirement 10% 14% 10%

Age 18 6% 3% 6%

Age 21/immediate service 4% 3% 4%

Age 21/1 year of service1 24% 27% 24%

Age 21/other service requirement 4% 3% 4%

Other age/service requirement 6% 14% 7%

Total 100% 100% 100%11 year of service and/or 1,000 hours of service.Note: Due to rounding, columns may not add to 100%.Source: Towers Watson.

Figure 14. Date benefit accruals are made as of:

Cash balance plans


Date of hire 68% 94% 71%

Date of participation 32% 6% 29%

Total 100% 100% 100%


“Hybrid plan sponsors have a variety of participation requirements for new employees.”


Pensionable Earnings

Sixty percent of all hybrid plan sponsors in the database include bonuses, overtime pay and commissions along with base salary as pensionable earnings when calculating the hybrid plan benefit (Figure 15). Twenty-six percent of PEPs and 18% of CBPs use base salaries only. CBPs are more likely than PEPs to use base pay plus bonuses when determining benefits, whereas PEPs are more likely than CBPs to use base pay plus overtime and commissions.

Pay Credit Schedules

Of all hybrid plans, 72% use a graded pay credit schedule based on age, service or points (combination of age and service). Only 29% of CBPs and 15% of PEPs use a single credit rate for all participants. For the rest of all hybrid plans, age-, service-, and especially points-graded pay credit schedules are used. Significantly more PEPs than CBPs base the grading on age alone (Figure 16).

Pay Credit Averages

Overall, the PEPs in our database 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 plan data shown below. The differences could reflect a stronger desire among PEP sponsors to more closely replicate the benefit accrual pattern of the final-average-pay plan being replaced. Below we explore patterns of pay credit averages for plans with each type of grading approach. Observations might indicate real differences in design approaches, but the sample sizes are sometimes too small to support broad conclusions.

The database includes both non-integrated and integrated plans. Non-integrated plans do not consider Social Security benefits at all. Integrated hybrid plans explicitly adjust their benefit structure to compensate for the employer’s contribution to Social Security. The objective in offering integrated plans is for all employees across all salary levels to receive roughly the same percentage of total retirement income from the employer’s retirement plan and Social Security combined. In integrated hybrid plans, the plan is typically designed using the excess rate method, in which the accrual rate is lower for earnings below the Social Security taxable maximum (or some other defined salary maximum) than above it.

Non-Integrated Hybrid PlansNon-integrated hybrid plans with an age-based formula typically increase pay credit percentages every five to 10 years (Figure 17). A typical participant younger than 25 receives a pay credit of 2.8% in a CBP and a pay credit of 4.2% in a PEP. A typical participant 60 or older receives a pay credit of 8.2% in a CBP and a pay credit of 12.3% in a PEP.

Non-integrated hybrid plans with a service-based formula typically increase pay credit percentages every five to 10 years. On average, newly hired participants receive 3.2% in a CBP and 3.8% in a PEP.

Figure 15. Pensionable earnings

Cash balance plans

Pension equity plans

All hybrid plans

Base pay only 18% 26% 20%

Base pay plus bonus 10% 3% 9%

Base pay plus overtime and commissions

10% 19% 12%

Base pay plus bonus, overtime and commissions

61% 52% 60%

Total 100% 100% 100%


Figure 16. 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%

Total 100% 100% 100%


Figure 17: Average pay credit for non-integrated CBPs and PEPs with age-based formulas

Cash balance plans Pension equity plans

AgeAverage pay credit for plans not integrated

Average FAP credit for plans not integrated

< 25 2.8% 4.2%

25–29 2.9% 4.3%

30–34 3.5% 4.8%

35–39 4.1% 5.3%

40–44 5.0% 7.0%

45–49 6.0% 7.9%

50–54 7.1% 10.1%

55–59 7.9% 11.2%

60+ 8.2% 12.3%


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Those with 35 or more years of service receive, on average, 7.5% in a CBP and 10.6% in a PEP (Figure 18).

Non-integrated hybrid plans that use points typically use the sum of age and service as the basis. Some companies use a grid formula to determine pay credits, and one company uses the formula two times age plus service. For a typical participant with fewer than 25 points, pay credits average 3.3% in a CBP and 2.3% in a PEP (Figure 19). For a typical participant with at least 95 points, pay credits average 8.9% in a CBP and 14.7% in a PEP.

Seventy-one non-integrated CBPs in the Towers Watson database use a fixed-percentage formula and provide an average of 4.6% to all participants. Three PEPs offer a fixed percentage and provide an average of 7%. One plan sponsor of three PEPs adds a fixed-dollar amount to the accounts.

Integrated Hybrid PlansFor hybrid plans that are integrated with Social Security, we again calculate the average pay credits but separately for pay below the Social Security Wage Base (SSWB — $106,800 for 2010) and for pay above the SSWB by age.13 For CBPs that have age-based formulas and are integrated with the SSWB, the typical employee receives a benefit for pay below the SSWB that ranges from 3% for those under 25 years old to 7.9% for those age 60 or older (Figure 20). For CBPs, the benefit accrual for pay above the SSWB ranges from 5.7% for those under age 25 to 12.7% for those age 60 or older.

For PEPs that have age-based formulas and are integrated with the SSWB, the typical employee receives a benefit for pay below the SSWB that ranges from 2.9% for those under 25 years old to 14.7% for those age 60 or older. For PEPs, the FAP credit for pay above the SSWB ranges from 3.5% for those under age 25 to 18.8% for those 60 or older.

For CBPs that have service-based formulas and are integrated with the SSWB, the typical employee receives a benefit for pay below the SSWB that ranges from 2.8% for those newly hired to 6.6% for those with 35 years of service or more (Figure 21). For CBPs, the benefit accrual for pay above the SSWB ranges from 5.1% for those newly hired to 10.1% for those with 35 years of service or more. Because only two PEPs in the Towers Watson database are integrated with service-based formulas, pay credit averages for that plan type are not reported here.

For CBPs that have points-based formulas and are integrated with the SSWB, the typical employee receives a benefit for pay below the SSWB ranging from 3% for those with fewer than 25 points to 7.4% for those with 95 points or more (Figure 22). For CBPs, the benefit accrual for pay above the SSWB ranges from 5.5% for those with fewer than 25 points to 12% for those with 95 points or more. For PEPs that have points-based formulas and are integrated with the SSWB, the typical employee receives a benefit for pay below the SSWB that ranges from 4.3% for those with fewer than 25 points to 14.5% for those with 95 points or more.

Figure 18. Average pay credit for non-integrated CBPs and PEPs with service-based formulas


Service (in years)

Average pay credit for plans not integrated


< 1 3.2% 3.8%

1–4 3.8% 4.4%

5–9 4.7% 5.4%

10–14 5.6% 7.2%

15–19 6.3% 8.6%

20–24 7.0% 10.6%

25–29 7.4% 10.6%

30–34 7.6% 10.6%

35+ 7.5% 10.6%


Figure 19. Average pay credit for non-integrated CBPs and PEPs with age- and service-based formulas


Points (age and service)

Average pay credit for plans not integrated


< 25 3.3% 2.3%

25–29 3.3% 2.4%

30–34 3.6% 3.0%

35–39 3.8% 3.2%

40–44 4.3% 4.5%

45–49 4.6% 5.2%

50–54 5.2% 6.8%

55–59 5.5% 7.6%

60–64 6.2% 9.3%

65–69 6.6% 9.7%

70–74 7.5% 11.4%

75–79 7.9% 11.7%

80–84 8.6% 13.4%

85–89 8.7% 13.6%

90–94 8.9% 14.5%

95+ 8.9% 14.7%

Source: Towers Watson. 13 A small number of plans use a maximum pay level other than the SSWB.


Figure 20. Average pay credit for integrated CBPs and PEPs with age-based formulas


Age

Average pay credit for pay up to the SSWB for integrated plans

Average pay credit for pay in excess of the SSWB for integrated plans

Average FAP credit percentage for pay up to the SSWB for integrated plans

Average FAP credit percentage for pay in excess of the SSWB for integrated plans

< 25 3.0% 5.7% 2.9% 3.5%

25–29 3.1% 5.9% 3.0% 3.6%

30–34 3.7% 6.6% 3.8% 4.8%

35–39 4.0% 7.3% 4.9% 6.7%

40–44 5.1% 8.7% 6.7% 8.9%

45–49 5.6% 9.5% 8.5% 11.6%

50–54 6.6% 10.8% 10.5% 13.6%

55–59 7.4% 11.9% 12.7% 16.5%

60+ 7.9% 12.7% 14.7% 18.8%


Figure 21. Average pay credit for integrated CBPs and PEPs with service-based formulas


Service (in years)



Average FAP credit for pay up to the SSWB for integrated plans

Average FAP credit for pay in excess of the SSWB for integrated plans

< 1 2.8% 5.1% * *

1–4 3.4% 5.6% * *

5–9 4.0% 6.6% * *

10–14 4.8% 7.7% * *

15–19 5.4% 8.6% * *

20–24 6.3% 10.0% * *

25–29 6.7% 10.6% * *

30–34 6.8% 10.5% * *

35+ 6.6% 10.1% * *

*Because we have only 2 PEPs in this category, pay credit averages are not reported.Source: Towers Watson.

Figure 22. Average pay credit for integrated CBPs and PEPs with points-based formulas


Points (age and service)



Average FAP credit for pay up to the SSWB for integrated plans

Average FAP credit for pay in excess of the SSWB for integrated plans

< 25 3.0% 5.5% 4.3% 6.8%

25–29 3.0% 5.5% 4.3% 6.9%

30–34 3.0% 5.6% 4.6% 7.2%

35–39 3.6% 6.3% 4.7% 7.4%

40–44 3.8% 6.8% 5.4% 8.1%

45–49 4.1% 7.3% 5.6% 8.4%

50–54 4.5% 7.9% 6.9% 10.0%

55–59 4.9% 8.4% 7.6% 10.7%

60–64 5.2% 8.9% 9.1% 12.7%

65–69 6.1% 9.9% 9.7% 13.4%

70–74 6.2% 10.1% 11.3% 15.3%

75–79 6.5% 10.4% 12.0% 16.2%

80–84 7.1% 11.1% 13.3% 17.7%

85–89 7.2% 11.2% 13.7% 18.2%

90–94 7.4% 11.4% 14.5% 19.0%

95+ 7.4% 12.0% 14.5% 19.0%


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For PEPs, the benefit accrual for pay above the SSWB ranges from 6.8% for those with fewer than 25 points to 19% for those with 95 points or more.

Fourteen CBPs using a fixed-percentage formula integrated with the SSWB provide an average 5% pay credit for pay up to the SSWB and 8.8% for pay that exceeds the SSWB.

Account Balance Accumulations

To illustrate how hybrid plan benefits accrue over a participant’s career, we simulate account balances at all ages under different formula types separately for CBPs and PEPs. As there are more than 300 CBPs in our Towers Watson database, we assemble a sample of 25 CBPs with an age-based formula, 25 CBPs with a service-based formula, 25 CBPs with a points formula and 25 CBPs with a fixed-percentage formula to determine account balances. Of these 100 CBPs, 23 are integrated with Social Security.

Because our sample of PEPs is small, we use all the PEPs in the Towers Watson data set to calculate account balances — 14 with an age-based formula, seven with a service-based formula and 10 with a points formula.14 Of these PEPs, 10 are integrated with Social Security. We calculate averages of the annual account balances by hybrid plan type and formula type.

We look at the career paths of two hypothetical workers. The “average” employee starts work at age 35 and works for the firm for 30 years until age 65. His starting salary is $40,000, and he receives a 4% raise every year. The other worker is considered a “fast-track” employee. Her starting salary is $40,000 and she receives a 5% raise every year. However, in her 8th, 16th and 24th years, she receives 25% raises linked to promotions. The interest crediting rate is assumed to be the average rate over the 1979–2009 period for the index or yield specified in the plan formula, e.g., the yield on the 10-year Treasury bond.

We first focus on CBPs and the average worker (Figure 23). For this employee, the average cash balance benefit based on a fixed percentage is slightly higher earlier in the career compared with the average benefit under the other formulas. This is not surprising, as a level pay credit would logically start out higher but end lower than a graded credit. Toward the end of the employee’s career, the

14 One PEP has an age-based formula and another one has a points-based formula, where the formula details are not known. One plan sponsor offers three identical PEPs and contributes a fixed-dollar amount to the employees’ notional accounts. Three other plans have fixed-percentage formulas. Because only four unique plans are based on a fixed percentage or a fixed-dollar amount, there was insufficient information to calculate the average account balances for PEPs without a graded formula.

Figure 23. Simulated CBP account balances by formula type for average worker

0.0

0.5

1.0

1.5

2.0

2.5

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average account determined by a fixed percentage falls below the averages of the accounts with graded formulas.

In our sample, the age-graded formulas provide the biggest benefit toward the end of the average worker’s career. The service-graded formulas tend to lag the other graded formulas somewhat but still exceed the fixed formulas by the time of retirement. After 30 years of service, the average worker will have, on average, an account balance of 2.36 times final salary based on a points formula, 2.4 times final salary based on an age formula, 2.18 times final salary based on a service formula, and 1.98 times final salary based on a fixed-percentage formula. Bear in mind, however, that the lower benefits full-career employees receive under the average fixed-percentage formula do not necessarily equate to less expense for the plan sponsor. For example, for an employer with high turnover (so that more employees terminate at the lower age/service levels where the flat-percentage formula is more generous, and fewer become full-career employees), the average fixed-percentage formula could be the most costly.

We next focus on the fast-track worker (Figure 24). She greatly benefits later in her career from a CBP that is integrated with Social Security. She also benefits from graded formulas because her pay increases exceed the interest credits, resulting in more valuable accruals in her later years. The average account balances are relatively close across formula types until the fast-track employee reaches her 16th year of service (i.e., the second promotion in the model). At that point, account balances under the graded formulas start to overtake those under the fixed formula, with the points and age grading rising the fastest. The account balances under the fixed percentage increase slightly faster early in the fast-track worker’s career but much more slowly than the other formulas later in her career.

When the fast-track employee is promoted and receives her 25% raise, the account balance as a percentage of pay dips, because the raise does not affect the account balance. Thus, her salary is outpacing her CB account. After 30 years of service, her account balance is a lesser percentage of pay than the account of the average worker, whose raises were only 4%. Under a CBP, the fast-track worker will receive, on average, a final lump-sum benefit accrual of 1.68 times final salary based on a points formula, 1.66 times final salary based on an age formula, 1.48 times final salary based on a service formula and 1.29 times final salary based on a fixed-

Figure 24. Simulated CBP account balances by formula type for fast-track worker

� Age and service (points) � Age � Service � Fixed percentage

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0.4

0.6

0.8

1.0

1.2

1.4

1.6

1.8

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percentage formula. That fast-track employees fare worse than typical employees is an often-voiced criticism of CBPs from a design perspective.

We look again at the same two hypothetical workers, this time in PEPs with different formula types. As noted earlier, the hypothetical average worker has a starting salary of $40,000 and receives 4% annual raises. The fast-track worker also has a starting salary of $40,000. She receives regular annual raises of 5% and three 25% raises tied to promotions in her 8th, 16th and 24th year of service. Both hypothetical workers complete 30 years of service. We calculated benefit accruals for 31 PEPs — 10 using a points formula, 14 using an age-based formula and seven using a service-only formula.

The average worker receives the highest benefit from PEPs with age-based formulas (Figure 25). Benefits determined under PEPs with points formulas are lowest early in the worker’s career, but catch up to age-based formulas toward the end of the worker’s career. After 30 years, the hypothetical worker will receive, on average, a final lump-sum benefit that is 2.6 times final salary based on a points formula, 2.59 times final salary based on an age formula and 2.33 times final salary based on a service formula.

For benefit accruals for the fast-track worker under a PEP, relationships among the grading methods are similar to those for the average worker. The age-graded formulas provide higher average benefits, with the points-based formulas lagging early but catching up later, and the service-based formulas always lagging (Figure 26).

After 30 years of service, the fast-track worker will receive, on average, a final lump-sum benefit that is 2.56 times final salary based on a points formula, 2.55 times final salary based on an age formula and 2.29 times final salary based on a service formula. Note that these final lump-sum benefits as a multiple of final salary are quite comparable to those of the first hypothetical worker, illustrating that under a PEP — unlike under a CBP — benefits keep up with the growing salary of a fast-track worker.

Figure 25. Simulated PEP account balances by formula type for average worker

� Age and service (points) � Age � Service

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2.5

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Pay Credit Frequency

The frequency of pay credits varies among our sample plan sponsors (Figure 27). Of CBPs, 64% record pay credits annually, 23% provide them monthly and 8% provide them quarterly. Almost all PEPs — 95% — record FAP credit percentages annually. These results make sense because a PEP account is essentially predetermined at any point in time based on the accumulated credits and then-current final average pay, and any earned FAP credit percentages are recorded at termination during the year, so the frequency of pay credits for ongoing employees typically does not affect their ultimate benefits. This contrasts with CBPs, where more frequent credits typically result in slightly more interest credits being earned over the career.

Interest Rates

Among the most significant issues for hybrid plan sponsors is determining appropriate interest crediting rates for CBPs and post-termination interest crediting rates for PEPs that have them. As set out in the PPA, the IRS requires hybrid plan sponsors to choose interest rates that do not exceed a regulation-determined market rate of return. Also, plan sponsors with certain graded pay credit schedules must use a minimum interest credit rate to avoid violating the prohibition on back-loading accruals. Hybrid plans using graded scales generally must use a minimum interest credit if the pay credit percentage received in one year is more than 133 1/3% of the pay credit percentage received in any earlier year. Because hybrid sponsors have been waiting for IRS guidance on the issue, however, they have remained somewhat in limbo — especially those with fixed rates or a minimum rate.

Plan sponsors typically choose from one of several types of interest rates. Some choose a fixed interest rate, such as 4%. Others use a variable interest rate based on a bond yield, such as the yield on 30-year Treasury bonds for a specific month before the start of the year. Others use a mixture of several variable rates (e.g., the lesser of six-month Treasuries or 30-year Treasuries or the average of five-year and 10-year Treasuries), or what is called a combination rate, which is a variable rate used with a minimum and/or a maximum fixed rate (e.g., 10-year Treasury rate with a 5% minimum and 10% maximum).

Figure 26. Simulated PEP account balances by formula type for fast-track worker

� Age and service (points) � Age � Service

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Figure 27. Pay credit frequency

Cash balance plans


Annual 64% 95% 67%

Semiannual 1% 0% 1%

Monthly 23% 5% 21%

Quarterly 8% 0% 7%

Pay period 3% 0% 3%

Biweekly 0% 0% 0%

Weekly 0% 0% 0%

Total 100% 100% 100%


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Of CBPs, 63% use a variable interest rate with no defined minimum or maximum and 30% use a combination interest rate as their interest crediting rate. Of PEPs, one-half also use a variable interest rate with no defined minimum or maximum and 34% use a fixed interest rate as their post-termination rate (Figure 28).

Seventy percent of CBPs with fixed pay credit schedules use a variable interest rate with no maximum or minimum (Figure 29). This is not surprising as these plans need not worry about back-loading. More than half of CBPs with graded formulas, however, also use variable rates with no minimum or maximum. This is surprising, as these plans could require a minimum interest credit to demonstrate compliance with the anti-back-loading rules. It might be because they are using an implied rate rather than an explicitly declared one, or because the “slope” of the graded formula for plans without a minimum interest rate was determined not to violate the back-loading rules even at an assumed interest rate of zero. Combination rates are not used except for age-based formulas in PEPs, while fixed rates are used more frequently regardless of benefit formula (Figure 30).

In Figures 31 and 32, we invert the focus to the interest rate type by benefit formula. Of CBPs using combination interest rates, a plurality (30%) use a points-based formula to determine the benefit. Of CBPs using fixed and variable interest rates, pluralities (36% and 32%, respectively) use a fixed-percentage-based formula. Most PEPs with variable interest rates use age-based formulas to determine the benefit (35%). Of PEPs using fixed interest rates, 33% use service-based formulas and 33% use age-based formulas. All PEPs using combination rates employ an age-based formula.

The most popular interest rate for hybrid plans is the 30-year Treasury bond yield, which is used by 41% of CBPs and 40% of PEPs (Figure 33). Among CBPs, one-year Treasury (19%) and 10-year Treasury (9%) are the second and third most frequently used interest rates, respectively. Seven percent of CBPs use a fixed interest rate. For PEP post-termination rates, although the 30-year Treasury yield is used most often, 34% of PEPs use a fixed rate, and the rest use 417(e) rates — the interest rates used to determine the present value of accrued benefits and the amount of any distribution (including a single sum) other than an annuity (26%).15

Figure 28. Interest crediting rate

Cash balance plan interest crediting rate

Pension equity plan post-termination rate All hybrid plans

Variable 63% 51% 62%

Combination 30% 14% 29%

Fixed 7% 34% 9%

Total 100% 100% 100%


Figure 29. CBP formula type by interest rate type

Interest rate

Benefit formulaFixed rate only

Variable rate only

Combination rate Total

Fixed percentage 6% 70% 25% 100%

Service 5% 65% 29% 100%

Points 2% 63% 35% 100%

Age 5% 51% 44% 100%

Other 11% 44% 44% 100%


Figure 30. PEP formula type by interest rate type

Interest rate

Benefit formulaFixed rate only

Variable rate only

Combination rate Total

Service 40% 60% 0% 100%

Fixed-dollar rate 25% 75% 0% 100%

Age 18% 55% 27% 100%

Points 17% 83% 0% 100%


Figure 31. Interest rate type by CBP formula

Interest rate

Benefit formula Fixed rate only Variable rate only Combination rate

Fixed percentage 36% 32% 23%

Service 29% 27% 24%

Points 14% 28% 30%

Age 14% 11% 20%

Other 7% 2% 4%

Total 100% 100% 100%


Figure 32. Interest rate type by PEP formula

Interest rate

Benefit formula Fixed rate only Variable rate only Combination rate

Service 33% 18% 0%

Fixed dollar 17% 18% 0%

Age 33% 35% 100%

Points 17% 29% 0%

Total 100% 100% 100%


15 Prior to the PPA, the §417(e) rate was based on 30-year Treasury bonds (a monthly average rate). More specifically, for calendar-year plans, this applied for years prior to 2008. For 2012 and beyond, the rate is now defined as a 24-month average of the long-term corporate bond rates published by the IRS. The new rates will be phased in from 2009 to 2011. Sponsors also must make decisions about look-back months and other details. Some plan sponsors may have incorporated the §417(e) rate by reference in describing their cash balance interest crediting, so it is important to ensure what was actually intended, given the PPA changes.


Interest credits on the pay credits generally begin to accrue as soon as they are recorded. The frequency with which interest is added to hybrid plan accounts varies. Most hybrid plans — 59% — add interest annually (Figure 34). 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. Eighty-five percent of PEPs add interest to accounts of terminated participants annually, while 8% add interest monthly and 8% add interest quarterly. For CBPs, the frequency of interest crediting generally aligns with the frequency of pay credits shown in Figure 27, but there are some differences.

Figure 33. Prevalence of interest rates

CBP interest crediting rate

PEP post-termination rate All hybrid plans

30-year Treasury1 41% 40% 41%



Fixed rate4 7% 34% 9%

5-year Treasury 6% 0% 5%

Other Treasury5 5% 0% 5%

Mixture of interest rates6 3% 0% 3%

§417(e) (post 12/31/2007) 2% 26% 5%

CPI7 2% 0% 2%

Equity-based interest rate 2% 0% 2%

Corporate bond rate 2% 0% 2%

Determined annually by board/committee 1% 0% 1%

Highest Notice 96-8 rate 1% 0% 1%

Code §430(h)(2)( C) 1% 0% 1%

Determined by participants 1% 0% 0%

Total 100% 100% 100%1 Two CBPs add 1% to 30-year Treasury, one CBP uses 90% of 30-year Treasury rate.2 27 CBPs add between 0.5% and 1.5% to 1-year Treasury.3 One CBP adds 1% to 10-year Treasury.4 Rates are between 3% and 8%.5 “Other” Treasury rates include 3-month Treasury, 6-month Treasury, 2-year Treasury, 20-year Treasury and 3-year Treasury. Most of the CBPs using one of these rates also add additional basis points. The additional 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 6-month Treasuries or 30-year Treasuries or the average of 5-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.

7 One CBP adds an additional 2% to CPI; two CBPs add an additional 3% to CPI. Note: Due to rounding, columns may not add to 100%. Source: Towers Watson.

Figure 34. Frequency of adding interest

Cash balance plans


Annual 58% 85% 59%

Semiannual 1% 0% 1%

Monthly 22% 8% 21%

Quarterly 13% 8% 13%

Daily 4% 0% 3%

Pay period 1% 0% 1%

Biweekly 1% 0% 1%

Weekly 1% 0% 0%

Total 100% 100% 100%


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Transition Methods

Plan sponsors have always used a variety of methods to convert their traditional DB plans to hybrid plans, but in 2006, the passage of the PPA changed conversions dramatically. The most common method pre-PPA — used by 40% of CBPs and 26% of PEPs — 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 (Figures 35 and 36). None of the plan sponsors in our database used an opening account balance as a transition method post-PPA.

Some plan sponsors — 7% of CBP sponsors and 5% of PEPs — used the A+B method before the passage of the PPA. 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. The A+B method has become considerably more popular since 2006, as it is required as a minimum by the PPA. Based on the Towers Watson data, after the passage of PPA, 33% of CBP conversions employed the A+B method.

Before the PPA, some plan sponsors grandfathered certain employees in the prior benefit plan. In other words, these plan sponsors moved employees into the hybrid plan only after a certain future date or they used provisions based on age and/or service to determine whether an employee would be in the hybrid plan or the traditional DB plan. The grandfathering might have been for a temporary period, such as five or 10 years, or for the remainder of the grandfathered employees’ careers. Prior to the passage of the PPA, 21% of both CBPs and PEPs

Figure 35. Transition methods for cash balance plans

Pre-PPA Post-PPA Both periods

Opening account balance 40% 40% 0% 0% 35% 35%

A+B method (sum of frozen prior plan benefit and current hybrid plan benefit as of effective date)

7% 7% 33% 33% 10% 10%

Grandfathered employees remained in prior plan, employees hired after a specific date participated in hybrid plan

15%

21%

47%

53%

19%

25%Grandfathered employees remained in prior plan, employees not meeting requirements were given a choice and were transitioned into the hybrid plan if they chose it

6% 7% 6%

Grandfathered employees remained in prior plan, remaining employees moved to hybrid plan using A+B method

1% 0% 1%

Greater of prior plan benefit and current hybrid plan benefit once the employee leaves the company

8%

13%

0%

0%

7%

11%Greater of prior plan benefit and current hybrid plan benefit. Opening account balance was used to determine current benefit if hybrid plan provided greater benefit

5% 0% 4%

Employee choice, opening account balance was established for those that chose to participate in hybrid plan

7%

10%

7%

7%

7%

10%Employee choice, participants moved to hybrid as if the plan already existed

3% 0% 2%

Employee choice, if hybrid was chosen, then sum of frozen prior plan and current hybrid plan as of effective date was used to determine benefit (A+B)

1% 0% 1%

New plan 2% 2% 7% 7% 2% 2%

Combination1 7% 7% 0% 0% 6% 6%

Total 100% 100% 100% 100% 100% 100%1Plan sponsors used several conversion methods for different groups in company.Note: Due to rounding, some subtotals may not equal the sum of cells. Source: Towers Watson.


Figure 36. Transition methods for pension equity plans

Pre-PPA Post-PPA3 Both periods

Opening account balance 26% 26% 0% 0% 25% 25%

A+B method (sum of frozen prior plan benefit and current hybrid plan benefit as of effective date)

5% 5% 0% 0% 5% 5%

Grandfathered employees remained in prior plan, employees hired after a specific date participated in hybrid plan

5%

21%

0%

0%

10%

20%Grandfathered employees1 remained in prior plan, other employees moved to hybrid plan using opening account balance

5% 0% 5%

Grandfathered employees1 receive greater of the prior plan benefit or current hybrid plan benefit

11% 0% 5%

Greater of prior plan benefit and current hybrid plan benefit once the employee leaves the company

16%

16%

0%

0%

15%

15%Greater of prior plan benefit and current hybrid plan benefit. Opening account balance was used to determine current benefit if hybrid plan provided greater benefit

0% 0% 0%

Employee choice, opening account balance was established for those that chose to participate in hybrid plan

0%

21%

0%

100%

0%

25%Employee choice, participants moved to hybrid as if the plan already existed

16% 0% 15%

Employee choice, if hybrid was chosen, then sum of frozen prior plan and current hybrid plan as of effective date was used to determine benefit (A+B)

5% 100% 10%

New plan 0% 0% 0% 0% 0% 0%

Always hybrid plan 5% 5% 0% 0% 5% 5%

Combination2 5% 5% 0% 0% 5% 5%

Total 100% 100% 100% 100% 100% 100%1Grandfathered provisions based on effective date or age and/or service provision.2Plan sponsors used several conversion methods for different groups in company.3 We have only one PEP that was established post-PPA.Note: Due to rounding, some subtotals may not equal the sum of cells.Source: Towers Watson.

transitioned employees who did not meet the grandfathering requirements into the new hybrid plan using the A+B method, applying the opening account balance method or moving only those who did not meet certain other requirements into the hybrid plan. After the passage of the PPA, 53% of plan sponsors used grandfathering to transition to CBPs, either retaining the prior plan for all employees hired after a certain date or allowing them to choose between plans.

In pre-PPA days, 13% of CBPs and 16% of PEPs used the “greater of” conversion method, which pays benefits under whichever formula — the traditional DB or the hybrid —pays out the larger amount. No plan sponsors used this method post-PPA. This is not surprising, as the PPA rules made such an approach difficult. In its determination letter process, the IRS claimed these greater-of transitions could

violate the accrual rules against back-loading. The IRS had earlier taken the position that the two benefit formulas (traditional and hybrid) had to be aggregated for purposes of the accrual rules — but that such aggregation often could not satisfy the accrual rules. Although the IRS finally released proposed regulations allowing a narrow exception for greater-of conversions to cash balance designs, in which each formula is tested separately under the accrual rules, final guidance has been slow to arrive. Also, these proposed greater-of regulations might cause problems for other DB plan designs.

Before passage of the PPA, 10% of CBPs and 21% of PEPs allowed current employees to choose whether to remain in the old plan or join the new hybrid. Since the passage of the PPA, only 7% of plan sponsors have used this method when converting to a CBP.

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Section 5: Simulated Costs and Risks of Hybrid Plans Compared With Traditional DB and DC PlansThrough stochastic simulations, we assess the costs and risks to a sponsor of a hybrid plan.16 We use a CBP as the representative hybrid plan and compare it with a DC plan and a traditional DB plan. The DB plan provisions reflect common practice, while the DC plan and CBP are set to be comparable to the DB plan in terms of benefit generosity.

In the traditional DB plan, one year of service accrues 1% of final five-year average pay that will be delivered as a fixed lifetime annuity in retirement. The CBP and DC plan pay participants a lump sum at retirement. The CBP benefit is determined by pay credit and interest credit rates that are guaranteed by the sponsor. The interest credit rate is assumed to be variable and tied to long-term 30-year Treasury yields, following common practice. The pay credit rate is fixed and determined in the model so the CBP and DB plan have equal lump-sum value when the participant retires at age 65.17 The calculation uses the average simulated earnings, applies the average 30-year Treasury yield as the interest credit rate and assumes a certain plan population (see below). The pay credit rate is about 9% for the CBP to be comparable to the 1% final-average DB plan. For clarity, the benefit equivalence operates at the plan level, but the eventual benefits to participants in the CBP vary along with the 30-year Treasury yield over the years. We also use this CBP pay credit rate as the employer contribution rate in the DC plan. This assumes that 30-year Treasury yields are equally earned by DC plan participants without any loss of principal when interest rates rise or gain in principal when interest rates fall, as might be, at least theoretically, experienced if a stable-value investment fund were used.

Plan funding in the model operates under legal and regulatory requirements and common practice. Plan contributions are subject to government limits. As mandated by the PPA, funding shortfalls in DB plans and CBPs are amortized over seven years. A faster six-year amortization schedule is used if funding is less than 70%, approximating the effect of the accelerated funding rules that apply when a plan is considered “at-risk.” If the funding ratio is below

60%, benefit accruals are not allowed. The analysis ignores other benefit restrictions triggered at various funded levels, such as a prohibition on plan amendments or the inability to pay lump sums.

The hypothetical workforce in these simulations starts with 100 employees between the ages of 26 and 60, with an average age of 40. Workers with a high school education are considered. These workers earn between $19,000 and $81,000 a year, with the average $43,000 initially. The annual real wage increase is determined stochastically with an average 1% throughout the workers’ careers. All employees work for the employer until they retire at age 65. The hypothetical workforce is also expanding and aging. Five new workers join the workforce annually in the same 26–60 age distribution and participate in the retirement plan. Simulations of labor earnings capture the lifecycle age-earning profile of workers, idiosyncratic (random) individual income variations and correlations of wage levels with macroeconomic shocks. Simulated real earnings average about $40,000 at age 30 and $52,000 for workers in their 50s.

We run simulations for each worker and calculate aggregate summary statistics for the workforce after 40 years. Levels and variations of funding costs are measured on a per worker basis. The mean statistics show the average level of costs, including extraordinary values, and standard deviations indicate the volatility of costs.

Asset returns and interest rates are stochastically simulated. The model includes standard market shocks in normal times and low-probability, large-magnitude rare economic disasters. Asset returns reflect persistence of shocks over time and correlations across different classes. Asset allocations in the DB plan and CBP are assumed to be a typical 60/40 mix of equities and corporate bonds. Returns are simulated based on S&P 500 Total Return and Barclays Capital Aggregate Bond Indices, respectively. Discount rates used in valuing CBP and DB plan liabilities are simulated based on the composite corporate bond rates (CCBR), which are published by the IRS for various regulatory purposes.

16 This section briefly outlines the simulation assumptions and results. Readers are referred to the complete analysis “Comparative Costs and Risks for Sponsors of Traditional Defined Benefit, Defined Contribution and Hybrid Plans” by Gaobo Pang and Mark J. Warshawsky, 2010, Towers Watson working paper.

17 No job turnover is assumed in this analysis. The cost pattern could differ if benefit generosity were defined differently, such as the termination values at various ages. Benefits paid to participants who leave before retirement age are often larger, and thus more costly, under the hybrid plan than under the traditional final-average-pay DB plan. On the other hand, the DB plan may be more costly if turnover is low or early retirement is heavily subsidized.


Figure 37 summarizes the simulated yields, rates and returns. The incorporation of rare economic disasters significantly lowers the expected real asset returns and increases their volatilities. The conservative investment returns here avoid particularly favoring the DB and CBP versus the DC plan. If economic disasters were not considered, the simulated average nominal equity return would be 7.4%.

Figures 38 and 39 report the results of the stochastic simulations. The DC plan has the lowest year-to-year fluctuations in funding cost, while the DB plan and the CBP experience significantly larger swings. Annual nominal costs for the DC plan have a standard deviation of $5,500 versus $7,100 for the CBP and $8,900 for the DB plan. Expressed as a percentage of total payroll, cost volatilities are 0.3% for the DC plan, 5.7% for the CBP and 6.6% for the DB plan. The cost volatility for the traditional DB plan and the CBP can be addressed through investment strategies, at the expense of expected investment return. This consideration however, is beyond the scope of this paper.

In the long run, however, the DC plan is more costly than the DB plan and the CBP. Mean annual nominal costs are roughly $9,300 per worker for the DC plan, $7,200 for the CBP and $7,600 for the DB plan. Over the 40-year period, the long-run total funding costs in real terms per worker average around $119,800, $98,700 and $89,200 for these plans, respectively (results not shown here; available in the complete analysis). Capital market fluctuations can cause funding shortfalls in the CBP and the DB plan, which are generally not considered a risk for the DC plan sponsor. Episodic economic and financial disasters

add further volatility to their funding costs. Still, the CBP and DB plan are more cost-efficient than the DC plan. Average costs as a percentage of payroll are 7.2% in the DB plan and 7.5% in the CBP — versus 8.9% in the DC plan.

Required contributions are more volatile for the DB plan than for the CBP. The DB plan costs as percentages of payroll exhibit a generally upward trend, as shown in Figure 39, because the recognition of benefit accruals is concentrated in the years preceding

Figure 37. Statistics of simulated yields, rates and returns with economic disasters (%)

Equity return

Corporate bond return

Composite corporate bond yield

30-year T-bond yield Inflation

Real

Mean 3.5 1.9 2.1 1.5 ––

Std. dev. 21.5 6.6 4.6 4.8 ––

Nominal

Mean 6.7 5.1 5.3 4.7 3.2

Std. dev. 19.5 4.1 0.9 1.9 4.8


Figure 38. Funding costs and volatilities per worker for a prototypical plan population

Annual nominal cost $000 Cost as % of payroll

Mean Std. dev. Mean Std. dev.

DC 9.3 5.5 8.9 0.3

CBP 7.2 7.1 7.5 5.7

DB 7.6 8.9 7.2 6.6


Figure 39. Average funding costs as a percentage of payroll in each year

0%

2%

4%

6%

8%

10%

12%

40393837363534333231302928272625242322212019181716151413121110987654321

� DC � CBP � DB Years


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retirement and the population is assumed to be aging. More importantly, the figure shows sharp variations from year to year. This uncertainty imposes a management burden on the traditional DB plan sponsor under the assumed investment strategy. Like the DB plan, the CBP funding cost varies with realizations of asset returns, interest rates and benefit accruals. The trajectories of average costs over time, however, are relatively stable for the CBP. As the workers approach retirement, more of their ultimate benefits are funded in the CBP compared with the DB plan. The CBP has a slightly better chance than the traditional DB plan of being 120% overfunded or not falling below 80% funded.

The differences in costs and risks are explained by the sources of uncertainties in these retirement plans. The DC plan sponsor contributes a fixed percentage of pay. The responsibility for investment strategies and outcomes rests with participants. Volatilities of dollar costs for sponsors lie in the stochastic changes in labor earnings.

For CBPs and DB plans, the sponsors are responsible for investing assets. This helps participants by insulating their retirement benefits from market fluctuations. It might also benefit sponsors because the longer investment horizon may give them opportunities to explore higher returns (plus various more sophisticated strategies, risk pooling and scales of economy in aggregate investment that are not directly modeled here), which can eventually reduce costs.18 There is, however, the downside risk of substantial market losses necessitating sharply larger contributions.

In addition, CBPs and DB plans face uncertainties in liability valuations. Traditional DB plan liabilities grow and fluctuate with salary increases and service

years. Calculated as present values of future benefits over a typically long duration, liabilities are also highly sensitive to changes in interest rates. Liability variations are mitigated in the CBP by its accrual formula. The CBP benefits are expressed as account balances upon retirement, and the pay credit rate is fixed. The liability accruals vary with new realizations of crediting interest rates. Liabilities are typically much less interest-rate sensitive under a CBP than under a traditional DB plan. For example, declines in interest rates for the CBP increase discounted plan liabilities but also reduce plan benefits through lower assumed interest credits. These opposite forces fully or partially offset each other. The lower volatility in liabilities is an important advantage of CBPs over traditional DB plans.

We also consider an alternative career-average-pay DB plan with a 1% accrual rate. For benefit equivalence, the pay credit rate is 5.8% for the CBP and DC plan. Figure 40 reports the results. Costs for all of the plans are lower than those in Figure 38 because the previous plan provisions offered more generous benefits to participants. Using career average pay in the DB benefit formula mitigates the risk of unanticipated wage inflation, especially later in workers’ careers. The results again show that the DB plan and CBP have a cost efficiency advantage over the DC plan but carry the volatility disadvantage. The CBP outperforms the DB plan in terms of lower cost and volatility, once again because liabilities are less sensitive to changes in interest rates.

Finally, we consider a scenario in which workers are covered by a mix of retirement plans. Some employers may choose to have benefit accrual in one plan and simultaneously add or enhance the benefit in another. Figure 41 reports the results for the plans described in the notes.

The DB+DC mix has a larger DB feature than other mixes — recall that a 1% final-average DB plan is equivalent to a DC plan or CBP with a 9% pay credit rate. This mix has the lowest average cost but the largest volatility. The CBP+DC mix benefits from the CBP component in terms of lower cost volatility, but the average cost increases as the mix moves toward the DC type. DC-only has the highest cost over the long run. Funding costs account for about 10.9%, 10.2% and 9.3% of payroll with standard deviations of 0.4%, 4% and 7.4% for DC-only, CBP+DC and DB+DC, respectively. In terms of annual average nominal cost, the CBP+DC mix gives an even lower standard deviation than the DC-only coverage.

Figure 40. Funding costs and volatilities per worker for a career-average DB plan and comparable DC plan and CBP



DC 6.0 3.6 5.7 0.1

CBP 5.0 4.8 5.1 3.7

DB 5.4 5.8 5.4 4.5


Figure 41. Funding costs and volatilities per worker, mixed plans for an expanding and aging plan population



DC-only 11.7 7.7 10.9 0.4

CBP+DC 10.4 7.4 10.2 4.0

DB+DC 10.0 11.1 9.3 7.4

Notes: For comparable benefit generosity, these mixed plans are set as follows: DC-only has an 11% employer contribution rate; CBP+DC has a cash balance plan with a 6% pay credit rate and a DC plan with a 5% employer contribution; and DB+DC has a final-average DB plan with a 1% accrual rate and a DC plan with a 2% employer contribution. Source: Towers Watson.

18 A series of empirical studies found that, over time, DB plans attained higher returns than 401(k) plans by roughly an average of 1 percentage point a year. See “Defined Benefit vs. 401(k) Investment Returns: The 2006–2008 Update,” Insider, Watson Wyatt, December 2009.


Section 6: Concluding RemarksAs the name suggests, hybrids offer a mix of the attributes of both DB and DC plans in terms of risk sharing, funding volatility, cost control and lifetime income. The prevalence of hybrid plans varies widely among industries and the plans differ from one company to the next — clearly one size does not fit all. In all variations, hybrid plans generally offer advantages 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 also avoid the risk and responsibility of investing their retirement funds themselves. In addition, many hybrid plans offer interest credits at levels 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. Having a portion of retirement savings earning this type of return can enable participants to tolerate more risk in investing other retirement assets, such as 401(k) balances.

Hybrid plan benefits are easier to understand than those in traditional DB plans, and hybrid plan participants need not fear a huge investment loss just before retiring. Employees with hybrid plans are less likely to elect annuities at retirement than those in traditional DB plans. Hybrid plan participants that elect to receive their benefits in a lump sum thus take on the burden of managing their retirement income, which increases the risk of outliving one’s income. As DB plans, however, hybrid plans must offer participants a lifetime annuity option, so this risk is optional. Unlike DC plans, hybrid plans always offer participants the opportunity to eliminate the risk of outliving their retirement income.

From the sponsor’s perspective, hybrid plans also offer a combination of the attributes of traditional DB plans and DC plans. Plan costs and liabilities tend to be less volatile in hybrid plans than in traditional DB plans, but hybrids are more volatile than DC plans. Conversely, as there is a natural tradeoff 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 include incentives to continue working or to retire at certain times as many traditional DB plans do, so turnover is likely to be more “natural.” Some of the other employee advantages mentioned above, such as improved

understanding and the ability to guarantee lifetime income, have obvious benefits to the sponsor as well.

Despite the advantages hybrids offer to employers and employees alike, their future is still evolving. While the courts have rejected the age discrimination charges, the delay in final regulations has left some employers hesitant to switch to hybrids. Some have gone ahead with a DC-plan only approach, while others have assumed a wait-and-see position.

The recently issued IRS regulations are critical to this evolution. After the new guidance is digested, many plan sponsors will have to amend their plans to comply, particularly with regard to maximum interest crediting rates and transition methods. More importantly, the guidance is expected to clarify legal requirements and resolve lingering ambiguities, and may thereby encourage more employers to convert their traditional DB plans to hybrid plans.

The recent deep recession shows the very attractive risk- and cost-balancing features of hybrid plans to greater advantage, especially given the consequent high contributions and funding volatility in traditional DB plans and the significant asset losses to many DC accounts. Employers might better appreciate hybrids’ mix of DB and DC features, while workers are likely to welcome their reliability and certainty.

While hybrid plans offer many advantages, no one type of plan — hybrid, traditional DB or DC — is right for all sponsors. Choosing a plan design is a complex decision, which should reflect a wide range of factors unique to each sponsor. But as this study demonstrates, for many employers, hybrid plans might well emerge as the best retirement plan choice.

“Choosing a plan design is a complex decision, which should reflect a wide range of factors unique to each sponsor. But as this study demonstrates, for many employers, hybrid plans might well emerge as the right retirement plan choice.”

About Towers WatsonTowers Watson is a leading global professional services company that helps organizations improve performance through effective people, risk and financial management. With 14,000 associates around the world, we offer solutions in the areas of employee benefits, talent management, rewards, and risk and capital management.

Copyright © 2010 Towers Watson. All rights reserved.TW-NA-2010-18036

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