Cash Balance and Other Hybrid Vehicles

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Cash Balance and Other Hybrid Vehicles

• 2006 Enrolled Actuaries Meeting
• Session 107
• Elizabeth M. Borkhuis and
• Christopher D. Kludy

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What is a hybrid plan?

• Hybrid plans incorporate both defined benefit and
  defined contribution plan characteristics into
  one retirement plan
• Hybrid plans strategically allocate various risks
  to the employer and the employees in a manner
  different from traditional retirement plans

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Common types of hybrid plans

• Cash balance plans
• Pension equity plans
• Floor-offset plans
• Target benefit plans
• Variable annuity plans

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Cash balance plans

• Description
• A cash balance plan is a defined benefit plan
  that looks like a defined contribution plan
• The benefit is expressed as a hypothetical
  account balance
• Accounts grow at a defined interest rate,
  regardless of actual asset performance
• Accounts grow with service credits based on pay
• Prevalence
• Most common type of hybrid plan

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Pension equity plans

• Description
• A defined benefit plan with the benefit expressed
  as a lump sum
• Lump sum is accumulation of percentages of final
  average pay earned each yearcan be either
  cumulative or step-up design
• Prevalence
• Research suggests around 5 of defined benefit
  plans are pension equity plans

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Floor-offset plans

• Description
• This vehicle is a coordination between a defined
  benefit and a defined contribution plan
• The DB plan is a traditional plan. It is offset
  by the value of a DC account, and the DB plan
  provides the difference, if any
• Prevalence
• Not common, although may apply to grandfathered
  groups
• May apply more with smaller employers

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Target benefit plans

• Description
• A defined contribution plan where contribution is
  based on funding a target benefit at retirement
  and spreading costs over career
• Target is defined by a traditional formula and
  career assumptions are set to determine
  contribution rate
• Prevalence
• Not common for large organizations. Were
  developed in early ERISA years for small
  employers
• May be used for bargained employees

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Variable annuity plans

• Description
• DB plan with benefit based on units earned
  each year
• Units have starting values and change based on
  performance of underlying assets
• Benefit can change, even in retirement
• Prevalence
• Not common, but may be more so for smaller
  employers
• Growing interest as a way to pass investment risk
  to participants

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Prevalence of hybrid plans
63
5
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Graph based on Towers Perrin survey data. Mercer
survey data suggests lower Cash Balance
prevalence (around 15).
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Cash balance planssample designs
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Cash balance planssample designs
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Cash balance planssample designs

• Integrated formulas
• Any of the sample formulas can be integrated
• Integrated formula x of pay up to integration
  level plus y (larger than x) of pay over
  integration level
• Most common integration level is Social Security
  Wage Base or a percentage of this amount
• Sometimes a flat integration level is used

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Cash balance planstransition approaches

• Simple conversion---no grandfathering
• Opening account balance lump sum value of
  benefit accrued to conversion date under prior
  formula
• Lump sum may incorporate early retirement
  subsidies, particularly if then eligible
• Prior plan optional forms, early retirement
  factors, conversion factors, etc. must be
  preserved with respect to benefit accrued at
  conversion date

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Cash balance planstransition approaches

• Grandfathering for selected employee groups
• Grandfathering is often used for mid-career or
  older employees, or for employees with
  significant service
• Grandfathering may be done with enhanced opening
  balances or transition pay credits
• Providing enhanced opening balances may create
  windfall opportunities for employees terminating
  soon after conversion
• Transition pay credits may vary based on age
  and/or service at conversion
• Transition pay credits may expire after a finite
  number of years or may apply indefinitely to
  eligible employees

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Cash balance planstransition approaches

• Better of old and new formula
• May continue indefinitely or for a set number of
  years
• May be done to ease transition from rich
  final-pay formula
• May also mitigate loss of early retirement
  subsidies for employees close to retirement
• If this approach is chosen, time period for
  running parallel formulas is typically limited
• Serves as implied grandfathering

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Cash balance planstransition approaches

• Choice between old and new formula
• May continue indefinitely or for a set number of
  years
• Fewest employee relations issues
• Generally most expensive transition approach, due
  to anti-selection
• Choice may given as a one-time alternative, or
  choices may be allowed annually or periodically
• Careful and complete communication is key to
  minimizing employee relations issues
• New participants are seldom given a choice they
  enter the cash balance plan

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Cash balance plansconversion issues

• 204(h) notices generally apply
• Usually provide such notices, even if no
  clear-cut future benefit cutback, due to
  elimination of early retirement subsidies, etc.
• Proposed legislation may limit conversion
  alternatives
• Some proposals mandate the greater of the old and
  new formulas for up to five years
• Effect of conversion on nondiscrimination testing
  must be ascertained

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Cash balance planstypical ancillary benefits

• Lump sum payment form
• Almost all cash balance plans provide for payment
  of benefits as lump sums
• Some plans may limit lump sums to employees
  eligible for retirement
• Lump sum availability is much more prevalent in
  cash balance plans than in traditional defined
  benefit plans
• Early retirement benefits
• Account balance is typically payable at
  termination without additional subsidies

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Cash balance planstypical ancillary benefits

• Vesting
• May follow typical five-year cliff pattern
• May offer accelerated or immediate vesting
• Death benefits
• Account balance typically paid at death, subject
  to REA minimums
• Account balance may also be paid out upon death
  of unmarried participants
• Disability benefits
• Account balance may be paid out at disability
• Pay credits may be continued and account balance
  payable at age 65 (or earlier retirement age)

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Pension equity planssample designs
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Pension equity planssample designs
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Pension equity planssample designs

• Integrated formulas
• Any of the sample formulas can be integrated
• Credit percentage x of final average pay up to
  integration level plus y (larger than x) of
  final average pay over integration level
• Most common integration level is Social Security
  Wage Base or a percentage of this amount
• Sometimes a flat dollar integration level is used

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Pension equity planstransition approaches

• Less likely to be a cut-bask, so generally less
  elaborate transition approaches
• Simple conversion---no grandfathering
• Lump sum at conversionsum of credit percentages
  based on all prior service times final average
  pay at conversion
• Minimum lump sum lump sum value of prior plan
  accrued benefit
• Prior plan optional forms, early retirement
  factors, conversion factors, etc. must be
  preserved with respect to benefit accrued at
  conversion date

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Pension equity planstransition approaches

• A B approach
• Benefit earned at conversion date is preserved,
  along with optional forms, early retirement
  factors, etc.
• Additional lump sum benefit begins to accrue,
  based on pension equity formula, but without
  accumulated credits for prior service
• Better of old or new formula, for limited or
  unlimited period
• Time period for running parallel formulas is
  typically limited

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Pension equity planstransition approaches

• Choice between old and new formula
• May continue indefinitely or for a set number of
  years
• Fewest employee relations issues
• Generally most expensive transition approach, due
  to anti-selection
• Choice may given as a one-time alternative, or
  choices may be allowed annually or periodically,
  significantly adding to complexity
• Careful and complete communication is key to
  minimizing employee relations issues
• New participants are seldom given a choice they
  enter the cash balance plan

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Pension equity plansconversion issues

• 204(h) notices may apply
• Such notices may be required, due to elimination
  of early retirement subsidies, etc.
• Proposed legislation may limit conversion
  alternatives
• Some proposals mandate the greater of the old and
  new formulas for up to five years
• Effect of conversion on nondiscrimination testing
  must be ascertained
• Lump sum payments may exceed formula amount, due
  to application of 417(e)

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Pension equity planstypical ancillary benefits

• Lump sum payment form
• Almost all pension equity plans provide for
  payment of benefits as lump sums
• Lump sum availability is much more prevalent in
  pension equity plans than in traditional defined
  benefit plans
• Early retirement benefits
• Account balance is typically payable at
  termination without additional subsidies
• Sometimes account balance is not payable until
  early retirement and early retirement reductions
  may apply

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Pension equity planstypical ancillary benefits

• Vesting
• Generally follows typical 5-year pattern common
  in traditional defined benefit plans
• Death benefits
• Account balance typically paid at death, subject
  to REA minimums
• Account balance may also be paid out upon death
  of unmarried participants
• Disability benefits
• Account balance may be paid out at disability
• Credit percentages may be continued and account
  balance payable at age 65 (or earlier retirement
  age)

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Variable annuity plans sample plan designs

• Unit Value 2
• Hurdle Rate 4
• Benefit Accrual 1 of Pay Per Year of Service
• Example
• Employees 2005 Pay 40,000
• Benefit Accrual 40,000 x 1 400, which buys
  200 units
• During 2006, the assets earn 7
• 1/1/2007 Unit Value 2 x (1.07/1.04) 2.08
• So, value of 2005 accrual (i.e. 200 units) as of
  1/1/2007 416

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Variable annuity plans sample plan designs

• Example (continued)
• During 2007, the assets earn -1
• 1/1/2008 Unit Value 2.08 x (0.99/1.04) 2.06
• So, value of 2005 accrual (i.e. 200 units) as of
  1/1/2008 412
• Sum of accrued benefit at retirement
  accumulation of units x unit value at retirement
• Actual benefit payments increase and decrease in
  retirement with change in unit value

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Variable annuity plans sample plan designs

• Observations
• Accrued benefit can go up or down with asset
  performance
• Does not violate Section 411 since benefit cant
  go down due to rendering of additional service
• Although benefit is career average,
  pre-retirement inflation is addressed with growth
  in unit value
• Post-retirement inflation is also addressed
• Retirees benefit amount is subject to investment
  risk
• As benefit accruals are funded upon accrual, only
  gain/loss is demographic (and therefore very
  minor)

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Key features of traditional plan approaches -cost
vs. benefit predictability
High

• Traditional DB pension withtypical investment
  strategy

• Pension Equity withtypical investment strategy

• Cash Balance with typical investment strategy

Benefit Predictability

• Variable annuity plan

• DC non-discretionary

• Floor offset with typicalinvestment strategy

• DC discretionary

Low
Cost Predictability
Low
High
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Reasons for level of benefit/cost predictability

• Benefit Predictability
• DC plans have low benefit predictability because
  of
• Unpredictable contributions
• Unpredictable investment performance
• Traditional DB design results in higher benefit
  predictability
• Benefits not contingent on employee contributions
  or profits
• Company retains equity risk

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Reasons for level of benefit/cost predictability

• Cost Predictability
• DC plans have high cost predictability
• Contributions are defined
• Cost equals the annual contribution
• Traditional DB plan design and investment
  strategy result in lower cost predictability
• Company owns equity risk and reward
• Asset/liability mismatch
• Investment strategy can affect cost and benefit
  predictability

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Effect of investment strategy on cost and benefit
predictability
High

• Traditional DB pension withtypical investment
  strategy

• Traditional DB pension withlow risk investment
  strategy

• Pension Equity withtypical investment strategy

• Pension Equity with low riskinvestment strategy

• Traditional Cash Balancewith low risk
  investmentstrategy

• Traditional CashBalance with typicalinvestment
  strategy

Benefit Predictability

• Variable annuity plan

• Equity Cash Balance with typical(matched)
  investment strategy

• Equity Cash Balancewith low riskinvestment
  strategy

• DC non-discretionary

• DC discretionary

Low
Cost Predictability
High
Low
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Defined benefit or defined contribution planskey
differences
Company Perspective
Employee Perspective
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Defined contribution plans compared to new
defined benefit designs
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Defined contribution plans compared to new
defined benefit designs
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Refresher -- Benefit accrual rules

• 133 1/3 rule
• Rate of benefit accrual in any future plan year
  does not exceed 133 1/3 of the current accrual
  rate
• Compensation assumed flat
• Fractional rule
• Current accrued benefit must be at least as large
  as
• Projected Normal Retirement Benefit Years of
  Participation Now/Years of Participation at
  Normal Retirement Date
• 3 rule
• Current accrued benefit must be at least as large
  as
• 3 x Years of participation (up to 33 1/3) x
  Normal Retirement Benefit

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Benefit accrual, funding, and ERISA
considerationscash balance plans

• Benefit accrual rule application
• Cash balance plans with increasing patterns of
  pay credits must test formula for backloading
• 133 1/3 rule often used
• Fractional rule may be usable, depending on
  structure
• May need project/prorate minimum to ensure
  compliance with fractional rule
• Accrued benefit typically defined as account
  balance, projected to NRA at current crediting
  rate, and annuitized using 417(e) assumptions

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Benefit accrual, funding, and ERISA
considerationscash balance plans

• Funding method issuescontribution basis
• Can fund using various approved actuarial cost
  methods PUC becoming increasingly popular
• IRS does not automatically approve a change in
  funding method to PUC or UC for a cash balance
  plan
• Method change approvals are granted after full
  filing and analysis by IRS
• For current liability, IRS expects the benefit
  valued to be an annuity based on CL assumptions.
  So will need to project cash balance account to
  NRD, annuitize based on plan assumptions and then
  value based on current liability assumptions

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Interest crediting rate issuesNotice 96-8
specifies deemed 417(e) safe harbors
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Interest crediting rate issues

• Most common to use rate that complies with Notice
  96-8
• Fixed crediting rate is sometimes used
• May result in lump sum larger than account
  balance
• Other indices may sometimes be used
• May result in lump sum larger than account
  balance
• A few plans permit participant-directed
  crediting rates based on DC plan rates
• May result in lump sum larger than account balance

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Benefit accrual, funding, and ERISA
considerationscash balance plans

• Testing for nondiscrimination
• Cash balance plans must be tested using numerical
  testing (safe harbor cash balance plan not
  usable)
• Can be cross-tested as DC plan if meet
  cross-testing criteria
• Whipsaw
• Occurs when required lump sums exceed account
  balance
• If plan complies with Notice 96-8, whipsaw
  avoided
• Several court cases on whipsaw, but no definitive
  guidance

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Benefit accrual, funding, and ERISA
considerationscash balance plans

• Age discrimination
• Recent age discrimination issues have revolved
  around whether cash balance plans violate Section
  411(b)(1)(H)(i) rate of benefit accrual cannot
  decrease due to advancing age
• Proposed pension reform legislation states that
  cash balance plans do not by design violate ADEA
  some courts have ruled differently
• IRS qualification
• IRS will not currently issue favorable
  determination letters on new cash balance plans
  or conversions

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Benefit accrual, funding, and ERISA
considerationspension equity plans

• Benefit accrual rule application
• Fractional rule compliance is most common for
  pension equity plans
• Accrued benefit may need to be set to no less
  than appropriate fractional rule benefit and no
  more than 100 of projected age-65 benefit to
  ensure compliance
• Whipsaw may occur, depending on how accrued
  benefit is defined.
• If plan uses a projection rate that does not
  comply with 417(e), lump sums paid out may exceed
  formula amount when 417(e) rate is less than plan
  rate

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Benefit accrual, funding, and ERISA
considerationspension equity plans

• Funding method issuescontribution basis
• Can fund using various approved actuarial cost
  methods PUC becoming increasingly popular
• For PUC funding, three attributed benefits are
  defined
• PVAB/current liability attributed benefit is
  benefit payable at expected retirement age in
  expected form, based on service and average pay
  at valuation date
• AAL attributed benefit is benefit payable at
  expected retirement age in expected form, based
  on service at valuation date and expected pay at
  retirement date
• NC attributed benefit is difference between AAL
  benefit one year after valuation date and AAL
  benefit at valuation date
• Attributed benefits must follow accrual pattern
  under plan.

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Benefit accrual, funding, and ERISA
considerationspension equity plans

• Testing for nondiscrimination
• Pension equity plans must use numerical testing
• Generally not a problem since formulas tend to be
  somewhat frontloaded
• Can cross-test as DC plans if meet criteria

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Benefit accrual, funding, and ERISA
considerationspension equity plans

• Age discrimination
• Recent age discrimination issues have revolved
  around whether cash balance plans violate Section
  411(b)(1)(H)(i) rate of benefit accrual cannot
  decrease due to advancing age
• Previously proposed age discrimination
  regulations would have made pension equity plans
  discriminatory by design
• Proposed pension reform legislation states that
  pension equity plans do not by design violate
  ADEA some courts have ruled differently

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Accounting considerationscash balance plans

• Application of PUC method
• Currently no consensus on application to cash
  balance plans. If fixed crediting rate, UC may
  be appropriate. PBOABOaccount balance.
  SCpay credit for year
• If variable crediting rate, may use approach like
  funding, with minimum PBOaccount balance
• Proposed FASB accounting treatment
• FASB proposed treating cash balance plans with
  variable crediting rates analogous to DC plans
  PBOaccount balance, SCpay credit discount
  ratecrediting rate
• Uncertain how most recent FASB proposed changes
  will impact these plans

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Accounting considerationspension equity plans

• Application of PUC method involves three
  attributed benefits
• ABO attributed benefit benefit payable at
  expected date based on service and average pay at
  valuation date
• PBO attributed benefit benefit payable at
  expected date based on service at valuation date
  and average pay at expected retirement date
• SC attributed benefit difference in PBO
  attributed benefit one year after valuation date
  and PBO attributed benefit at valuation date
• Must follow pattern of benefit accrual in plan.
  Often must use project/prorate approach. Other
  attribution approaches may also be used
• Proposed FASB accounting treatment
• Uncertain how most recent FASB proposed changes
  will impact these plans

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Trends in hybrid plan designsprevalence of such
designs

• Hybrid designs have grown steadily in popularity
  since the early 1990s
• Useful in merger integration
• Useful in cost control and predictability
• Some reluctance in recent years to adopt new
  hybrid designs, particularly cash balance ones in
  light of confusing and conflicting court
  decisions and lack of definitive IRS guidance
• Cash balance and pension equity conversions still
  continuing
• Cash balance conversions now sometimes viewed as
  an intermediate step in change from a DB to a DC
  retirement structure
• Lump sum availability and account balance
  orientation

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Cash balance plan conversions
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Trends in hybrid plan designrecent hybrid plan
variations

• Most recent conversions have tended to have
  simpler approaches
• Almost all use crediting rate meeting Notice 96-8
• Significant portion use flat pay crediting
  formula
• Transitions tend to be either absent, choice, or
  better of two formulas for a period of time

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Trends in hybrid plan designdevelopment of
choice plans

• Choice plans developed in late 1990s and early
  2000s
• A way to mitigate transitions from traditional DB
  plans to hybrids
• Operation of choice planmay apply to all
  employees or a subset
• May involve choice among several sets of benefit
  programs
• May be one-time irrevocable choice, or may allow
  annual or periodic choices
• Careful, complete, extensive communication is
  crucial
• Recent choice plan developments
• Mandated transition approaches in proposed
  legislation may encourage choice as a way to
  comply

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Questions?