“The number of employer-sponsored hybrid pension plans insured by the federal Pension Benefit Guaranty Corp. nearly tripled between 2001 and 2010, reported Business Insurance magazine in May. A hybrid pension plan combines features of both defined benefit (DB) and defined contribution (DC) plans, which can benefit both employers and employees.
Virtually all pension plans fall into two categories: defined contribution plans and defined benefit plans.
Defined benefit plans: Defined benefit plans are what most people think of when they think of a “traditional” pension plan. And when you hear in the news about pension plans being in trouble, pension negotiations or governmental bodies seeking to change pension agreements with retirees, the plans in question are probably defined benefit plans.
Funded by the employer, a defined benefit plan promises participants a specific monthly benefit at retirement. The plan may state this promised benefit as an exact dollar amount, such as $100 per month at retirement. Or, more often, it may calculate benefits through a formula that includes factors such as salary, age and the number of years worked at the company. For example, an employee could earn a pension benefit equal to 1 percent of average salary for the last five years of employment times total years of service.
Employees often prefer defined benefit plans because they know what they will receive in retirement. On the employer side, businesses can generally contribute (and therefore deduct) more each year than in defined contribution plans. Defined benefit plans are also more complex to establish and maintain than defined contribution plans. Because the employer promises to provide a set amount for the life of the pensioner, defined benefit plans require complex actuarial calculations to ensure that the employer sets aside enough money to meet its pension obligations far into the future. All investment and funding risk lies with the employer.
Defined contribution plans: Over the past 20 or 30 years, the number of new defined contribution plans formed has far outstripped defined benefit plans, as employers seek to control their retirement benefit costs and reduce administrative expenses. Defined contribution plans include 401(k) plans, SIMPLE IRAs, employee stock ownership plans (ESOPs), and profit-sharing plans.
Defined contribution plans do not promise participants a specific benefit amount at retirement. Instead, the employee and/or the employer contribute money to an individual account in the plan. In many cases, the participant chooses how these contributions are invested and decides how much to contribute from his or her paycheck through pretax deductions. The employer may add to an employee’s account, in some cases by matching a certain percentage of employee contributions.
The value of the account depends on how much is contributed and how well the investments perform─ the employer has no investment risk. At retirement, the employee receives the balance in his or her account, reflecting the contributions, investment gains or losses, and any fees charged against the account.
Hybrid, or cash balance, plans: Although it is technically a defined benefit plan, a cash balance plan shares some features with defined contribution plans, and shares some of the advantages of both.
As with defined contribution plans, the benefits an employee receives at retirement are defined in terms of the balance in his/her account. But as with a traditional defined benefit plan, the employer makes contributions for participants. In a typical plan, the employer credits a certain percent of the employee’s pay each year, plus an interest credit, to the employee’s account. The employer can invest these amounts as it sees fit, and increases and decreases in investments do not directly affect participants’ benefits.
Traditional defined benefit plans define a retiree’s benefit as a series of monthly payments for life to begin at retirement, while cash balance plans define the benefit in terms of a stated account balance. These accounts are often referred to as “hypothetical accounts” because they do not reflect actual contributions to an account or actual gains and losses allocable to the account. When participants are entitled to receive benefits under a cash balance plan, he or she can convert the account balance into an annuity or (under some plans) take a lump sum distribution.
Employers bear the investment risk with a cash balance plan, unlike with a defined contribution plan. However, cash balance plans do not require the complex actuarial calculations that a defined benefit plan requires, They also present somewhat less investment risk to employers, if the employer selects a conservative interest credit.