Traditional pension plans have been going the way of the Dodo for a few years, but many employers are switching to hybrid plans to minimize their risk while continuing to offer a lifelong benefit to employees.

Hybrid pension plans pull some of the best features from defined contribution and defined benefit plans, making them very attractive to large public and private sector employers who have struggled with massive unfunded liabilities in their traditional pension plans.

Many companies have frozen their pensions to new hires. Others have abandoned their pensions in favor of a 401(k) or other defined contribution plan. But not everyone is happy with defined contribution plans because they often leave participants to fend for themselves when most have never had to make investment decisions.

Hybrid plans share the risk between employers and employees. In 2013, 30 of the Fortune 100 companies were still offering pension plans to their employees: seven of those were traditional pensions and 23 were hybrid plans, according to research by Towers Watson. The rest of the Fortune 100 were offering only defined contribution plans.

The hybrids getting the most play in the past 15 years have been cash balance plans, which are defined benefit plans where the “benefit is defined as an account balance, rather than an annuity,” explains Towers Watson. Other hybrids that are just starting to take off include variable annuity and adjustable pension plans.

“I think we are going to see more hybrid arrangements and fewer defined contribution and traditional defined benefit plans [in the future],” says Mark Olleman, principal and consulting actuary at Milliman, Inc. in Seattle. “I think we really need more plans to provide people with a lifelong income, without providing employers unpredictable contributions.”

Employers who sponsor cash balance plans have a stated contribution amount, like in a defined contribution plan, but also promise a certain level of benefits, like a defined benefit plan. In a typical cash balance plan, a participant’s account is credited each year with a certain amount of money, say 5% of compensation from his or her employer, and an interest credit, which is either a fixed rate or a variable rate that is linked to an index such as the one-year treasury bill rate.

Also see: Cash balance plans, anyone?

Changes in the value of the plan’s investments don’t affect the participants’ benefits, so the investment risk is borne solely by the employer, according to the U.S. Department of Labor. But, when it comes time to retire or change jobs, the participant has the right to turn his account balance into an annuity or take it as a lump sum distribution.

Wisconsin, Rhode Island, Nebraska and Utah have all switched their pensions to hybrid plans. Most have chosen the cash balance option, but some are considering newer plan designs.

Also see: State pension plan benefits on the decline: report

Wisconsin’s plan looks more like a variable annuity pension plan. Its goal is a 5% return. If the plan returns better than 5% over the long term, retirees get dividends. If it returns below 5%, the dividends will be taken away, Olleman says. Retirees receive a minimum amount regardless of how the market performs.

The big difference between public sector and private sector plans is that public sector plans need to get permission from the legislature to make changes, he said. Both sectors have shown an interest in hybrid options.

Kelly Coffing, a principal and consulting actuary for Milliman who works more closely with private sector employers, says that variable annuity pension plans have been around for a while but have not been popular with retirees. The reason? They don’t like it when their benefits go down, she said. In a VAPP, the monthly benefits move up and down based on the performance of the plan. If the assets go up, the benefits go up. If the assets go down, the benefits go down.

Despite the volatility, these types of plans always stay funded and have very predictable, rational employer costs, Coffing says. They also offer longevity pooling and inflation protection, which is something participants don’t get in a defined contribution plan.

“While they are volatile, they do go up over time. With all that going on, you would think they would be more popular,” she says.

Milliman has attempted to smooth out some of that volatility for retirees in its latest version of the VAPP.

“In years where returns are high, we don’t give the whole upside to participants. We tap the increases. Any excess above 8% builds a reserve. When the market goes down, we can shore up the benefit to the high water mark,” she says. This way, participants don’t see a rollercoaster of ups and downs in their retirement accounts.

She added that with a variable annuity pension plan, the investment risk is borne by the participants and the longevity risk is borne by the plan.

VAPPs minimize the risk regardless of the maturity of the plan, Coffing adds, because they take some of the money from up years and use that money as a hedge against down years.

Milliman’s experts say they hope the variable annuity pension plan will gain in popularity now that the Internal Revenue Service has given its approval to the New York Times’ adjustable pension plan, which is another type of hybrid pension plan.

The IRS approved the New York Times’ plan in June. The Newspaper Guild of New York, which represents news employees at the Times, worked with a team from Cheiron, Inc., an actuarial and financial consultancy, to develop the adjustable pension plan that went into effect in July 2013. They had until July 31 of this year to get IRS approval of the plan model. If the IRS had not given its blessing, the plan would have automatically become a 401(k) plan.

“It is very welcome news and very happy news for our members at the New York Times,” says Bill O’Meara, president of the Newspaper Guild of New York.

The IRS’ approval means that, like a traditional defined benefit plan, participants will receive a check every month for life. It also means the plan is covered by the Pension Benefit Guaranty Corporation, unlike a 401(k) plan, he says.

The adjustable plan was devised as a replacement for the company’s traditional defined benefit plan and “was really a key to getting our contract settled,” O’Meara explains. “[Employees] were reluctant to give up the defined benefit plan. They understand the value of it.” The adjustable plan was a compromise that addressed the concerns of the company and the employees.

It combines the flexibility of a 401(k) plan with the guaranteed income stream of a defined benefit plan.

Like the VAPP, the adjustable pension sets more conservative goals with its investments. From the employer’s perspective, the plan operates in the same way as a 401(k). Each year, the trustees for the fund look at earnings on investments to determine the level of contributions that are needed to pay benefits. Once that amount is set, it is set. There is no changing it.

“It insulates them from a big drop in the stock market, something that would cause them to put in a lot more money than expected into the pension plan,” O’Meara says. “That doesn’t happen. Whatever the company agrees to put in each year is the benefit.”

In an adjustable plan, employers and employees share the risk. Participants know they will receive a check of some kind every year from their plan. It will either be the minimum amount set when the plan was started or the adjustable amount, whichever is more.

“More employees want a defined benefit plan. They are willing to give up salary for more retirement security,” says Richard Hudson, principal consulting actuary at Cheiron Inc. and one of the developers of the adjustable pension plan. “This gives employees what they want: a defined benefit plan. The reason employers don’t want to offer a traditional defined benefit plan is cost volatility.”

Under the adjustable pension plan, “the benefit accrual rate will adjust to meet the minimum funding requirement. It won’t be subjected to a doubling or tripling of the contribution. It gives [employers] contribution stability. It gives employees what they want: retirement security and a lifelong benefit,” Hudson said.

Also see: GAO reports on alternative approach to private pensions

O’Meara likes the plan to a plate of pancakes. One year, a participant’s pancake may be small and the next year, big. But no matter what, when they retire, participants know they will have a plate of pancakes waiting for them.

“The average 401(k) balance is nowhere near enough for people to retire on,” O’Meara says. “Because this plan offers payment every month for life, I think it could be a solution to the retirement crisis. I hope other unions and companies look at this to provide economic benefit to employees in a way that doesn’t expose the company to risk and volatility.”

The Newspaper Guild of New York and Cheiron devised a similar retirement plan for Consumer Reports.  The IRS has until March 2015 to make a decision about that plan, O’Meara said. He is confident the IRS will rule favorably in that case since the Consumer Reports adjustable pension plan is nearly identical to the one the IRS just approved at the New York Times.

Cheiron has also worked with some large public sector plans, including Maine Public Employees Retirement System, to implement an adjustable pension plan.  Maine is still waiting for the state legislature to make a decision about its proposed plan.

Milliman has a couple of clients implementing variable annuity pension plans in the near future, but “they are not as far along. We don’t have a determination letter from the IRS. Any tweaks to the variable annuity design may require a determination letter,” Coffing adds. “That’s what has caused many plan sponsors to be hesitant [about this plan design], but I think we are seeing movement on it anyway. Since the IRS approved one such plan design, people will be more willing to jump in.”

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