RPA2 Module 8 Flashcards
What are hybrid retirement plans, and why are they used by plan sponsors?
Plans that blend attributes of traditional defined benefit pension plans and traditional defined contribution plans.
Hybrid retirement plans are implemented by plan sponsors in an effort to meet plan objectives that these plan sponsors find difficult to achieve with either traditional defined benefit or traditional defined contribution plans, alone or in pairs.
Are hybrid retirement plans a distinct structural category like a defined benefit or defined contribution type of plan for tax qualification purposes? Explain.
No. While hybrid plans come in several types and plan designs, each is considered either a defined benefit or a defined contribution plan for the purposes of tax qualification.
What factors should be considered in designing a hybrid retirement plan?.
(a) Workforce demographics and mobility
(b) Employee attitudes toward current retirement benefits
(c) Relative levels of benefits and rates of benefit accrual
(d) Cost constraints for the plan sponsor
(e) Certain other items, such as awareness of the legal, regulatory and public
relations environment of hybrid plans. These are especially important since plan sponsors have been criticized for the negative effects on benefit accruals or values for certain groups of plan participants upon conversion to a hybrid plan. This criticism of plan sponsors has, at times, resulted in costly litigation.
Describe what features defined benefit hybrid plans possess that are
characteristic of a) traditional defined benefit plans and (b) defined contribution plan structures.
(a) Defined benefit hybrid retirement plans possess certain features that are
characteristic of traditional defined benefit plans. These plans promise a specific benefit level for participants, and plan sponsors manage the investing of plan assets through commingled funds. Hence, the plan sponsor bears the investment risk and reaps the benefit of investment rewards should these occur. Defined benefit hybrid plan structures make it relatively easy for plan sponsors to integrate the plan with Social Security and target income replacement ratios.
These plans offer distributions in the form of annuities and are subject to
Employee Retirement Income Security Act (ERISA) requirements such as
minimum standards for eligibility, vesting and funding. Annual actuarial
valuations are required, as is payment of plan termination insurance premiums to the Pension Benefit Guaranty Corporation (PBGC).
(b) Defined benefit hybrid plans also possess certain features that are characteristic of traditional defined contribution plans. In addition to allowing for distribution of benefits in an annuity form, defined benefit hybrid plans express benefits in terms of lump-sum values and, at times, also offer lump sums as a distribution option. This feature, which makes for portability and benefits expressed in terms of lump-sum values, typically makes these hybrids of greater appeal to younger and more mobile workers.
(a) What is a cash balance plan, and (b) do such plans involve self-directed
investments by plan participants in individually allocated accounts?
(a) A cash balance plan is a defined benefit hybrid retirement plan where the sponsor typically makes plan contributions based on a specified formula that provides an annual contribution credit and applies a fixed interest rate credit.
Although this is the typical cash balance design, there can be variations on this benefit design. Some variations include:
• Linking benefits to an equities index rather than a fixed rate of return, or
• A lower level of guaranteed benefits but profit-sharing elements allowing for increased contributions in periods of superior business performance.
Cash balance plans are considered to be career average plans since they typically base contributions on a formula that considers pay in each year of
employment. The portable lump sums and relatively early accrual of benefits under these plans are attractive to employees terminating at younger ages and after fewer years of service, while workers with longer service are likely to receive greater benefits from a plan that utilizes a traditional defined benefit formula.
(b) Cash balance plans do not involve self-directed investments by plan participants in individually allocated accounts. However, cash balance plans take on the appearance of individually allocated defined contribution accounts, since plan participants receive periodic benefit statements based on hypothetical accounts showing accrued benefit balances. These statements are merely a communication tool, however, since in actuality plan assets are commingled, and their investment is directed by the plan sponsor. The amount of benefit shown on the account statement bears no relationship to actual assets held by the plan.
Does a plan sponsor benefit by converting from a traditional defined benefit plan to a cash balance plan structure?
Plan sponsors may benefit from conversion of a traditional defined benefit plan to a cash balance plan structure because, as a career average plan, it is likely to be less expensive than a final pay defined benefit plan.
Additionally, the plan sponsor of a cash balance plan may guarantee an interest rate below what the sponsor expects it can generate on actual plan investments, and the higher rate of return reduces the future plan costs for the sponsor. (This difference is sometimes referred to as the investment differential.)
What are pension equity plans?
Pension equity plans are a type of defined benefit hybrid retirement plan where benefits are based on both final average pay and the percentage credits that participants receive each year while they are plan participants.
Upon termination of employment or retirement, the sum of percentage credits is applied to final average pay to determine the lump-sum benefit, which is portable.
The percentages upon which credits are based can be relatively flat but often increase in steps with age or length of service.
Although the benefits earned under a pension equity plan are expressed as a lump sum, participants must have the option to receive these benefits
in the form of an annuity distribution.
The age- or service-weighted credits and final average pay formula make pension equity plans appealing to older workers and persons hired in midcareer who have fewer years to accrue benefits.
(a) How do benefit accrual rates differ between cash balance plans and traditional defined benefit plans, and (b) how do the benefit accrual rates under cash balance plans appeal to various workforce groups?
(a) Compared with the traditional defined benefit plans they often replace, more benefit accrual typically takes place in earlier years of service for participants of cash balance plans.
(b) Combining earlier benefit accrual with portability makes cash balance plans more favorable to younger, more mobile workers. Conversion to a cash balance plan from a traditional defined benefit plan could negatively affect the benefits of midcareer or older workers who had begun to accrue sizable benefits in a traditional defined benefit plan.
Provisions enacted into law as part of the Pension Protection Act of 2006 (PPA) have mitigated some of the adverse consequences related to conversion to a cash balance plan from a traditional defined benefit plan
How do benefits accrue in a pension equity plan as compared to a cash balance plan or traditional defined benefit plan?
In the case of pension equity plans, benefits build steadily but in steps, since credit percentages increase as participants move from one age bracket to the next age bracket. The age-weighted brackets of pension equity plans often increase the rate of accrual with age.
In contrast to cash balance plans, pension equity plans are more favorable to older workers and persons hired at midcareer who have fewer years to accrue benefits. Yet the effect of age weighting is not likely to tilt benefit accrual toward later years as significantly as a traditional defined benefit plan.
(a) How do benefit portability and the availability of lump sums in a retirement plan tend to be advantageous to an employer offering these plan features, and (b) what disadvantages can arise with these same plan features?
Benefit portability and the availability of lump-sum distributions are key features offered by many defined benefit hybrid retirement plans. These plan features usually are perceived as being advantageous to the employee. There are also several advantages that an employer receives by offering these plan features.
At times, however, there are certain disadvantages to the employer that accompany these plan features.
(a) Since benefit portability and the availability of lump-sum distributions typically result in employees seeing greater value in a retirement plan, such features may provide advantages to an employer in recruiting and retaining human resources.
Specifically, the following direct advantages may result:
• It may be easier to attract and retain younger and more mobile employees
who would not normally expect to receive a significant benefit from
traditional defined benefit plans.
• Midcareer employees who are only remaining with the employer because of pension benefits can take their account balances and move their careers in a new direction. Companies find this to be beneficial since employees who are unhappy are able to leave and be replaced by more highly motivated employees.
(b) There are certain disadvantages that can accompany benefit portability and lump-sum distributions. Specifically, the following disadvantages may result:
• Portable account balances may make it too easy for employees to leave for other employment too quickly.
• If benefits do not accrue quickly enough, younger and more mobile
participants may not perceive sufficient value in the retirement plan.
• If the overriding purpose of the plan is to provide retirement benefits, then
the option to take a lump-sum distribution upon retirement or termination of
employment may defeat the plan’s primary purpose.
Must defined benefit hybrid plans place investment decisions and the resulting risk and reward solely with plan sponsors?
No.
Defined benefit hybrid plans can include design features that shift investment risk-and-reward opportunities to participants in whole or in part. Some varieties of cash balance and other defined benefit hybrids are creative in how they assign risk and reward.
For example, a minimum balance pension plan is a cash balance variant that offers participants the greater benefit of either a traditional defined benefit pension plan (often final average pay) or the benefit accumulated by the cash balance method (based on career average pay).
Other cash balance variations give employees the option of linking the growth rate of their accounts with an equities index, introducing the prospect of both higher returns and more risk to participants.
What issues should a plan sponsor address in converting a traditional defined
benefit plan to a defined benefit hybrid plan?
Plan conversions often involve sensitive issues. Since different plans have different rates of accrual or allocation methods, some plan participants will fare better than in the previously offered plan, and other plan participants will see a less favorable situation with the new plan.
Employers need to consider:
(a) The impact of plan changes on participants
(b) Since many plan participants may not be able to determine the impact of plan changes on themselves without assistance from the employer, plan sponsors should consider how to best communicate these impacts and educate plan participants on the specific relevance of plan changes.
(c) Regardless of the impact of these changes, employee attitudes toward change and feelings about employer motives are important considerations. Failure on the part of a plan sponsor to adequately plan for and address these issues can result in detrimental effects to workforce morale and productivity loss, as well as costly litigation.
What is pension wear-away?
Pension wear-away is a term used to describe a condition occurring when a
traditional defined benefit plan is converted to a cash balance plan.
This condition occurs for participants with longer service records because of the difference in benefit accrual patterns between the two different types of plans.
Employees who have reached or are nearing the final stage of a traditional defined benefit plan, generally in the later years of a career when the benefit accrual rates increase rapidly, will experience a sudden decrease in accrual rates and expected benefits under a cash balance plan with less of the overall benefit accrual taking place in later years.
Although pension wear-away occurred in early conversions of traditional defined benefit plans to cash balance plans, PPA prohibited wear-away in conversions occurring after June 29, 2005.
Additionally, if a plan had already converted and was in existence on June 29, 2005, amended interest-crediting rules did not apply until plan years beginning after 2007, unless the employer elected to have those rules
apply as of June 29, 2005.
In converting from a traditional defined benefit plan to a hybrid defined benefit plan, are there approaches that companies can use to allow employees to avoid the adverse effects of plan conversion? Explain.
Yes.
Including the following:
(a) Allowing all employees to choose between the old plan and the new plan
(b) Allowing employees whose benefits are adversely affected by the conversion the choice to remain in the old plan
(c) Making an adjustment to initial account balances of the new plan for adversely affected employees
(d) Making additional contributions to other plans sponsored by the employer and within which the adversely affected employees are participating
Describe two key events that have occurred and their implication in quelling the controversy that has accompanied plan conversions from traditional defined benefit plans to hybrid retirement plans.
Passage of PPA contained various clarifications related to age discrimination in hybrid plans. PPA amended the Internal Revenue Code (IRC), ERISA and the Age Discrimination in Employment Act (ADEA) to provide that defined benefit plans are not age-discriminatory if, as of any date, a participant’s accrued benefit is at least equal to the accrued benefit of any similarly situated, younger individual. Accordingly, cash balance plans are not agediscriminatory as long as pay and annual interest credits for older workers are not less than pay and annual interest credits for younger workers. (Note that this provision does not apply unless interest credits are not greater than a market rate of return, and cumulative interest credits are not negative.)
The second key event was the decision by an appellate court in the case of Cooper v. IBM. The appellate court reversed a lower court ruling on the issue of “accrued benefits” and determined that cash balance plans generally are and always have been legal.
