Voice | Published in September 2006

Demystifying the Hybrid Pension Plan

The pundits, academics, and other prognosticators had a field day over the past two years, declaring that the traditional pension plan in the US was dead and the only remaining formality was the burial

By PS | September 2006
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The pundits, academics, and other prognosticators had a field day over the past two years, declaring that the traditional pension plan in the US was dead and the only remaining formality was the burial. In those instances where companies had tried to offer workers something in between (the hybrid "cash balance" plans), suspicion, hostility, and even lawsuits sometimes followed. Then, during the first two weeks of August, two events in rapid succession may have turned the "collective wisdom" on its collective head. First, the Congress approved sweeping pension reform legislation and, second, the U.S. Court of Appeals overturned a lower court ruling that had declared the IBM "cash balance" pension conversion discriminatory against older employees. Those decisions on the legislative and legal fronts may well breathe new life into both traditional and hybrid defined benefit (DB) pension plans that some had given up for dead.

The Pendulum Has Swung

Once upon a time, a corporate pension plan in America was a defined benefit plan. Period. Often forgotten by many people is the fact that the 401(k) plan was conceived and introduced as a vehicle to augment, not replace, the DB plan. DB plans paid a guaranteed annuity based on final average pay at the time of retirement. In most cases, the worker received the annuity following a 20- to 30-year career with the same employer.

Things began to change significantly following enactment of the Employee Retirement Income Security Act of 1974 (ERISA). In fairly rapid succession, a series of new laws served to limit the amount of contributions or benefits that could be paid into or flow out from DB plans.

Importantly, most of these new laws totally ignored any retirement policy. They were purely revenue-driven. As a result, the maximum benefit that could be paid, the maximum salary that could be reflected in a DB plan, and the maximum tax-deductible contribution a corporation could make were limited. Not surprisingly, three things happened: Some companies stopped contributing to their DB plans; benefits were reduced (especially for executives); and plans became much more complicated and, therefore, more costly to administer.

Fast-forward to the "Go-Go" late '80s and early '90s. Driven by a booming stock market, assets ran up and DB plans became fully funded. Despite strong earnings and healthy markets, prudent companies still saw a need to contribute to their pension plans, given their expectations of continued growth, the need to provide for new hires, etc. However, under the existing rules, contributions most likely would not be tax-deductible and, instead, might be subject to a 10% excise tax. That prompted many companies to go on what looked at the time to be a very long "contribution holiday."

Concurrently, new companies were starting up that didn't want to take on the administrative burden of DB plans. Instead, for these companies, awards of shares and future stock options replaced the traditional defined benefit plans.

As the leaders of this genre (Microsoft, Intel, Dell, and others) have grown up and become corporate mainstays, their old-line competitors, especially in the technology industries, increasingly found themselves on an uneven playing field, disadvantaged financially by their DB plans—plans that became increasingly expensive as asset performance and interest rates nosedived. DB plans suddenly and rapidly required big contributions.

Another fundamental shift also was under way, this time on the employee side. The concept of "cradle to grave" service at one employer was evaporating rapidly. Sometimes induced by layoffs or downsizing, sometimes pursued as career advancement, "job-hopping" had lost its old stigma. With a potential "benefits gap" for job-hoppers at retirement, the traditional DB plans designed for career-service with one employer were no longer attractive to the suddenly mobile workforce.