Uncertainties spawn hybrids
The shift from defined benefit (DB) to defined contribution (DC) pension plan designs has been widely reported in the UK and further a field. However, a ‘pure’ DC scheme is not always possible and, even when it is, it is not always the ideal solution. To what extent are we seeing the emergence of alternative or ‘hybrid’ designs that are neither pure final salary DB, nor pure DC?
UK: Surveys show that very broadly around 10% of occupational plans in the UK could be classed as hybrid.
The growth of hybrid plans in the UK is unlikely to be as dramatic as the growth we have seen in DC plans, because of the different drivers. The move to DC was part of a global trend, driven largely by financial considerations, as plan sponsors sought to take control of both the volatility and the overall cost of their defined benefit plans.
Plan sponsors may be reluctant to move back to a position of taking on corporate risk in relation to employees’ pension promises. However, many of the factors that may lead to a greater prevalence of hybrid plans stem from the very uncertain outcomes inherent in DC plans and the volatility of members’ accounts (where they follow equity-orientated strategies designed to maximise their future pensions):
❑ Some sponsors will be reluctant to pass on the investment risk to employees and so will offer career average, cash balance or combination plans instead. This could lead to a more balanced sharing of risk between sponsor and employee.
❑ Concerns about the susceptibility of members’ retirement dates to market conditions, may persuade DC sponsors to take on limited amounts of pension risk.
❑ Government may wish to consider whether the variability of DC plans is acting as a disincentive and that individuals are being discouraged from saving sufficiently for their own retirement.
❑ Members themselves, and their trade unions, may reject DC benefits; labour market pressures may lead to some more controlled outcomes through hybrid plans.
The growth of hybrids in the UK may come from a variety of directions, with global precedents for each of the main forces of change.
The moves away from the polarised scheme designs of pure final salary DB and pure DC look set to continue.
US: Cash balance plans (the most common form of hybrids in the US) were introduced in the 1980s, largely because they were perceived as being better understood and appreciated by employees (a ‘pot of money’) than a traditional final salary scheme. About a quarter of major US employers now offer such a design.
The overall design is similar to UK cash balance plans referred to earlier, but the rates of revaluation are often different and typically related to yields on long-dated government bonds. For the sponsors of these plans, the ability to provide a defined benefit related to bonds, but investing in equities which are expected to give a higher return, has been a useful way of reducing long-term costs (at least until the market downturns in recent years). Cash balance plans in the US have definitely been seen as a replacement for more conventional DB plans at least until the recent high-profile issue of whether US cash balance plans breach a specific aspect of their age discrimination legislation.
Switzerland: Plan design in Switzerland is in practice less varied than in the UK or US. Virtually all plans are effectively hybrid plans because of legislation: DC plans are required to offer a guaranteed minimum annual investment return, and DB plans are subject to DC-based guaranteed minimums, on a defined slice of salary. It is interesting to note that the guaranteed investment return in a DB plan may be underwritten by an insurance company if the plan is insured. In this case, the plan design from the employee’s perspective is clearly hybrid, even though from the employer’s perspective (and for accounting purposes) it may be regarded as a defined contribution plan.
Netherlands: Some 50% of Dutch employees were members of final salary plans in 2003 but this declined to 10% in 2004. Employees are increasingly being given revalued career average benefits, or “combination” hybrids offering revalued career average benefits up to a salary limit and DC on salary over the limit.
In many schemes “conditional indexation” of pensions takes place, under which indexation is only given if financial conditions permit.
Belgium: Again, legislation has led to the majority of plans being hybrid plans, according to our definitions.
From 2004, all DC plans have to offer a guaranteed minimum annual investment return. Also, most DB plans now define their benefit in lump-sum terms, thus transferring the post-retirement mortality risk to the employees.
Other countries: In most cases, the hybrid plans that exist in other countries are as a result of constraining legislation, similar to Belgium and Switzerland. For example, tax relief in Germany is much more generous for defined benefit plans, so companies wishing to move to DC often introduce a cash balance design. This is because a cash balance design is generally regarded as being the “furthest they can go” on the track to DC while continuing to be able to benefit from the more generous tax relief accorded to DB plans.
The US and the UK appear to be the most advanced in terms of development of hybrid plans, perhaps because their employers are the most willing to invest the time and effort to consider complex pension designs and communicate them to their employees.
Legislation can be a driver that either stimulates or discourages the development of hybrid plans. So, for example, in several European countries, government insistence on minimum rates of return has automatically created a hybrid environment. In the US, cash balance plans did not, in contrast, arise out of legislation changes; they arose largely to address poor perception among members of their existing (DB) plans. However, the future for these cash balance plans is now subject to significant uncertainty as a result of legislative developments, and in particular the age discrimination claim in the IBM case. The fact that this issue came to light some 10 years after the plans started to become popular is a major concern for US corporations which have introduced these plans.
It is therefore important to distinguish between the imposition of a hybrid design by local legislation on the one hand, and the choice by employers to adopt hybrid designs in the context of flexible legislation on the other. Some of the barriers to the wider global development of hybrids are:
❑ The reluctance of employers to ‘rock the boat’ in terms of pension scheme design, or to become involved in pension provision more than they have to.
❑ The perceived complexity and difficulty of communication of some hybrid designs.
❑The absence of third parties such as insurance companies willing (on a cost-effective basis) to offer guarantees that employers themselves are reluctant to offer (eg, investment guarantees).
❑ Members being suspicious of new designs and reluctant to embrace employee choice.
As far as insured pension plans are concerned, insurance companies tend to offer guaranteed minimum investment returns only to the extent required by legislation, and the current low-interest-rate investment environment makes offering any guaranteed return difficult. However, capital guarantees (that is, a guarantee that the overall investment return over the whole period to retirement will not be negative) are widespread, as the concept that “values can go down as well as up” is not widely understood or accepted by the general public in many countries, particularly in continental Europe.
Generally, the products offered by insurance companies tend to be relatively simple in design, with complexity and innovation focused on the investment return credited.
DC remains the preferred choice of most employers as they disengage from final salary DB pension promises. However, a significant minority are not convinced that pure DC is the ideal solution, and as a result have implemented hybrid plans. But most of the hybrid plans that exist around the world are there because of legislation, not employer choice.
Nevertheless, the choice does exist in many jurisdictions, and employers are paying more attention to the design and risks attached to what is one of the most expensive benefits that they provide to their employees.
Tim Reay is a senior member of the global retirement and financial management team of international consultants Hewitts, based primarily in London