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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
Switzerlan. 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

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