Hybrid retirement plans

ERISA consultants at the Retirement Learning Center (RLC) Resource Desk regularly receive calls from financial advisors on a broad array of technical topics related to IRAs, qualified retirement plans and other types of retirement savings and income plans, including nonqualified plans, stock options, and Social Security and Medicare.  We bring Case of the Week to you to highlight the most relevant topics affecting your business.  

A recent call with a financial advisor from Colorado is representative of a common inquiry related to hybrid plans. The advisor asked: “Is ‘hybrid’ just another name for a cash balance defined benefit plan?”    

Highlights of the Discussion

Sort of—a cash balance plan is a type of hybrid defined benefit plan; a pension equity plan is another type of hybrid plan. The term hybrid applies to a category of defined benefit plan that uses a lump-sum based formula to determine the guaranteed benefit. A participant must refer to plan documentation to determine which type he or she may have.  

Functionally, hybrid plans combine elements of traditional defined benefit plans and defined contribution plans. Hybrid plans specify contributions to an account (or balance) like a defined contribution plan, but guarantee final benefits like a defined benefit plan. Such plans grow throughout an employee’s career and allow employees to see that growth through an account balance. There are basically two types of hybrid plans:  cash balance and pension equity. The account for each participant in a hybrid plan is theoretical, and is not actually funded by employer contributions. The employer contributes to the plan as a whole (covering all eligible workers in the plan) to ensure that sufficient funds will be available to pay all benefits.  

Cash balance plans were the first type of hybrid plan, emerging in the late 1980s.1 Under a cash balance plan an employee’s hypothetical account balance is determined by reference to theoretical annual allocations based on a certain percentage of the employee’s compensation for the year and hypothetical earnings on the account. In a typical cash balance plan, a participant's account is credited each year with a pay credit (such as 5 percent of compensation from his or her employer) and an interest credit (either a fixed rate or a variable rate that is linked to an index such as the one-year Treasury bill rate).  

Another common type of hybrid plan is a pension equity plan or PEP. While pension equity plans and cash balance plans share methods of accumulating value, a major difference is the earnings used to determine the benefit. Cash balance plans specify a credit each year, based on that year’s earnings, whereas pension equity plans apply credits to final earnings (IRS Notice 2016-67). 

While traditional defined benefit plans specify the primary form of distribution as an annuity (with lump sums sometimes given as a optional form of benefit), hybrid plans specify the primary form of distribution as a lump sum, which can be converted to an annuity (see Treasury Regulation 1.411(a)(13)–1). Pursuant to Revenue Procedure 2019-20,  the IRS provides a limited expansion of IRS’s determination letter program for individually designed retirement plans to allow reviews of hybrid plans, as well as  merged plans. 

The Bureau of Labor Statistics has put together the following comparison table showing the similarities and differences between cash balance and pension equity plans. 

Conclusion

The term hybrid plan refers to a category of defined benefit plans that uses a lump-sum based formula to determine guaranteed retirement benefits. Cash balance and pension equity plans are the two most common types of hybrid plans. The provisions of the governing plan document will specify which type of hybrid plan a participant may have.