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Benefits Column

A New Dawn for Hybrid Pension Plans?

Many congressional leaders share the widely publicized view that the 401(k) as we know it has "failed." The pension reform act offers some design reforms, but increased tax preferences and other innovations may be seen in the coming year as well.

Monday, November 27, 2006
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November brought us a split-party national government, more questions about the intent(s) of the Pension Protection Act, more announcements of employer freezes of traditional defined-benefit plans (including the parent company of the largest Dallas newspaper), and more contradictory court decisions on past conversions to cash-balance plans. The Pension Benefit Guarantee Corporation announced a substantial reduction in its deficit, and a $100 billion improvement in its calculation of the funded status of all DB plans.

Against this backdrop attendees at a Federal Reserve Bank of Boston/Boston University conference heard a union official speak of the likely end of traditional defined-benefit pensions and their replacement with hybrid plans that would avoid unfunded liability and would only provide for payment of life income annuities.

Most of the other speakers at that conference focused on the "failure" of 401(k) plans and the need to "make them look and act like defined-benefit plans".

Conferences throughout the fall -- following the passage of the PPA -- were dominated by these last two points: (1) 401(k) failure and (2) make them look and act like defined-benefit plans.

The draft regulation from the U.S. Department of Labor on "default investment safe harbors" moves 401(k) plans in that direction by requiring that employers move participants into equity portfolios (and the assumed higher rates of return higher risk brings), while denying safe-harbor status to fixed return options. The months ahead will bring many new PPA regulations that will serve to remake 401(k) plans.

A number of consultants have written that, in this new environment, hybrid plans may make more sense than an "enhanced" 401(k). They note the focus of the Congress and plan sponsors on the expansion of annuity options in 401(k) plans, contrasted with the very low rate at which individuals choose annuities, as an argument for moving to a hybrid that only provides annuity payouts.

They add to this, the ability to achieve desired asset allocation at lower expense with a hybrid, as opposed to an enhanced 401(k), and the ability to retain extended vesting in order to focus contribution dollars on workers that remain for at least five years.

These are the same attributes that labor finds appealing. Constant plan cost as a percentage of payroll. Investments set by the trustees. The greatest retirement income efficiency per dollar contributed for workers that do not churn thorough extended vesting and annuity-only payouts.

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Many in the new congressional leadership, and in unions, would like to see tax preferences for retirement focused on plans that have the greatest probability of actually providing life income in retirement.

For decades they focused their attention on traditional defined-benefit annuity-only plans to achieve this end, but they are moving toward recognition that changes in our economy now beg for an alternative.

They share the widely publicized view of business that the 401(k) as we know it has "failed," which contributed to overwhelming bipartisan passage of PPA with its many "reforms" to move 401(k) plans towards design changes that will, hopefully, bring with them greater retirement plan effectiveness.

They ask, however, as many plan sponsors may ask as well, can we achieve more retirement income, with less expense and trouble, with a hybrid design? As the Internal Revenue Service publishes PPA guidelines on "legal" cash-balance plans in the months ahead, we are likely to see new hybrid plan innovations and a second wind for annuity income-only retirement plans.

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