Over the last decade, economic, demographic, and political pressures have led state and local governments to consider alternatives to their traditional defined benefit (DB) pension plans. While a few have switched to defined contribution (DC) plans, others have turned to hybrid approaches that combine DB and DC plan features. Hybrid plans can help governments reallocate retirement costs and risks while continuing to provide sustainable lifetime retirement benefits.
A variety of hybrid plan designs exist, including pension equity plans, floor offset plans, target balance plans, cash balance plans, and combined DB/DC plans. However, only two designs are currently used by state and local governments: combined DB/DC plans and cash balance plans.
THE KINDS OF PLANS
Combined DB/DC Plans. Public-sector hybrid plans are often developed as separate but coordinated DB and DC plans. The DB portion of the benefit is typically funded by the employer, and benefits are based on a modest multiplier (e.g., 1 percent or 1.25 percent of final average salary) times years of service. Retirement eligibility and distribution options are usually similar to those of a DB plan, but might be less generous (e.g., based on a longer period for determining final average salary or requiring later ages for retirement eligibility). The DC portion is typically based on mandatory minimum employee contributions, although additional voluntary employee contributions might be allowed. Upon retirement, the employee's DC account can be distributed as a lump sum or roiled over. In many cases, the DC account can be converted to an annuity.
Cash Balance Plans. While most public-sector hybrid plans use the combined DB/DC approach, a few are cash balance plans. Under this design, individual accounts are established for employees and credited with a fixed percentage of the employee's pay (e.g., 6 percent). In this respect, they function much like DC plans. Additionally, interest is credited to the individual's account based on a rate established by the plan. Consequently, in this respect, they are like DB plans, since the interest rate is guaranteed. Upon retirement, the accumulated account balance can be paid as a lump sum or converted to an annuity. Public-sector cash balance plans are often funded by both the employer and employees.
ALLOCATING RETIREMENT RISKS AND COSTS
Key retirement risks include investment risk, longevity risk, and inflation risk.
* Investment risk is the risk that investment earnings will fall short of the amount required to pay the benefits.
* Longevity risk is the risk that plan participants will live longer than expected and, therefore, require greater assets at retirement than originally assumed.
* Inflation risk is the risk that price increases will lower the benefit's purchasing power over time.
These risks affect retirement plan costs, since adverse risk experience (e.g., low investment returns) increases benefit costs, while favorable risk experience (e.g., high returns) lowers costs. Exhibit 1 shows how these risks are allocated to employers and employees through DC, DB, and hybrid plan designs.
Generally, the risks fall on the employee in DC plans and on the employer in DB plans, and in hybrid plans, the risks are allocated between the employer and employees. However, in DB plans, investment risk can be reduced through professionally directed asset allocation, and investment costs can be reduced through negotiated investment management fees. Nevertheless, as a DB plan matures and the size of its fund increases, the investment risk grows in dollar amount and as a percentage of payroll.
There are two kinds of mortality risk--individual mortality risk and population mortality risk. In DC plans, employees must accumulate account balances that are sufficient to pay benefits over each individual employee's retired lifetime (e. …