Replacing Traditional Defined-Benefit Plans with Hybrid Plans

Many large employers have replaced traditional defined-benefit plans with hybrid plans­—most commonly with cash balance plans, which describe their benefits in terms of individual account balances. Benefits are based on a hypothetical individual account that is allocated a pay credit from employers, plus an annual interest credit. Unlike a 401(k) plan, benefits are not solely tied to the performance of the plan’s investments. Pension experts are exploring the potential for other hybrid plans that will better allocate investment, interest, and longevity risks between the plan sponsor and the participant.

The conversion of a traditional defined-benefit plan to a cash balance plan can negatively affect older workers. Older, longer-serving employees may work for many years after a plan conversion without receiving any additional pension credits under the new cash balance plan (an effect often called “wear-away”).

The Pension Protection Act (PPA) addressed these issues, but only on a prospective basis. It redefined the methods for reducing an employee’s pension accruals based on age, but it still required employers to provide older workers with benefits equal to those of younger workers with identical tenure and wage histories. Lastly, the PPA permitted hybrid plans to distribute the participant’s account balance only if certain requirements are met. Federal law was amended to require notification not only of changes to the plan, but also of the impact of these changes. Internal Revenue Service regulations implementing this change have been issued.