Hybrid Retirement Plans

W W W . W A T S O N W Y A T T . C O M

Hybrid Retirement Plans

University of Illinois

September 14, 2005

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Introductions

Julie [email protected]

Michelle [email protected]

Watson Wyatt Worldwide– 6,000 associates

– 90 offices in 32 countries

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What does Watson Wyatt do?

Consult with employers to design, finance and administer benefit plans to attract and retain employees

We balance these needs with the employer’s financial constraints

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What does Watson Wyatt do?

Benefits consulting – Retirement – Investment consulting– Group & health care– International– Workforce planning– Communication

Technology solutions

Human capital consulting

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Agenda

Hybrid Plans

Cash balance plans

Case Studies

Future of Retirement Plans

Questions

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Hybrid Plans

What are they?

Why were hybrid plans created?

Why would an employer be interested in a hybrid plan?

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Hybrid Plans

Defined contribution features

Defined benefit features

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Hybrid Plans

Characteristics – Defined benefit plans that are made to look and

act like defined contribution plans, or– Defined contribution plans that mimic accrual

patterns similar to defined benefit plans

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Hybrid Plans

Examples – Cash balance plan

Defined benefit plan that expresses a participant’s benefit with a hypothetical account balance

– Defined lump sum/Pension equity planLump sum at retirement based on pay credits (age

and/or service)

– Age/Service based profit sharing plansAnnual employer contributions (% of pay)Contribution % based on age and/or service

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Cash Balance Plans –

What is a Cash Balance Plan?

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Pension plans that define a participant’s benefit as a hypothetical account balance– Combines strengths of Defined Benefit and

Defined Contribution Plans– Account grows with annual pay-related credits

and interest credits– Employees receive lump sum or annuity at

retirement/termination

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Account is established for each employee (hypothetically, no actual asset allocated in the trust)

Each year the account is credited with a deposit equal to 6% of the employee’s pay

Each year the account is credited with interestequal to a public index (5.5%)

Example

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Contribution is based on 6% of pay; Salary increases are 4% per year;Interest credits are based on the published rate of 5.5% per year

Example

Year PayPay

CreditInterest

Credit Balance

#1 $50,000 $3,000 $0 $3,000

#2 $52,000 $3,120 $165 $6,285

#10 $71,166 $4,270 $2,154 $45,580

#20 $105,342

$6,321 $7,247 $145,327

#30 $155,933

$9,356 $17,660 $348,111

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Comparison of Benefit Accruals

0.0

1.0

2.0

3.0

4.0

5.0

35 40 45 50 55 60 65

Ben

efit

Val

ues

as

a M

ult

iple

of

Tota

l P

ay

Age at Termination or Retirement

Benefit Accrual

Employee age 35 with 0 years service. Base Pay of 50000 and Total Pay of 50000. Salary increase 4%.

1% Final Avg Pay6% Cash Balance Plan

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Transition from 1% Final Avg Pay to 6% Cash Balance – Winners and Losers

Ratio of New Plan Benefits to Current Plan Benefits

Benefits calculated as of Age 65

Completed Years of Service

0-4 5-9 10-14 15-19 20-24 25-29 30-34 35+

Curren

t Age

< 25

25-29

30-34

35-39

40-44

45-49

50-54

55-59

60-64

65+

111%

111%

111%

111%

111%

111%

111%

111%

97%

97%

97%

97%

97%

97%

97%

97%

84%

84%

84%

84%

84%

84%

84%

80% 94%

71%

70% 71%

69% 70% 71%

69% 69% 70% 71%

68% 69% 69% 70% 71%

67% 68% 69% 69% 70% 71%

65% 71% 72% 72% 73% 74%

Big Loss Loss Neutral Win Big Win

0% - 79% 80% - 94% 95% - 104% 105% - 119% 120% +

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Why Do CompaniesImplement Them?

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Why Do Companies Implement Cash Balance Plans?

Improve employee understanding and appreciation

Easier to communicate

Complement 401(k) plans

Attract and retain talent

Provide portable retirement benefits

Meets the company’s business strategy

Potential Savings

More stable costs

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Why Do CompaniesAvoid Them?

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Why Do Companies Avoid Cash Balance Plans?

Does not meet the company’s business strategy

Uncertainty regarding the future of these plans

Negative press

Transition issues– IBM

Legal issues– IBM (Cooper vs. IBM – age discrimination)– Xerox (Berger vs. Xerox – whipsaw issue)

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Legal Issues

Two employees, one age 25, the other age 55– Each receives a contribution credit equal to $1,000– Plan provides interest credits at the rate of 6% per year

– Age Discrimination claim because 55-year oldreceives a smaller retirement benefit at age 65

– Whipsaw issue if the age 65 account balance is discounted back to current age at a lower rate than 6%

Cash Balance Plans

25-year-old 55-year-old

A. Pay Credit 1,000 1,000

B. Interest credits to age 65 10,286 1,791

C. Account balance at age 65 11,286 2,791

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Proposed Pension Reform Legislation

Change the funding of pension plans

Hybrid Pension Plan legislation would: – Retroactively clarify the legal status of hybrid

plans for plans that are not currently subject to litigation;

– Establish retroactive conversion requirements; and

– Establish additional requirements for future conversions.

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Case Studies

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Employer View• What: Assess “alignment” by clearly

defining “desired state”• Why: Ensure benefits programs

meet business and HR goals

Employee View

• What: Consider employee expectations and perceptions by distinct segments of your workforce

• Why: Perception is stronger than reality…how your programs are perceived is how they ARE

Competitive View

• What: Review position in the relevant marketplace

• Why: Ensure that market positioning reflects strategic intent

Six Views

Workforce View• What: Demographic analysis &

forecasting to customize recommendations to the unique make-up of your workforce

• Why: Averages are misleading; we need to dig into details to know where risks are hidden - where you may have challenges recruiting and retaining over time

Financial View• What: Assess financial impact

and return on investment of current and alternative designs

• Why: Understand costs and cost drivers before recommending changes

Environmental View• What: Determine which non-design

factors may affect program acceptance

• Why: Changes to environmental factors may be more powerful - and less costly - than changes in design

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Sample Conversion Questions

Given:

An employer is considering a pension plan redesign.

The plan currently provides a benefit equal to 1.5% of a participant’s final average compensation multiplied by years of service.

The employer is considering a cash balance plan that provides a benefit with pay credits equal to 3% of pay.

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Why would an employer consider this change?

Reduced volatility

Less expensive plan on an ongoing basis

Enhanced employee understanding

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How will employees view this change?

Reaction will depend on management’s relationship with employees

Employees will want to understand the reason for the change

Reactions will vary dramatically depending on employees’:– Individual situation– Understanding of the current plan and the

difference in these types of plans

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Other Issues

How will the costs of these programs compare?

Does the proposed plan provide competitive benefits?

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Case Study A

Large manufacturer wants to review current benefit programs

Mature population in decentralized locations

Employer has maintained an extremely paternalistic culture to date

Current Business Situation

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Case Study A (cont.)

Mostly rural locations where company is major employer in town

Publicly traded company with mandate to reduce costs

Company has grown through acquisitions


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Objectives for Retirement Program – Case Study A

Facilitate integration of acquired companies

Share responsibility between employer and employee

Provide minimum floor of protection

Improve perceived value of program

Provide competitive program

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Objectives for Retirement Program – Case Study A (cont.)

Improve employee understanding

Provide a program that does not encourage retirement at a certain date

Maintain a cost neutral program

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Case Study A – Current Program

Pension Plan:– 2% of Career Average Pay payable at age 65– Unreduced benefits payable at age 60– Subsidized early retirement provided at age 55

with ten years of service.– Eligibility is after 1 year of service– Vesting is 100% after 5 years.

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Case Study A – Current Program (cont.)

401(k) Plan:– pre-tax deferrals– 50% match on deferrals up to 3% of pay

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Case Study A – Current Costs

Present value of pension benefits for active participants

– $1,200 M

Matching contribution– $10 M

Total - $1,210 M

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Case Study A

Given this situation, what would your proposed plan design be?

How would your proposed design satisfy the objectives?

How do you think the employer/employees will respond to your proposal?

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Employer Proposal

Discussion

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Employee Proposal

Discussion

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Case Study B

Two liked size companies merge and a year later merged company acquires three smaller businesses

Logistics company

Company is re-branded

IPO likely in near future

Low margin business

Paternalistic culture at the two original companies


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Case Study B – Background

Company A Program – 1.5% final average pay pension plan– 401(k) pre-tax contributions with discretionary matching

contribution– a retiree medical and life program

Company B Program– No pension plan– 100% match up to 3% of pay

Smaller acquired businesses– No pension plan– 50% match up to 6% of pay

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Case Study B – Objectives

Integration of companies

Build retirement program consistent with business goals

Reduce costs of programs

Create a program which will attract and retain employees

Promote joint responsibility for retirement

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Case Study B

Given this situation, what would your proposed plan design be?

How would your proposed design satisfy the objectives?

How do you think the employer/employees will respond to your proposal?

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Case Study B – Employer Proposal

Discussion

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Case Study B – Employee Proposal

Discussion

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Baby boomers are retiring

Uncertainty regarding social security system

Employer sponsored plans

Phased retirement

Retirement age

Health

Life expectancy

Pension reform

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Retirement Consulting

Design retirement programs based on changing objectives

Determine cash flow for plans– Contributions satisfying ERISA requirements– Benefit Payments

Calculate pension expense under FASB # 87 and 132 and IAS #19 accounting standards

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Retirement Consulting (cont.)

Calculate benefits

Perform budget planning calculations

Asset liability modeling

Non-discrimination testing

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Questions

Documents

Hybrid Retirement Plans