Cash Balance and Other Hybrid DB Plans Are Here To Stay

On October 18, 2010, the IRS published final regulations, and a new set of proposed regulations, governing cash balance (“CB”) and other hybrid defined benefit pension plans. This article:

  • reviews what hybrid plans are and how they work;
  • reviews some of the controversy associated with hybrid plans; and
  • briefly discusses the most recent IRS guidance.

The new rules are lengthy, broad, complex, and often involve actuarial concepts that are beyond the scope of this article. If you have any questions concerning the new regulations and how they work, please contact one of our attorneys for more information.

What Is a Hybrid Plan?
Over the past several decades, the number of traditional defined benefit pension plans (“DB plans”) has been decreasing. Employers have been moving away from restrictive legal requirements for DB plans, unpredictability in amounts of contributions required, and the long term benefit payment obligations associated with the annuity forms of benefits that accompany them. Some employers have moved from DB plans to defined contribution plans (“DC plans”), such as 401(k) plans, which shift all of the risk of investment loss to the plan participant. However, other employers have taken the middle ground and have begun to offer hybrid plans, which combine aspects of both traditional DB plans and the somewhat more modern DC plans.

Although they contain some features of DC plans, these hybrid plans are DB plans for purposes of the Internal Revenue Code (the “Code”) and the Employee Retirement Income Security Act of 1974 (“ERISA”), the federal laws that govern retirement plans.

This means that they are subject to all of the provisions of the Code and ERISA that are applicable to DB plans, including funding obligations and insurance by the Pension Benefit Guaranty Corporation.

There are many different types of hybrid plans, but the two most popular are CB plans and pension equity plans (“PEPs”).

How Does a Hybrid Plan Work?

Cash Balance PlansCB plans contain elements of both DB and DC plans. They resemble DB plans because benefits accrue according to a fixed (defined) formula in the plan, the employer is responsible for funding the plan, and the employer bears all the risk of investment losses incurred by the plan. They resemble DC plans because participants’ benefits are expressed as an account balance (albeit, a hypothetical account balance because plan assets have no true relevance to promised plan benefits) that is payable as a lump sum upon retirement.

A participant’s hypothetical account balance in a CB plan is determined by two factors. The first is a “pay credit,” and the second is an “interest credit.” The pay credit is an amount that is credited annually to a participant, and is most commonly a set percentage of the participant’s pay, but can also be graded based on age and/or years of service or a preset dollar amount. The interest credit is the amount of interest that the plan sponsor has specified that it will pay on a participant’s account balance for the year.

Pension Equity Plans
PEPs are similar to CB plans because the benefit payable from a PEP is also expressed as a lump sum amount. However, the lump sum from a PEP is typically a percentage of final average pay. Under a PEP, participants earn percentage points based on age or service, which is applied to final average pay upon retirement, instead of the annual pay and interest credits earned in a CB plan.

Why Would an Employer Choose a Hybrid Plan over a Traditional DB Plan?
The biggest advantage of maintaining a hybrid plan over a traditional DB plan is that the benefit under a hybrid plan is expressed as an account balance payable in a lump-sum. Benefit calculations under a traditional DB plan are often very complicated and based on many factors, some of which have to be actuarially determined, using a projected date of death of the participant and projected interest rates. Often, these calculations can be overwhelming to participants, making it difficult for them to understand exactly how their benefits are being calculated and administered. With a hybrid plan, participants can more easily see and understand their benefit when it is expressed as a hypothetical account balance.

Controversy and the Road to Stability

Legal ControversyBeginning in the late 1990s, some participants whose plans had converted from traditional DB plans to hybrid plans were dissatisfied with the new formula that was being used to determine their retirement benefit. Many took legal action, claiming that CB plans were age discriminatory because younger participants received more interest credits than those nearer to retirement. For example, if two employees, one age 25 and one age 60, each receive a pay credit of $5,000 in 2010, because of the accumulation of interest credits, this $5,000 pay credit will be significantly more valuable to the younger employee when he or she reaches retirement age (say age 65) than it will be to the older employee when he or she reaches age 65. This may seem like a reasonable and natural result of the fact that the younger employee is 40 years from retirement while the older employee is only 5 years from retirement. The problem, however, is that under the law, the benefit payable from a defined benefit plan is normally stated as a benefit payable at retirement age. Thus, stated as a retirement age benefit, the younger employee’s benefit is much larger.

In addition, many participants were distressed by the manner in which their traditional DB plan benefit was converted to a CB Plan benefit. Under a common conversion technique known as “wear away,” upon conversion to a CB plan participants were credited with a hypothetical CB account (often using the account balance the participant would have earned if the CB plan was in place their entire career). For many participants, this hypothetical account was much less than the present value of their accrued benefit under the traditional DB plan at the point of conversion (which represented the minimum amount the participant could be paid from the plan). Under the wear away method, a participant did not accrue any additional future benefits from the plan until the CB benefit (including pay and interest credit following the conversion) caught up to the value of the traditional DB plan benefit at the time of the conversion. For some, the net effect of the wear away was a temporary freeze on benefits that could have lasted for years.

Even plan sponsors who decided to avoid the perceived draconian effect of the wear away, and employed a conversion method that provided participants with the “greater of” the benefit they earned under the traditional DB Plan formula or the CB plan formula were challenged by the IRS, which claimed that such a conversion method violated the rules against back-loading benefits.

Another worry for plan sponsors involved what is known as the “whipsaw effect.” This occurred because plans were required to calculate a participant’s actual benefit payment by projecting a participant’s (hypothetical) account balance to normal retirement using the plan’s interest crediting rates, converting that amount to an annuity payable at normal retirement age, and then discounting that annuity to a minimum single sum present value amount based on statutory defined interest rates. The end result was a benefit payment that was greater than the participant’s hypothetical account balance, an obvious disappointment to plan sponsors.


Eventually, all the federal circuit courts determined that CB plans were not inherently age discriminatory and Congress memorialized those decisions in the Pension Protection Act of 2006 (“PPA”). The PPA also addressed the “wear away,” “greater of” and “whip saw” issues mentioned above. For a further description of the changes that the PPA made regarding hybrid plans, please see Robert Schwartz’s article, Cash Balance Plans — A Clearer Future? from our November 2006 issue.

While the PPA confirmed the legality of hybrid plans and provided some guidance on how to administer them, a lot of guidance was still needed, as is the case with most statutory changes. On January 16, 2007, the IRS issued Notice 2007–6, lifting the then existing moratorium on processing determination letters for DB plans intending to convert to CB plans, and providing some guidance on the implementation of the provisions enacted by the PPA. The IRS then issued proposed regulations in December of 2007, and on October 18, 2010, issued final regulations plus a new set of proposed regulations.

New Guidance
The final regulations adopt the majority of the guidance from Notice 2007–6 and the December 2007 proposed regulations, with some clarifications, and the 2010 proposed regulations expand that guidance.

The following is a brief overview of the final regulations (or proposed regulations where noted).

  • Applicable Defined Benefit PlansApplicable Defined Benefit Plans (plans subject to these rules) are described as “statutory hybrid plans,” which have a “statutory hybrid formula.” A statutory hybrid formula is a lump sum based formula or a formula that has an effect that is similar to a lump sum based formula. The final regulations clarify that if a PEP formula provides for interest credits after PEP accruals have ceased, the formula generally will be considered a “lump sum based benefit formula.”
  • Safe-Harbor Present Value DeterminationsThe current benefit (e.g., hypothetical account balance) under a statutory hybrid formula is deemed to be the present value of the accrued benefit, without having to project the benefit using interest credits to normal retirement age and then discount that benefit using the IRS minimum lump sum interest rates. This eliminates the “whipsaw effect.”

    The 2010 proposed regulations contain additional rules for satisfying the safe-harbor present value determination.

  • Full Vesting after 3 Years of ServiceUnder the PPA, benefits under a statutory hybrid plan must fully vest after 3 years of service. The final regulations apply this rule very broadly. For example, the 3-year vesting requirement applies to a participant’s entire benefit under the hybrid plan, not just the portion of the benefit that is calculated under a statutory hybrid benefit formula.
  • Alternative Age Nondiscrimination TestingThe final regulations offer an alternative test for determining whether the plan improperly discriminates in favor of younger participants. The alternative test generally permits plans to compare the current hypothetical account balances of participants at different ages as opposed to their benefits projected to normal retirement age.
  • Market Interest Rate RequirementIn order to satisfy the age nondiscrimination requirements, a statutory hybrid plan must not credit interest at a rate greater than a market rate of return. The final and proposed regulations offer wide flexibility for satisfying this requirement. The proposed regulations anticipate that relief from ERISA’s anti-cutback provisions will be granted to plans that have to decrease the rates at which they credit interest in order to comply with the new market interest rate requirement.
  • Prohibited ConversionsUnder the PPA, the conversion of a traditional DB plan to a statutory hybrid plan violates the age nondiscrimination rules unless the plan precludes a “wear away” of a participant’s traditional DB plan accrued benefit. The final and proposed regulations include detailed rules for determining whether a conversion has occurred and whether the pre-conversion accrued benefit is appropriately protected.

On November 30, 2010, the IRS issued Notice 2010–77, which generally extends the deadline for amending a hybrid plan to comply with the final regulations to the last day of the first plan year that begins on or after January 1, 2011 (December 31, 2011, for calendar year plans).