Best practices in hybrid retirement plan design

Introduction

The hybrid retirement pension plan design, a design that typically combines a guaranteed benefit and 401(k) style individual retirement account, has seen ever-increasing interest from public sector employers in the United States since the market downturns of the late 2000s. Although hybrid retirement plans have been around for decades—notably one of the first adopters being the Federal Employee’s Retirement System—most stakeholders know relatively little about their purpose and possible structure.

A hybrid plan’s goals are no different than any other retirement benefit design’s goals: to provide adequate benefits to workers at an affordable cost to them and their employers. Yet hybrid plans are also beginning to help answer a political question in the wake of the stock market volatility in the last 20 years: What is the appropriate level of risk that employers should shoulder to provide retirement benefits to their employees? The viability of future traditional defined benefit pension plans may depend on a common outlook on this question from both employers and participants.

The recent shift toward offering hybrid plans to newly hired government employees suggests that governmental employers may be changing their perceptions of the balance of financial risk between employees and employers and whether governments should put greater risk of investment returns on employees by distancing from the traditional defined benefit pension. Employee and labor associations on the other hand, often have extreme— whether fair or not—biases against the 401(k)-style defined contribution retirement plans that are typical in the private sector.

The hybrid retirement plan offers policymakers and stakeholders a potential compromise between the two opposing viewpoints, potentially offering a “best of both worlds” blended approach.

As with the design of any pension system, the quality of a hybrid plan comes down to how it is structured. A well-designed hybrid strikes a proper balance of risk between employees and employers while putting career-long employees on a secure path to retirement and granting non-career members the flexibility they need to get the most out of their retirement contributions. Intelligently designing the defined contribution portion of the benefit is crucial, as generally half of the hybrid employee’s retirement benefits will be paid out of their accumulated assets.

When designing the DC, policymakers need to ensure proper contributions are being made by employees (and sometimes employers), grant a wide array of investment options, and offer annuities to guarantee lifetime income.
Although the path to an adequate retirement benefit may look different from a traditional pension, intelligently designed hybrids have nonetheless shown to provide relatively similar pension benefit accruals for employees—at a much lower risk to the states and local governments who provide them.

Full Policy Brief: Best Practices in Hybrid Retirement Plan Design