In my article published here in May, I presented an overview of hybrid plans&#8212plans that deliver the better of a defined benefit(DB)promise and a defined contribution(DC)account balance. The focus of this article will be to provide a little more detail about the design of hybrid plans by looking at an example. In addition, I will touch on how such a plan might fit into the total rewards structure of an employer, a topic rightly raised by a respondent to the previous article.

As a starting point in the design, consider the following question: What contribution would be needed in order to provide a 1% final three-year average benefit for an employee who participates in a plan from age 30 to age 65? While most employers would not expect that the typical employee will work for one employer for 35 years, the question helps define a reasonable relationship between the DB benefit and a DC contribution. It turns out that if you use reasonable(but conservative)assumptions, a 9% annual contribution can provide a 1% DB benefit for an employee retiring at age 65 with 35 years of service. This result assumes that the DB benefit is paid on a level basis. If instead, the benefit is fully inflation protected, the annual contribution would need to be 12%.

With this information as background, the hybrid plan might be designed as follows:

• DC component: 5% of earnings contributed by both the employer and the employee for a total contribution of 10%
• DB component: 0.8% of final three-year average earnings for each year of employment, with no inflation protection

In the event that an employee terminates before retirement, in almost all circumstances, the DC account balance would be larger than the value of the DB benefit. Even at retirement, the DC account balance would often be larger. In the event of poor investment performance, very low bond yields, or a combination of the two, the DB component provides the employee with a safety net.

From a tax perspective, the “Factor of Nine,” used to determine the annual Pension Adjustment(PA), values the DB component at a lower level than the DC component. So, the PA is based on the DC component, which is what the plan will deliver in most circumstances. This is a far better result than the typical hybrid plan in 1990, which often had a more generous DB component than our example. This design, coupled with high bond yields resulted in PAs being determined based on the DB component, but typically paid benefits based on the DC component.

How does this design fit into the pension component of an employer’s total rewards strategy? Like a DC plan, the hybrid plan encourages employee participation and a sense of shared responsibility for retirement planning. And, with the safety net provided by the DB component, employees will likely feel that their employer cares about their well-being. This is significant when you consider that Towers Perrin research found that the top driver of employee engagement in Canada is employees’ belief that senior management cares about their well-being.

Why would an employer be interested in financing this safety net? The main benefit that an employer would get from this design is that they would retain a tool for workforce planning. As an example, the safety net might be more attractive to certain employee segments and function well as an attraction/retention tool. Alternatively, in the event of a short-term need to accelerate attrition, the employer could offer an “early retirement window,” providing an attractive and tax-effective alternative to paying cash severance amounts. Although, given the upcoming changes to the Canadian workforce at large, we expect that the attraction/retention piece of this equation will be more important.

As set out in the first article in this series, there are a number of issues that an employer would still need to explore before deciding whether this design is right for their organization.

• What should the funding policy and related contribution strategy for such a plan look like?
• How should the DB portion of the plan be invested?
• What investment options, if any, should be offered to plan participants?
• How should the plan be communicated to participants?

The balance of this series of articles will address these issues.

If you’d like to comment on this story, click here.

For more about our Online Expert Panel, click here.

Copyright © 2018 Transcontinental Media G.P. Originally published on benefitscanada.com

Benefits Canada Newsletter

For the latest industry news and opinions, sign up for our daily newsletter.