Pension Reform: New Mandates for Hybrid Plans

Pending pension reform would attempt to clear up the legal ambiguity surrounding hybrid plans and would impose new restrictions on conversions of traditional defined benefit plans to hybrid plans. But the new rules may leave existing plans in legal limbo.

Clarification in House and Senate Pension Legislation

Pension reform legislation pending in the House and recently passed by the Senate would prospectively settle the legal status of hybrid plans.

Under the Pension Protection Act (PPA, H.R.2830), hybrid plans would not violate age discrimination law as long as the accrued benefit for an older worker was the same as the accrued benefit for a similarly situated younger worker. The clarification would be effective after June 29, 2005.

In the Senate, the Pension Security and Transparency Act (PSTA, S.1783) also aims to clar-ify the legal status of hybrid plans. Under that act, a "qualified cash balance" plan — a plan that met specific vesting and interest-crediting requirements — would not violate age discrimination law simply because younger participants had more time to earn pay and interest credits. The act would become effective after July 31, 2005.

Although the PPA and PSTA include "no inference language" — language providing that the legislation does not govern earlier hybrid plan designs or conversions — their prospective nature could leave existing hybrid plan sponsors vulnerable to charges of age discrimination in the past.

Senate Bill Includes New Mandates and Conversion Standards

The PSTA would legally sanction qualified cash balance plans. To be qualified, a cash balance plan would have to fully vest all participants after three years of service and meet interest-crediting requirements. The interest-crediting rate could not fall below the federal midterm interest rate or rise above the interest rate on amounts conservatively invested in long-term corporate bonds. Hybrid plans that violated these conditions would not be protected under the PSTA.

The PSTA would also impose new restrictions on future conversions of traditional defined benefit plans to hybrid plans. All such conversions would have to be to a qualified cash balance plan. Employers would have to meet one of the following conversion standards:

• Disallow any wear-away of the participant's early or normal retirement benefit and either:
  • Give all affected participants the larger of the accrued benefit under the old plan formula or the benefit under the new plan formula for the first five years after the conversion
  • Give participants who were 40 or older and whose combined age and service equaled at least 55 either the larger benefit under the old or new formula, or let them choose between the old and new formulas
• Allow all participants to choose between the old and new formulas, or give them whichever benefit would be larger
• Provide additional credits or a higher opening account balance to bring the benefits up to what would be provided under the first two conversion techniques, under regulations issued by the U.S. Department of the Treasury

If plan sponsors allowed participants to choose between the traditional and the hybrid plan, other requirements would kick in. The plan sponsor would have to give participants sufficient information to project benefits under both plan formulas and model the effects of their decisions. The information would also have to describe circumstances in which the participant might not receive expected benefits. And plan sponsors could not make other benefits, such as retiree health benefits or 401(k) benefits, conditional on the participant's election.

Next Steps

The Senate approved the PSTA, and the House Ways and Means Committee approved the PPA this month. Even if the House and Senate approve these pension reform bills, important and contentious differences remain to be resolved, especially relating to hybrid pension plans.

Enacting any hybrid plan provisions this year could have significant consequences for sponsors of existing hybrid plans, as well as for plan sponsors that have been waiting for legal clarification of hybrid plans before settling on a benefits strategy.