In the past few articles, we have seen how defined benefit, as well as defined contribution schemes, work. We have also seen how the pros of defined contribution schemes are the cons of defined benefit schemes and vice versa. The end result is that the employee is forced to choose between the two types of pension schemes. However, that need not necessarily be the case. It is possible and even desirable for employees and employers to work collaboratively toward managing the risk associated with pension funds.
As a result of financial innovation, there are several types of hybrid schemes which have come up over the years. These hybrid schemes share some of the characteristics of both defined benefit plans as well as defined contribution plans. This means that the risk related to the pension funds does not have to be completely borne by either the employer or the employee. Instead, this risk can be equitably split between the two parties. In this article, we will have a closer look at the various types of hybrid pension schemes as well as the manner in which they operate.
Types of Hybrid Pension Schemes
Over the years, several forms of hybrid pension schemes have experimented in the market. Some of the prominent variations of the hybrid schemes have been mentioned below:
- Combination schemes are quite popular amongst many employers and employees. Combination schemes are a combination of defined benefits as well as defined contribution plans. Hence, a percentage of the funds contributed are allocated towards defined benefit plans whereas another percentage is allocated towards defined contribution plans. The end result is that the risk is not borne by either party but is shared between the two. However, such plans can become quite complicated and the average retiring employee is unable to understand the workings of these plans.
- Final salary lump schemes are also a hybrid between defined benefit as well as defined contribution schemes. Under this scheme, the employer guarantees the amount of money that they will pay to the employee as a lump sum during retirement.
For example, an employer may pay 10% of wages for every completed year of service. Hence, if a person has worked in the same company for 40 years, then they will be eligible to receive 400% of their annual salary as a lump sum. This money is then used to buy pension annuities at the market rate. Hence, the employer is only responsible for providing a fixed sum till the retirement date. The monthly payment which the employee will receive will still be bound by the market rate.
- Self-annuitizing schemes are the opposite of fixed salary lump sum schemes. Here too, the risk is shared between the employer and the employee. However, the components of risk-sharing are reversed.
This means that the first component i.e. the contribution of money into the scheme is done at the market rate. Hence, the employer and employee keep adding money to the pension scheme. This money keeps growing based on the rates which are prevailing in the market. However, when the employee retires, the lump sum is withdrawn from the markets. At that time, the employer takes responsibility for the lumpsum and promises monthly returns which are in excess of the market rate being offered.
- Underpin schemes are another form of a hybrid pension scheme. As a part of this scheme, the calculation for the payout of benefits is based both on the defined benefit as well as the defined contribution basis. The customer is finally paid out the higher of the two calculations as benefits.
Underpin schemes were mainly offered when the transition from defined benefit plans to defined contribution plans was initiated. At that time, employees were scared that they would lose their life savings in case the market went down. Hence, they were guaranteed the minimum payout of a defined benefit scheme if such an event ever took place. Over the years, underpin schemes have been used by some other companies as well.
- Cash balance schemes are like defined contribution schemes in the sense that employees have to contribute money to this scheme. After such a contribution is made, they do not have to rely on the market returns for the money in their account to grow. Instead, the employer provides a fixed rate of return on the investment. This helps smoothen out the unpredictability in the markets to some extent. However, a large portion of the risk is still passed on to the employee via such schemes.
- Fixed benefit unit schemes are schemes in which member accumulates a fixed sum of money for every year of completed service. Usually, there is no link to the amount of money being earned by the employee. The contribution to the scheme is independent of the earnings. This is not beneficial for medium to high-wage earners since the amount being contributed towards retirement is not commensurate with their incomes.
From the above examples, it is evident that a wide variety of hybrid schemes exist in the pension market. However, even after many years, they account for a small portion of the market which is still largely dominated by defined contribution schemes. It is also true that the awareness of hybrid pension schemes has been increasing over the years.